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The S&P500 has gone over 1,000 days without a 10% drop, the third longest stretch in the past 25 years. Since October 2011, when the S&P500 was wrapping up a five-month, 19% decline, the stock index has rallied 80% without a 10% correction getting in the way. While that uninterrupted strength in the stock market is not, in and of itself, enough to cause a correction in stock prices, it does point out that we have entered into a period of higher risk for stocks in general. Such an uninterrupted gain is not without precedent, it happened for just under 7 years in the 1990’s and 4.5 years in the last decade, as shown in the chart below. However, in both of those prior cases the ending was quite ugly as both periods preceded major bear markets. While we don’t currently see the typical economic and interest rate signals that we see near the end of a bull market, we do see many indicators that suggest stock prices are ‘ahead’ of the near-term fundamentals supporting them, and that some of those ‘supports’ could quickly turn into headwinds instead of tailwinds!
While the 2nd quarter earnings reports have been beating consensus estimates, we have to be aware of the recent economic data, particularly from Europe, which is losing momentum again, probably due in some part to the Russian trade sanctions and their large impact on that region. Some of the more worrying points about stocks are coming from the action of the market itself, including the deteriorating ‘breadth’ of the market. This refers to the number of issues participating in the advance. Bull markets in their early stages tend to have ‘increasing breadth’ (i.e. more stocks joining the advance as the indices move higher) while ‘declining breadth’ is more indicative of a market advance in its later stages. The table below shows that as the S&P500 Index has moved to subsequent news highs over the past year, almost every new high in the index has seen fewer new highs in individual stocks, with the most recent peak in the index seeing only 173 new highs, well below the 472 daily new highs seen when the market hit a new high last October.
Another area of support for the stock market that is likely to go away is the low interest rate policy of the central banks, particularly the U.S. Federal Reserve (the ‘Fed’). Looking at the current economic conditions in the U.S. there would be very few strategists who would say that the ‘zero interest rate policy’ in place is the correct one. This is still a holdover from the Financial Crisis that is quickly running out of effectiveness and is no longer appropriate for an economy where the risks between inflation and deflation are now much more ‘balanced.’ The bottom line is that the only way this easy policy will stay in place is if the economy starts to lose momentum again. Otherwise the risk of inflation will rise. The Fed’s current policy mistakes are eerily reminiscent of the ones made by Chairman Greenspan in the early 2000s. Following the implosion of technology stocks in 2000-2001, the ‘Greenspan Fed’ kept interest rates at 2 percent or lower for the following three years. Low interest rates, along with deterioration in mortgage underwriting standards, led to huge increases in housing prices. We all remember how badly that turned out as the housing crisis in the U.S. helped to create the financial crisis that brought on the global recession in 2008. Logic certainly suggests that the Fed will not want to make that mistake again!
The aggressive interest rate moves of the U.S. Federal Reserve following the financial crisis have helped create strong stock markets and a recovery in the housing market which have, in turn, lead to a sharp increase in the net worth. Aggregate household net worth in the U.S. has increased by $26 trillion to $82 trillion (an all-time high) since the first quarter of 2009. But the Fed’s goal was not simply to make people wealthier (which they did). Rather, they have been operating under the assumption that higher asset prices would lead to plentiful jobs and higher incomes for everyone. But the result has not been the spending surge they expected but rather a more conservative approach of paying off the record debt levels accumulated during the housing boom last decade. We highlighted the chart below in our letter last month as well as it shows how household debt is getting paid down since the financial crisis. This is the main reason why the wealth created from ultra-low interest rates and the recovery in the stock market has not worked its way into consumer spending and job creation. Corporations have been similarly ‘tight’ with their record cash balances, choosing to use the funds to buy back their own stock or supplement their growth with acquisitions, as opposed to putting the money directly into business expansion, capital spending and greater employment growth.