S&P500 Continues to Climb Higher

April 22, 2019

Despite two weeks of weakening US economic data, the S&P500 continued to push higher. As of Friday’s close….at 2,905….the large cap index now stands at less than 1% below its all time highs, highs reached last fall, about seven months ago.

So without any major news or developments, the S&P500 has almost recouped its entire 20% loss, the loss that peaked at the end of December 2018.

Over these last two weeks, industrial production missed badly. Wholesale trade also missed. Factory orders shrank. Consumer and producer inflation came in hotter than expected. On the positive side, retail sales have rebounded slightly from their abysmal drop two months ago. And initial jobless claims continue to hover near 40 year lows.

At the same time, the Federal Reserve’s balance sheet continues to shrink, which is ironic because when the S&P500 was bottoming in late 2018, many experts were pointing to the Fed’s quantitative tightening as one of the leading culprits behind the market losses. But now, several months later….after the S&P has bounced massively….the Fed’s balance sheet is substantially smaller than it was in December 2018. Apparently, the impact of the Fed’s balance sheet is less than many experts had feared it was.

The technical picture for the S&P is now mixed. The weekly charts are now solidly bullish, but the daily charts are starting to show some weakness. Perhaps a modest pullback is around the corner; even a 2-4% drop would be sufficient to satisfy the weakness shown in the daily charts.

Finally, our Simple Rule is still bullish, after temporarily turning bearish a couple of months ago. That said, the fundamental components of this Simple Rule are weakening; while they’re still positive, it would not take much more weakening in US fundamentals to flip them to a bearish stance. Let’s see what the US economic data does over the next several weeks.

S&P500 Continues to Rally as the Fed’s Balance Sheet Shrinks

April 8, 2019

Impressively, the S&P500 gained another 2% last week. Volume was light, and volatility inched downward. This most recent rally brings the S&P500 back to within a few percentage points of its all-time high, which was reached in early October 2018, about six months ago.

What’s also impressive is that this recovery has happened as many US economic indicators have disappointed. Just last week, retail sales (both headline and ex-autos) missed badly. Retail sales are very important because it’s a sign of how much consumers are spending, and in an economy that’s about 70% dependent of consumption, this result is concerning. At the same time, PMI manufacturing, ISM services, and durable goods orders all registered drops. While the headline jobs report beat consensus estimates, the labor force participation rate worsened, and most disturbingly, average hourly earnings missed badly. So as the US stock market powers on to reclaim old highs, the US economy is not supporting this advance in stock prices.

Another major divergence with the US stock market rally is the stealthy reduction in the Federal Reserve’s balance sheet. Through last week, the Fed’s balance sheet has dropped by $525 billion. What makes this so interesting is that on the way up, the Fed’s balance sheet’s growth correlated fairly well with the rise of the S&P500 since mid-2009. Naturally, many market experts took this correlation a step further and argued that is was actually a causal effect–in other words, the Fed’s quantitative easing helped to drive stock prices higher. So it was not a big step to then argue that when the Fed shrinks its balance sheet, US stock prices would struggle to retain their gains. And when the 20% drop was registered in late December 2018, this argument looked like it was correct.

But since then, it’s broken down. As the Fed has continued to shrink its balance sheet in January, February, and March, the S&P has continued to move in the opposite direction–up.

Many experts are now arguing that the effect of the balance sheet is merely delayed. They point to the fact that the Fed started growing it’s balance sheet many months before the S&P started to rally in March 2009. So they’re arguing that something similar…but in reverse….may be happening now.

Even with the Fed recently announcing that the balance sheet roll-off will end near the end of 2019, the total balance sheet reduction by then will be approaching $1 trillion. It will be interesting to see if this massive reduction….with passage of even more time….will finally act to pull down the S&P500 by any meaningful amount.

S&P500 Bounces

April 1, 2019

After losing ground the previous week, the S&P500 bounced right back and gained 1.2% last week. Volume was light, which has been very typical in this multi-month advance. And volatility crept back down—the VIX index dropped back to the lower teens.

What was odd about the advance in the US stock market is that it happened during a week when the US economic reports were exceptionally weak. Well over 10 reports disappointed, when compared to consensus estimates. And only a handful beat their respective estimates:  consumer sentiment, new home sales, and international trade in goods. So investors are beginning to look beyond the dismal economic data and instead, they’re starting to bank on more monetary easing from the Federal Reserve, which is now—at least in the view of the markets—expected to cut interest rates in 2020, instead of hiking them as everyone had expected in 2018.

This massive shift in expectations for US monetary policy has not only helped to prop up the stock markets over the last couple of months, but it has driven down longer US interest rates dramatically. The US 10 year Treasury yielded over 3.3% last fall; last week, it dropped all the way down to a 2.3% handle.

Another more ominous interpretation of this drop in US Treasury yields is that the Fed has over-tightened in the last 12 months. As a result, the odds of a recession in the US have risen dramatically…..and the drop in US yields reflects the bond market’s anticipation of this upcoming recession.

Ironically, if this recession materializes, then corporate earnings….and presumably US stock prices…would fall. So we are now witnessing a dramatic divergence between the US Treasury market and the US stock market, where the Treasury market is bearish and the stock market is bullish.

This divergence will not be resolved over a couple of days or weeks; it will likely take several months. And when it does get resolved, one of these markets will very likely get repriced….in a very meaningful way.