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.
PNN Capital Management 