11 March 2019
Is the U.S. Market Overcorrecting the Correction?
65%! That’s the annualized gain for 2019 if the S&P continues along the pace of gains registered year-to-date. Of course, that’s highly unlikely. And with volatility across asset classes in very low territory, we’re also concerned that a bit of complacency among investors may be setting in.
With the winter weather much of the country has seen recently, a young driver trying to correct a skid on ice came to mind—they often overcorrect, making the situation worse. We’re concerned that’s the environment we’ve entered as we begin the final month of the first quarter. With the stock market’s gains, alongside a deteriorating corporate earnings outlook, the valuation recovery suggests equities are priced for a stream of good news—a deal with China, a continued-dovish Fed, no inflation, continued economic growth, no damaging Brexit, etc. While we believe there is hope for some of these to come to fruition, it’s a stretch to assume the full crescendo. And with investor sentiment continuing to extend into the overly optimistic zone, according to the Ned Davis Research Crowd Sentiment Poll, contrarian analysis suggests a near-term pullback is increasingly likely.
The recent market gains are in contrast with the slowing in economic data. We’re not calling for a recession in the near-term; but as we often say “better or worse tends to matter more than good or bad,” and the trend in many indicators is decidedly down.
Trade hopes and fed turn
There is little doubt, however, that at least some of the gains seen over the past couple of weeks can be attributed to some positive reports coming out regarding the Chinese/U.S. trade dispute. Given the market’s rally since last Christmas, we now believe there may be more market downside if no deal is struck than there is upside opportunity if we get some sort of deal—especially if the deal doesn’t address the longer-term issues around intellectual property theft, patent violations, forced technology sharing, etc. We believe the most likely scenario is an announcement of an agreement that both sides will proclaim as ground breaking; but ultimately won’t change the competitive landscape all that much. As such, this could be setting up as a classic buy the rumor, sell the news scenario. And even if there is a deal in this trade dispute, Congress is making noise about holding up the USMCA (United States, Mexico, Canada Agreement), while the threat of increased tariffs on European autos appears to be accelerating (and is under-appreciated).
However, the major positive that has the potential to counteract some of the above is the clear dovish turn by the Federal Reserve. The release of the minutes from the January Federal Open Market Committee (FOMC) meeting solidified that the Fed is keenly aware of the slowing in U.S. economic growth; while also not, for now, feeling pressure from rising inflation. In fact, the minutes revealed that the Committee is contemplating keeping a larger balance sheet than may have been expected by noting that, “Almost all participants thought it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.” That’s sooner than the consensus had expected and could provide a cushion to equities and the economy if the slowdown in growth continues.
It isn’t just slowing economic growth that would likely pressure top line corporate revenue growth—rising labor costs also pose a key risk for a potential earnings recession this year.
Analysts have been lowering their 2019 earnings forecasts over the past few quarters. The cuts have been tied to last year’s oil price collapse, the effect of the “roll-off” in the corporate tax cuts’ impact on year-over-year earnings growth, and slower global growth. In particular, the global economic slowdown is visible in the widely-watched global purchasing managers’ index (PMI). Slower sales on the “top line” of the income statement flow all the way down to earnings.
Equity markets can swing like a pendulum—moving beyond what fundamentals justify in both directions. We believe the strong rally off the Christmas Eve 2018 lows may be an example of that, suggesting a rising risk of a near-term pullback. U.S. economic data has softened alongside weak global growth, while ongoing trade uncertainties threaten to throw a wrench in stock market gains if deals not to be had. We recommend a modestly defensive position for tactical investors, while keeping an eye on tried-and-true longer-term disciplines like diversification and rebalancing.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.
The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.
Markit J.P. Morgan Global Manufacturing PMI gives an overview of the global manufacturing sector. It is based on monthly surveys of over 10,000 purchasing executives from 32 of the world's leading economies, including the U.S., Japan, Germany, France and China which together account for an estimated 89 percent of global manufacturing output. It reflects changes in global output, employment, new orders and prices.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research