27 Feb 2017
Rising Investor Caution Should Help the US Bull Market Continue
Since the Dow finally breached the 20k mark, equities have been largely range-bound. The enthusiasm seen in measures of investor sentiment following the election of Donald Trump has waned a bit as the realities of policy priorities—and getting things done in Washington—begin to set in. Both the Ned Davis Research (NDR) Daily Trading Sentiment Composite and the AAII (American Association of Individual Investors) bull-bear ratio have pulled back from overly optimistic territory, which should be a positive development for the continuation of the bull market.
Much ink has been spilled about the extremely low level of equity market volatility—with the volatility index (VIX) remaining near record lows. This suggests heightened investor complacency; but it also masks a notable development in the market’s internal behavior. Correlations among U.S. equity sectors have plunged according to ISI Research, which means that certain sectors doing well have been largely offset by other sectors doing poorly; thus there's been a "cancelling out" effect which has contributed to today's low volatility. Interestingly we appear to have moved from this cycle's earlier "risk on, risk off" mode (when correlations were high) to perhaps "Trump on, Trump off" mode (with correlations having plunged).
Politics has been a dominant force behind both market behavior and confidence measures. A market, an industry or a company, which can be moved by a single tweet, is a new twist. There is little doubt that there have been some bumps in the initial stages of the new administration but there's also little question that this White House has gotten more done in the first few weeks of a term than any other in recent memory. However, that breakneck pace has multiple speed bumps put in by the Constitution, which means that tax reform and some of the more complicated regulatory reforms will likely take longer than investors and companies had hoped. But at this point we view these as potential buying opportunities as we remain bullish on U.S. equities. Patience is likely to be a virtue.
Economic improvements may slow
As we've often preached, the direction and relative strength of economic data tends to matter more than the level or absolute strength. But despite a potential reduction in upside surprises, the data continues to look good. The Institute of Supply Management's (ISM) Manufacturing Index rose again to 56.5 from 54.5. For context, the average level in 2016 was 51.5 and in 2015 it was 51.4, so it seems clear that manufacturing sentiment has broken out on the upside. Additionally, the new orders component, which is more forward looking, remained robust at 60.4. The service side of the economy also continues to look good, with the ISM Non-Manufacturing Index posting a solid reading of 56.5, just a tick lower than the previous month. The labor market is equally strong, with a better-than-expected 227,000 non-farm payroll jobs added in January. The unemployment rate did tick up to 4.8% from 4.7%, but that was for a "good reason" and due to the participation rate rising from 62.7% to 62.9%. Wage growth fell back toward its recent trend, but we continue to believe the labor market remains tight enough to keep wage growth on an upward trajectory.
The story is much the same with the now-mature earnings season. Expectations going into the season were elevated, so investor reaction to releases was more cautious than we have seen in previous quarters. Results that beat expectations weren't necessarily rewarded to the same degree as during the past several reporting periods, while misses appeared to be punished a bit more harshly. This is to be expected given higher expectations, but the results themselves were largely positive and as mentioned above, the forward-looking commentary from managements remained cautiously optimistic. Patience is likely to be required with regard to potential tax and regulatory reform, but ultimately we do believe that if something on both fronts gets done this year it would be a meaningful net positive for the earnings.
Fed also remains cautious
The January Federal Open Market Committee (FOMC) meeting ended with no rate hike, as expected; while the accompanying statement that was perceived to be slightly more dovish than expected. If economic data continues to surprise on the upside, a March rate hike is likely to be on the table; while there is an additional risk that the Fed may be forced to speed up the tightening process should inflation accelerate from here.
Patience is key for investors, with political realities colliding with hoped-for reforms. Elevated earnings and economic expectations could lead to a pullback or more sideways action. Ultimately, we believe fiscal stimulus is coming—although perhaps later than anticipated—and the bull market in U.S. stocks will continue.
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.