Market View Update - September 2016

The Dow Jones Industrial Average, Nasdaq Composite, and S&P 500 have all hit record highs in recent weeks. At their best levels of the year so far, the Dow, Nasdaq, and S&P 500 have been up 7.1%, 5.6%, and 7.3%, respectively.

Those aren't huge gains when viewed in isolation, yet when pitted against a period of six straight quarterly declines in S&P 500 earnings, they look "yuuge" as one presidential candidate might be inclined to say.

It has been a remarkable show of strength really considering those record highs were also established on the other side of real GDP growth averaging less than 1.0% in the first half of the year, UK voters shocking the world with a majority decision to leave the European Union, and both presidential candidates exhibiting an inclination to favor protectionist trade practices.

Ah, but the idiom holds true that the devil is in the detail.

Fed Courts T.I.N.A.

"We stand ready to do more if necessary."

Sound familiar? It should.

That has been the guiding mantra of central bankers around the world and it is a declarative statement, combined with the persistence of low policy rates, that has underpinned the stock market during a fundamentally challenging time that has featured weak economic growth and no earnings growth.

The European Central Bank (ECB) and the Bank of Japan (BoJ) have worn out the aforementioned line. The Federal Reserve uses it more these days in an obligatory fashion. Its preferred path -- we think -- is to raise the fed funds rate as soon as it is convinced the data suggests it should.

Anyhow, if the Fed truly has to do more before it does less, the world isn't likely to be in a happy place.

That understanding boils down to two considerations: (1) increasing policy accommodation would occur only after another nasty downturn in growth and/or inflation, which would (and should) have all investors on edge and (2) market participants are already starting to question the effectiveness of the Fed's policies to date and whether doing more would (or could) even make a difference.

Why, then, has the stock market hit new record highs? In one sense, it has almost been forced to by the persistence of low interest rates.

That condition has forced investors to seek higher rates of return outside the Treasury market where the yield on the benchmark 10-yr Treasury note languishes below 2.0%. Accordingly, REITs, utilities, telecom services, consumer staples companies, and basically just about anything with a dividend yield above 2.0% has been the beneficiary of a forced march driven by the Fed's monetary policy.

That move has inflated the major averages without any corresponding earnings growth. That's a sad reality, because it demonstrates how the Fed's monetary policy has facilitated the disavowal of fundamentals in many instances in favor of money flows. It is the essence of the so-called TINA trade, which purports that "There Is No Alternative."

Reasons and Risk

It's a blind trust of a different sort. Market participants are blindly accepting, as they have for years now, that the persistence of low rates is going to be the ticket to escape velocity for the U.S. economy and a halcyon period of robust earnings growth.

That's why many have been undeterred by the prolonged period of negative earnings growth mentioned above and a market valuation that is stretched at 25.1 trailing twelve-month GAAP earnings and 22.2x trailing twelve-month operating earnings.

The Shiller PE ratio, which is based on average inflation-adjusted earnings from the previous 10 years, stands at 26.5x today versus 27.3x just before the stock market peak in October 2007. Granted interest rates are lower today than they were then, yet interest rate risk is even greater today than it was then.

Long-term rates are at generational lows.

The Fed would like to raise its policy rate, and there is a burgeoning sense that the ECB and BoJ have effectively reached policy limits with their asset purchase programs, which could lead to some upsetting adjustments at the back end of sovereign bond curves that have the potential to create some real fits for global equity markets.

There has been a taste of that potential upset more recently after the ECB held off on increasing the size of its asset purchase program. Further upset could occur if the BoJ does the same.

Bond markets aren't in a comfortable place right now and they pose a real risk factor for the stock market in the second half of the year if they become unhinged, leading to a jump in long-term rates for the wrong reasons.

The stock market could probably tolerate long-term rates going up gradually for the right economic reasons (i.e. faster growth and a gradual pickup in inflation), but if they go up for the wrong reasons (i.e. reverse money flows driven by a loss of faith in central bank policies), that would trigger insecurities and valuation concerns that would be resolved with lower equity prices.

Data Needs to Deliver

It is becoming increasingly important for the economic data to start validating the growth assumptions embedded in highly-valued stock prices. That would not only temper the market's concerns about monetary policy being feckless, it would also spur a belief that companies will indeed have the earnings to justify some lofty earnings multiples.

At the moment, the consensus estimate for third quarter earnings calls for a 0.7% decline year-over-year. That compares to a prior growth estimate of 2.2% seen on July 1.

On the off chance readers don't see the disconnect between that fundamental reality and the market reality, bear in mind that the S&P 500 climbed to a new record high as the third quarter, fourth quarter, and calendar year 2016 earnings per share growth estimates were all being revised lower.

Q3 9.1% 4.8% 2.2% -0.7%

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