As we go into the second half of the year, there are two questions that are dominating market discussions: 1) Why doesn't anyone want to sell? and 2) Is it time to rotate market leadership?
Let's tackle the first question:
1. Why doesn't anyone want to sell? The markets sure look a little odd. When was the last time you saw almost every asset class up over a six-month period:
Key metrics this year
: up 9 percent
Long bonds (): up 6 percent
Gold: up 8 percent
Kind of odd, no? This should happen all the time. Everyone's a winner! Everyone gets a balloon!
That's the way market participants seem to want it. Everyone wants to have their cake and eat it too. And that contradictory data is a problem that needs to be resolved.
The so-called Goldilocks investment scenario seems to even extend to inflation. ECB Chief Mario Draghi recently said that reflation was coming back, but in the same speech he also said inflation was more muted than expected. No wonder the market was confused.
I think this contradictory data is the main reason everything is up. No one is quite sure what is happening, so everyone has stayed with their convictions: gold being up means more uncertainty, higher bond prices mean the economy is weaker than expected, stocks rising means the global economy improving.
Everyone is entrenched in their camps.
Here's another seeming contradiction: economic data is disappointing at the same time earnings growth is improving. The Citigroup Economic Surprise Index, a gauge of how economic data is coming in compared to expectations, is at its lowest level since 2011.
That's not good news. It means there has been a lot of economic data that has disappointed recently. This week, Goldman Sachs revised down its second-quarter GDP tracking estimate by two-tenths to 2.3 percent following a weaker-than-expected durable goods report.
Bonds, not surprisingly, have been strong in the second quarter.
But there's no disappointment in earnings land: First-quarter earnings are up 15.3 percent, and second-quarter earnings estimates are also up a healthy 7.9 percent, according to Thomson Reuters. Third-quarter estimates are up 8.7 percent, and while the forward estimates usually come down, early second-quarter earnings reports have been solid.
So, who should we believe, stocks or bonds?
The market believes both. Stocks have made new highs even as the economic data has disappointed. This is not completely incomprehensible: Economic data may be weaker, but there is no sign of recession. And with no recession and earnings growth still evident, a notable drop in stocks — greater than 10 percent — is not likely in the near future.
Look, I get the argument of the bulls: For the past 10 years, fear — of the Fed, of inflation, of the Chinese, of everything — has been a losing trade. So you can excuse the market for some degree of complacency, but it is a bit harder to explain the dichotomies. Hard data versus soft data, economic disappointment versus earnings growth, bonds and gold and stocks up, inflation versus deflation. It's all a bit odd.
But something has to give. Who's going to blink first?
Not surprisingly, Goldman Sachs thinks that everyone blinks. In a note Wednesday it raised its 2017 price target on the S&P 500 to 2,400, from 2,300. But wait — the S&P is already at 2,440. Goldman Sachs clearly believes higher interest rates will keep the market in check.
In other words, both bonds and stocks blink, even if just a bit.
Let's tackle the second question:
2. Is it time to rotate sector leadership?
It's very rare to get a 30 percentage point spread between the market leader (technology) and the market laggard (energy):
Sector winners/losers in first half 2017
Technology: up 18 percent
Health care: up 16 percent
Consumer discretionary: up 11 percent
Industrials: up 8 percent
Banks: down 1 percent
Retail: down 8 percent
Telecom: down 11 percent
Energy: down 14 percent
A few observations here:
- Market rotation has been a big factor stabilizing the markets. There have been periods when tech has notably underperformed, and periods when retail and even some energy stocks have outperformed. This week, the market outperformers were among the year's biggest losers: retail, oil service and banks.
- If that holds, than we can expect that banks, oil stocks and even telecommunications (all losers on the year) should have their moments in the sun in the second half. The Street is already well-positioned for a bank rally: Bank stocks have tended to rise right around the time the CCAR results are announced and banks raise dividends. And the fact that traders threw in the towel on energy weeks ago is sure to attract interest once again.
- Will there be a pullback in the second half? Of course there will. The worst pullback we had this year was a measly 3 percent pullback from the March high to the March low. That's not a correction, and it's not even a pullback. It's more like indigestion. Meaningless. You can bet there will be bigger moves in the second half.
But the difference is that most stock traders remain bullish: Everyone wants a 5 to 10 percent pullback so they can buy more stocks for cheaper. Weakness is viewed as an opportunity, not as an omen.
There are two other factors that make the second half stew much more complicated than usual: the "Trump trade" and the Fed.
We know there is some premium in the market for the Trump trade of lower taxes. We don't know how big it is, but we saw stocks weaken even on the mild disappointment that Senate leaders were delaying the health-care vote — but not by much. Despite evidence that tax cuts are more elusive than ever, the market moves very little. Another dichotomy.
As for the Fed, it faces the very tricky task of continuing to talk about higher rates while trying to reduce its balance sheet, all of which means less liquidity in the system. Shouldn't there be just as much fear of a lack of liquidity as there was joy when the Fed was increasing liquidity?
You would think so, but there isn't. There's another dichotomy.