Santoli: After a smooth 5% climb in the 1st quarter, market showing no signs of imminent failure

Published Sun, Apr 2 20176:43 PM EDT

After a bridge buckles or a train derails, the investigation almost always concludes that closer inspections would have detected structural weaknesses before the failure, when everything seemed to be just fine. In that spirit, let's look carefully at a stock market that's been running smoothly, to stress-test the tape for potential vulnerabilities. Here a couple of areas where concern has been building - justified or not: It's so calm, so must a storm be near? Yes, it's been quiet. In the past three months, the S & P 500 moved at least 1 percent on only two days – the fewest times for any quarter in decades, and last month it finally ended a 109-day streak without a 1 percent one-day loss. At last Monday's low, the S & P was only 3 percent from its March 1 all-time high, yet that was its deepest setback since October. During its recent eight-day losing streak, the Dow Jones Industrial Average had lost a total of just 1.9 percent, the definition of a grudging, orderly pullback. The S & P 500 Volatility Index's average level last quarter was its lowest since the fourth quarter of 2006. That period gave way to 2007, when the tape grew more skittish but still advanced for another nine months (ahead of the singular, prolonged meltdown through 2008). Yet while every storm follows a calm, not every phase of quiet skies leads quickly to dangerous weather. The VIX, now near 12, isn't "too low" given that the actual, realized volatility of stocks is running near 8. And one reason the market itself is so steady is the mix of offsetting strong and weak sectors – a relatively healthy pattern. And pretty much every historical study of prior streaks without a 1 percent drop, like the one just ended, augurs above-average forward returns over months or more after they end – though each also suggests that a deeper pullback at some point should be expected. Even the best years for stocks typically see at least a 5- to 10-percent gut check or two. April is a strong month seasonally, but also the end of the best six months of the calendar. Consider a deeper downside probe a bit of deferred maintenance this market should get around to before long, but nothing that would likely represent "the Big One." Are investor expectations too high? Depends what we're looking at. The latest University of Michigan consumer sentiment survey found more than 10 percent of respondents said there's a "100 percent probability" that stocks will be higher in a year. The proportion of consumers who are certain of more upside has only exceeded 10 percent four times before since 2001 – once each in 2004 and 2007, twice in 2015. A year later, the best equity return was up 5 percent, the worst down 39 percent. Broader gauges of investor sentiment and positioning are more mixed, with the requisite surface bullishness for a market near a record high, coupled with a reserve of caution - a quickness to hedge and a stated desire for a dip to buy. Strategist Michael Hartnett of Bank of America Merrill Lynch characterizes institutional investors' stance as "bullish but light positioning," and he's been waiting for a crescendo into "hubris" to mark the end of what refers to as the "Icarus trade." This trade favors stocks and commodities until confidence in growth, central-bank policy and earnings growth peak together - perhaps in the second half of this year with the S & P 500 up another 6 percent or so. Much is being made of the gap between "soft" economic data such as business and consumer surveys – which show extreme strength – and "hard' macro data such as GDP growth and industrial production, which are positive but far less so. Clearly, hope for policy catalysts under Trump and a return to decent growth in Europe are stoking anticipation of better times. This confidence will probably come off the boil, rather than directly drive hotter economic activity. Yet this doesn't seem like a stark problem given that both hard and soft data are to the plus side, and the leaders of the market this year (tech and other big growth stocks, emerging markets, European equities) do not seem to reflect hazy hopes of a Trump policy bump. Maybe a gut-level enthusiasm for tax reform or fiscal stimulus is keeping sellers at bay and making investors more tolerant of high valuations. But this is hard to quantify, unless it gets tested by the outright banishing of hope for policy progress. As for earnings, they are expected to be up near 10 percent in both the first quarter and for the full year. If the usual pace of forecast cuts holds, actual growth will be a few percent lower. The rate of estimate cuts had been lighter than usual. FactSet notes the first quarter was the 16 th of the past 20 in which S & P 500 earnings forecasts were cut, yet the index was up. Clearly, the market's used to this drill. It's hard for stocks to go down much and stay down when global growth is in gear and sales and profits in aggregate are rising, as now. Source: Strategas Research Partners Still, stocks are already up plenty in the nearly three years since we've seen broad earnings growth, so valuations are pretty aggressive right now, and much rides on second-half growth against decent 2016 results. Those stout valuations are smothering long-term future returns, for sure. But Bespoke Investment Group notes that the market's P/E ratio has been higher than the current level more than a quarter of the time over the past three decades. Taken together, all this depicts a market that's come a long way, but is not yet showing obvious signs of imminent failure. Corporate credit markets have been powerfully strong, growth expectations seem plausible for now, the tape's action itself has earned it the benefit of the doubt. And, if – if - this cycle is to have a full bull-market upside overshoot in prices and risk-taking behavior, it's probably yet to come. But how far away is such a "peak moment?" Hartnett notes that if the S & P 500 were to gain another 7.5 percent to 2540 and the 10-year Treasury yield rises to 3 percent, the stock-to-bond return ratio would return to the tech bubble peak in the year 2000. (Gulp.) As I keep saying, it's not over, but it's far from early.

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In that spirit, let's look carefully at a stock market that's been running smoothly, to stress-test the tape for potential vulnerabilities. Here a couple of areas where concern has been building - justified or not:

It's so calm, so must a storm be near?

Yes, it's been quiet. In the past three months, the moved at least 1 percent on only two days – the fewest times for any quarter in decades, and last month it finally ended a 109-day streak without a 1 percent one-day loss.

At last Monday's low, the S&P was only 3 percent from its March 1 all-time high, yet that was its deepest setback since October. During its recent eight-day losing streak, the Dow Jones Industrial Average had lost a total of just 1.9 percent, the definition of a grudging, orderly pullback.

The S&P 500 Volatility Index's average level last quarter was its lowest since the fourth quarter of 2006. That period gave way to 2007, when the tape grew more skittish but still advanced for another nine months (ahead of the singular, prolonged meltdown through 2008).

Yet while every storm follows a calm, not every phase of quiet skies leads quickly to dangerous weather. The VIX, now near 12, isn't "too low" given that the actual, realized volatility of stocks is running near 8. And one reason the market itself is so steady is the mix of offsetting strong and weak sectors – a relatively healthy pattern.

And pretty much every historical study of prior streaks without a 1 percent drop, like the one just ended, augurs above-average forward returns over months or more after they end – though each also suggests that a deeper pullback at some point should be expected. Even the best years for stocks typically see at least a 5- to 10-percent gut check or two. April is a strong month seasonally, but also the end of the best six months of the calendar.

Consider a deeper downside probe a bit of deferred maintenance this market should get around to before long, but nothing that would likely represent "the Big One."

Are investor expectations too high?