US Markets

In this market, peak happiness gives way to a series of trade-offs for stocks

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Key Points
  • After a quick drop of more than 10 percent off the S&P's January high, the market has chopped around spasmodically, showing acute sensitivity to headlines and spending more time near the lows than the highs.
  • The adjustment to equity valuations and investor expectations come as inflation and interest rates perk up and conditions turn from "good as it gets" to "still good, but with some offsets."
  • Upside to the old highs and perhaps beyond would likely be a more fitful "brute force" advance rather than the elegant choreography of the "no pullbacks" 2017 rally.
Carlos Jasso | Reuters

It's been exactly three months since stocks peaked in a flourish of giddy momentum, and the market is now more volatile, less expensive and not quite as beloved, as the indexes struggle to maintain their long-term uptrend.

After a quick drop of more than 10 percent off the 's Jan. 26 apex of 2,872, the market has chopped around spasmodically, showing acute sensitivity to headlines and spending more time near the lows than the highs — but also finding support repeatedly around the 2,600 level.

Looking at the S&P since its ramp off the post-Brexit low in mid-2016 and then the postelection acceleration higher, it looks pretty clear that in the past three months stocks have been largely in a retrenchment to correct the upside overshoot from about Thanksgiving through January.

Built on runaway optimism over impending corporate tax cuts, good global economic momentum and abundant financial liquidity, that aggressive rally gave way to the current downward adjustment to equity valuations and investor expectations as inflation and interest rates perk up and conditions turn from "good as it gets" to "still good, but with some offsets."

The correction and ongoing churning in stocks amid strong corporate profit growth have remained almost entirely a localized equity event. Yes, of course, short- and long-term Treasury yields have climbed to multiyear highs, with the 10-year note hitting 3 percent, raising the cost of borrowing and pinching liquidity around the edges. Yet credit spreads have remained tame, economic data have held up fine even as momentum has waned and currency markets have been uneventful.

Some strategists, such as Tony Dwyer at Canaccord Genuity, have argued that the ever-changing cover story for the market setback is implicit proof that it's mostly been a stock-specific reset of valuation and sentiment rather than a leading indicator of deeper economic troubles.

First, it was "all about" rising bond yields, then it was the implosion of "short volatility" funds, then a flat yield curve, then trade-war fears, then the War on Big Tech and now worries of peaking profit margins.

There is truth to all of these issues, but the real news is stocks' sudden susceptibility to them after reaching their most expensive point in this cycle. In 2017, the market managed to glide higher no matter the news.

With the broad market still more than 7 percent from its high, here's a tale of the tape comparing the backdrop of Jan. 26 to today's setup:

This compression of market valuation and dampening of enthusiasm comes as investors contend with the prospect that the 2017 rally and its exuberant vertical encore in January reflected a "best of times" phase, when high growth and business-friendly policy and still-undemanding interest rates combined for effortless upside.

January was likely the moment of peak happiness.

We now have some trade-offs and offsets: A good economy and fiscal stimulus mean a determined Fed and heavy supply of Treasury paper. Full employment and rising commodity prices lead to cost pressures on companies. And stocks are at a point where their valuation cushion against corporate bonds is as thin as it's been this bull market.

This doesn't at all mean the bull market is over, but the upside to the old highs and perhaps beyond would likely be a more fitful "brute force" advance rather than the elegant choreography of the "no pullbacks" 2017 rally. Rebounds in recent months have been fairly unimpressive, and the "sell-the-news" response so far to good earnings is keeping traders off balance.

Whether the recent lows near 2,600 on the S&P 500 hold or not, high-teens percentage earnings growth and newly subdued investor attitudes would need to overcome a higher cost of capital and the chance that 2018 profit levels will be tough to beat.

Plenty of pain has been absorbed at the single-stock level already. As of Thursday, a quarter of all S&P 500 stocks were down at least 20 percent from their highs, and one-third were down 15 percent.

Todd Salamone of Schaeffer's Investment Research makes the case that the current market pattern and investor-sentiment mix are reminiscent of November 2016: The S&P chopping around the year-to-date flat line, with a series of frustrating failed rally attempts. The Bank of America Merrill Lynch fund manager survey just showed the highest cash holdings since November 2016. Other sentiment surveys and the Cboe Volatility Index likewise are tracking the fall of 2016.

This is not to suggest stocks are poised to blast off in anything like the way they did in the radical repricing following the 2016 election. We are later in the cycle and stocks are at a more expensive threshold. But Salamone's point is simply that the market is getting to a place from which it could be receptive to an upside surprise, whether relief on the trade front or some other removal of uncertainty.

The counterpoint to this: If stocks can't make headway through this whole earnings season while credit markets hang tough and the macro picture still appears stable, the market might be working through something a bit more serious than a simple attitude and valuation adjustment.