- Progress along most of the crucial fronts Wall Street was watching (the economy, earnings, vaccines, the election) has been better than expected.
- Many market behavioral indictors have reached levels not seen since January 2018, a moment of investor celebration following the corporate tax cut that preceded a down year.
- When the crowd broadly believes next year will be a good one, the threshold rises for what amounts to market-friendly developments and something often comes along to challenge the happy consensus.
For most of the eight months since the Covid crash culminated, the stock market's recovery has fed off rampant doubt, disbelief and cognitive dissonance toward resurgent asset prices set against a severely damaged economy.
No more. Wall Street's rally has now entered the belief phase, with stocks riding a wave of conviction at the end of a trying year that better times are surely near.
As with any collective mood shift, there are obvious and clear reasons for this one. Aside from the S&P 500 having vaulted by more than 60% since the March bottom to another record high last week, progress along most of the crucial fronts has been better than expected.
The "economic surprise" indexes, gauging macro data relative to forecasts, went positive in June and stayed there for five months. Third-quarter corporate earnings were better relative to expectations than any period in more than a decade. And two vaccine candidates showing 90%-plus efficacy was a far better outcome than the consensus had allowed itself to anticipate.
Add a (mostly) settled election whose result investors have decided to spin as a positive, and it's as if Wall Street the past several weeks has been watching a film called "The Subtraction of All Fears."
Thus, the upwelling of belief that the market can continue to barrel higher, which has lifted risk appetites toward some notable extremes.
Get used to the phrase "since January 2018," because plenty of behavioral indictors have reached levels last seen then.
The four-week total of global inflows into equity funds? Highest since January 2018.
Likewise, the ratio of upward to downward profit-estimate revisions for S&P 500 companies.
Fund managers in Bank of America's latest monthly client survey had their highest portfolio allocation to equities since January 2018.
And the week before last, the American Association of Individual Investors survey showed 55% were bullish, the most since….well, just guess.
January 2018 was a moment when investors went all in, celebrating the just-passed corporate tax cut that had been incrementally priced in for many months. Shortly thereafter I called it the moment of "peak happiness" for the bull market, and it remained so.
Sudden stress in the market for volatility instruments then coincided with stirrings of trade hostilities to trigger a fast 10% correction, a months-long sideways trading range, a summertime marginal new high and then a fourth-quarter collapse to seal a down year, even as the economy performed quite well the entire time.
This is not anything like a prediction for a rerun of that exact experience. As noted here a couple of weeks ago, not every rally needs to feed of pervasive pessimism to keep going. The early-cycle recovery forces at work now are not the same as the mature-expansion/Fed-tightening backdrop of 2018.
And the year preceding January 2018 had been one of the strongest and most hypnotically calm in recent memory — not like 2020, with its melt-up/meltdown/phoenix-rising pattern.
So, it could well be early to sound loud alarms about investor belief spilling into "over-belief" in good things to come.
Still, when markets have already feasted on a run of better-than-expected news and the crowd broadly believes next year will be a good one, the threshold rises for what amounts to market-friendly developments and something (Who knows what?) often comes along to challenge the happy consensus, at least temporarily.
In previous Decembers when the indexes and sentiment have seemed overstretched and yet the market kept rising (2014, 2017, 2019), corrections of various severity followed in the first quarter of the following year, notes technical strategist Chris Verrone of Strategas Research.
On a practical basis now, it suggests investors remain aware of just how much of a cyclical rebound has already been factored into areas of the market and into individual stocks.
The recent broadening out of the market from huge, indomitable growth stocks into smaller, laggard, less popular and more cyclical stocks has been pitched as the mark of a healthy tape with positive economic implications. And, sure. But the trick becomes sorting out when prices have arrived at a point where they embed a very good recovery.
Looking at the industrial sector of the S&P 500, the forward price/earnings ratio is well above the past decade's range, both on an absolute and relative basis. For sure, this reflects depressed near-term earnings due to Covid interruptions and the impairment of Boeing's business. But suffice it to say it is not news to the market that global manufacturing is on an upswing into next year.
Or consider Walt Disney, whose shares last week briefly returned to their record-high price from almost exactly a year ago, in a fresh burst of optimism around its streaming-video strategy.
The stock is now both a favorite "stay-at-home" play given subscription growth in Disney+ and a central "reopening" proxy given its theme-park business. Great company, weathering the tough times well with stellar brands and solid long-term consumer-retention strategy.
Yet, given the share price and its quite-high debt levels, even if Disney cash flow matches its 2018 peak level soon (a very big if), the company at today's price is still at a record multiple of enterprise value to cash flow. If the market is now happy to place a Netflix-type multiple on Disney streaming subscribers to render the historical valuation parameters irrelevant, so be it, but be aware as a buyer that this is implicitly one's bet.
Again, this does not amount to an indictment of this rally as irrational or doomed. The market has been impressively resilient, rotating among groups in a way that refreshes itself, affirmed by global equity strength, supported by impressively strong credit markets and favored by seasonal tailwinds that are difficult to fight.
Most of the relevant leading indicators based on recent market breadth and cyclical trends suggest attractive returns looking out six or more months, with the short-term less clearly so.
A bull market can be like Tinkerbell, brought alive and lit up indefinitely by audience applause alone. If only there were a way to know when the crowd will tire of clapping.