The Big Picture
2018 has gotten off to a tremendous start with the S&P 500 gaining 7.0%. That's not the best start to a year, but it is among the best dating back to 1950.
If things didn't change at all between now and the close of trading on January 31, this January would qualify as the seventh-best start to a year for the S&P 500 since 1950.
The latter isn't a trivial point for investors.
According to the Stock Trader's Almanac, there has never been a down year for the stock market since 1950 when the S&P 500 has gained at least 4.0% in January; moreover, the average full-year price gain for the S&P 500 is 22% for the 20 years when it has gained at least 4.0% in January.
In fact, there have only been three down years since 1950 when the S&P 500 has recorded any gain in January. Two of those three years -- 1966 (-13.1%) and 2001 (-13.0%) -- registered major losses, demonstrating that the January Barometer isn't gospel.
The latter point aside, the statistics above are the basis for the adage, "as goes January, so goes the year."
The Irony of Optimism
Why has 2018 gotten off to such a robust start? Explanations abound, but here are some of the more widely cited reasons in no particular order:
- A fear of missing out on further gains (aka the "FOMO" trade)
- Asset reallocation out of bonds and cash and into stocks
- Economic growth optimism fueled by the implementation of tax cuts for businesses and individuals
- The weakening dollar, which has helped boost commodity prices (and related stocks) and has bolstered earnings prospects for U.S. multinational companies
- Increased M&A activity and the healthy premiums target companies are receiving
- The hot start for most of the so-called FAANG stocks, which are widely owned -- Facebook (FB), up 6.3%, Amazon.com (AMZN), up 19.6%, Netflix (NFLX), up 41.1%, and Alphabet (GOOG), formerly known as Google, up 11.9%. Apple (AAPL), up 1.3%, is the exception.
- The persistence of fundamental drivers: low interest rates, low inflation, and impressive earnings growth
- Upward earnings revisions for 2018
There isn't much that has gotten in the stock market's way so far in 2018. The jump in market rates has undercut bond proxies like the utilities sector (-3.4%) and the real estate sector (-2.8%), yet their lightweight representation in the S&P 500 means their losses have been negligible from a broad market standpoint.
Everything seems to be going the stock market's way at the moment, which, ironically, has a lot of market followers concerned.
Spying a Pullback
The long and short of things (no pun intended) is that the palpable wave of optimism is registering as a contrarian indicator. Often, the stock market experiences a pullback of some kind when "everyone" is leaning in the same direction.
There are a number of indicators feeding the narrative that the January run will soon be done -- and we don't mean on a calendar basis.
Brett Manning, who is a Sr. Market Analyst and a lead voice on Briefing.com's Briefing Trader product, publishing under the ticker CHART, has highlighted numerous indicators that suggest a near-term peak in stock prices could be close at hand:
- The Retail-Only Buy-to-Open Put/Call ratio (ROBO ratio)
- Odd-lot short interest
- The American Association of Individual Investors bullish sentiment ratio
- The Investors Intelligence bullish sentiment ratio
- Low cash levels among fund managers
- Week-over-week records in total equity inflows
It is only fair to provide the reminder that the stock market can stay overbought longer than one might think. The run this January is a case in point as calls for a pullback have escalated with every 1.0% increase in the S&P 500 following a year in which it closed with a flourish and gained 19.4%.
Eventually, there will be a pullback. The inclination to buy on that pullback will be proportional to the confidence in the fundamental backdrop, and there isn't anything thus far that has shaken the confidence in that backdrop.
Granted interest rates have moved up, but they are still low under 3.00%. Inflation expectations are rising, but the data thus far has shown that inflation itself is still low. Earnings growth estimates, meanwhile, have only gotten better since the start of the year.
There are a lot of people hoping for a pullback right now so they can buy into the stock market at lower prices. Why?
Part of it is because they have missed out on the gains and are hoping to get an opportunity to participate, but will feel more comfortable doing so with an initial entry at a lower-cost basis. The other part -- and the more important part -- is the optimism rooted in economic and earnings growth prospects.
Raising the Bar
The trend in earnings growth estimates has been a sight to see. To be brief, analysts have raised their earnings growth projections for every quarter this year as they are playing catch up with the tax reform legislation
On December 31, S&P 500 earnings growth in 2018 was projected to be 12.2%, according to FactSet. Today, the earnings growth estimate sits at 16.3%, with expectations for double-digit earnings growth all four quarters.
Despite the increased growth estimate, the S&P 500 still trades at 18.4x estimated forward twelve-month earnings, which is a 30% premium to the 10-year average based on FactSet data.
That premium valuation underscores the importance of interest rates remaining low. They are like a support beam, but if interest rates move up sharply and the support beam is removed, the foundation for tolerating the historically high stock market valuation will be weakened.
That's why future inflation data will be extremely important. It is not only going to feed the stock market's assumptions about monetary policy, but also the direction of interest rates based on those assumptions.
What It All Means
To this point, the jump in the 10-yr note yield hasn't rattled the stock market because it has been regarded as a symptom of the stock market's success. In other words, investors are embracing risk because they feel confident about the stock market's return prospects at a time when inflation is low along with interest rates.
That is the case because nothing has challenged that perspective in early 2018 -- not even the brief government shutdown, which could be back in play if Congress doesn't reach a funding resolution by February 8.
It will be a different story, though, if rates start moving up on concerns the Federal Reserve might have to be more aggressive in tightening monetary policy than market participants currently think.
Seasoned market participants are cognizant that a positive start in January often bodes well for the full year. By the same token, they also understand the Federal Reserve typically has a guiding hand in pulling the plug on a bull market.
The stock market won't keep going up in a straight line, but its ability to bounce back continually from any size dip will hinge on the persistence of low interest rates. If that factor is removed, the road ahead will get bumpy and the stock market's return prospects won't look as rose-colored as they have this January.
