The stock market went up big this week after going down big in the prior week. In both cases, sentiment took over as the stock market's guiding force.
Which week, though, was more important for the stock market? Was it the week driven by panicky selling or was it the week led by opportunistic buying?
The answer is that the two weeks were equally important, because they embodied the actions of a market staring at numerous inflection points that will be the pathway for more roller-coaster action.
When things have been one way for a long time, it is easy for complacency to set in with the idea that they will not change. Accordingly, when change happens in an unexpected fashion, it can be a shock to the system.
Anyone who was short volatility certainly got shocked a few weeks ago when the volatility that had long been suppressed (thereby enabling them to profit handsomely from being short volatility) suddenly spiked.
The CBOE Volatility Index was not expected to deviate from its trend, let alone spike more than 100% in one day. But it did.
The CBOE Volatility Index has settled down in the past week as the rush to hedge portfolios for downside protection has tailed off with the rebound in the stock market. Nevertheless, there is some festering angst that things are actually "settled" and that there will be a permanent return to the very low readings in the CBOE Volatility Index.
The movement in the CBOE Volatility Index, though, hasn't been the only important change.
- Interest rates have changed
A 10-yr note yield of 2.90% is not high (the 20-year average is 3.74%); however, it looks high relative to the 1.36% yield seen in July 2016, the 2.05% yield seen in September 2017, and the 2.43% yield seen at the start of the year.
The trend is noticeable and bothersome because rising yields create some competitive headwinds for stocks and call into question premium valuations that have been rationalized on the basis of interest rates remaining low.
It is also bothersome because rising inflation expectations, concerns about the Fed tightening more than expected, a rising budget deficit, and an assumption that foreign central banks will soon distance themselves from their ultra-easy monetary policy have become more prominent in the narrative explaining the latest bump in rates.
In the past, it was accepted that rates would stay down because inflation expectations were subdued, the Fed wasn't going to raise rates, inflation was bound to remain low, foreign central banks didn't have an economic basis to raise rates, and because the budget deficit as a percentage of GDP was decreasing.
- The budget deficit is changing... and not for the better.
According to the Committee for a Responsible Federal Budget, the budget deficit could top $1 trillion in fiscal 2019 after accounting for the tax reform plan and the two-year budget agreement that will boost spending for defense and non-defense programs by approximately $300 billion.
We haven't seen a trillion dollar deficit since the financial crisis -- and what's alarming is that this trillion dollar deficit would be achieved at a time when the economy is not in crisis.
An increased deficit means more debt issuance, which means more supply for the Treasury market to digest at a time when the Federal Reserve is trying to cut back its balance sheet.
- Consumer inflation isn't changing much, but inflation expectations are.
Total CPI was up 2.1% year-over-year in January while core CPI was up 1.8%. Those aren't high rates of inflation relative to the inflation rates in pre-financial crisis years. They aren't high either relative to the Federal Reserve's 2.0% inflation target.
The PCE Price Index, which is the Fed's preferred inflation gauge, is even lower with total PCE up 1.7% year-over-year and core PCE up 1.5%.
However, inflation rates are firming, and the market is beginning to sniff the specter of a pickup in inflation with the weakness in the dollar, the tightening labor market, and the arrival of fiscal stimulus. That is evident in the pickup in inflation expectations, which are still low, too, but which are rising nonetheless and adding to the feel of an inflection point perhaps being at hand with inflation trends.
- Earnings are changing... and for the better.
According to FactSet, S&P 500 earnings growth, which is a key source of support for the stock market, is expected to increase by double digits every quarter this year and to increase 17.9% for all of 2018.
That is stupendous growth that is being amplified by the lower corporate tax rate, a pickup in end demand, and corporate buyback activity.
Things are looking so strong on the earnings front that there is some burgeoning concern this year could be the peak for earnings growth. That is, earnings growth could soon be arriving at an important inflection point.
- The Federal Reserve is changing. It is under new leadership and has a new panel of FOMC voters this year.
More to the point, though, the Federal Reserve is sounding more confident about its ability (and desire) to raise the fed funds rate, whereas, in past years the Federal Reserve talked the talk but rarely walked the walk.
That changed last year when three rate hikes were announced. Three is the median order for this year, yet there has been some nervous market chatter that four might be possible.
What It All Means
Angst increases at inflection points, because a new reality begins to take shape that deviates from what had been the norm.
The future, therefore, starts to look less certain, because past linkages that enabled the stock market to rally so confidently -- and complacently -- are changing.
Interest rates are trending higher; the budget deficit is trending higher; consumer inflation is firming and inflation expectations are trending higher; earnings growth is trending higher; and the Federal Reserve is changing its tone.
With these forces in mind, it isn't shaping up to be an easy year. It's shaping up to be a roller-coaster year as the reality is setting in that the easy money has been made and that it will be difficult to achieve multiple expansion.
That understanding, then, could give way to a newfound inclination to sell into strength as opposed to riding the prospect of higher highs following every dip.