The S&P 500, the Nasdaq Composite, the Nasdaq 100, and the Russell 2000 have all hit record highs in the past few weeks, yet the excitement surrounding those performances has been pretty muted -- so muted that it has everyone wondering where the celebratory noise and animal spirits went.
Our perspective on the matter is that the celebratory noise and animal spirits have been stifled in risk-reward assessments taking place among investment committees.
Specifically, those committees, which can sometimes be a committee of one (i.e. the individual investor), are recognizing the stock market isn't trading cheaply after pricing in a lot of good news and the expectation that more good news is sure to follow.
That awareness has throttled the market at record-high levels as investment managers are becoming more attuned to the stock market's near-term, downside risk than its near-term, upside potential.
Blast Off Postponed
For all intents and purposes, the stock market hasn't gone anywhere since March 1. The S&P 500 traded as high as 2400.98 that day and on Wednesday, May 10, it closed at 2399.63.
It just so happens that the March 1 high was a record high at the time, so it is fair to say the market has been very resilient to selling efforts. At the same time, though, it hasn't commanded much buying interest, with the exception of the relief rally pertaining to the results of the French presidential election, which took the worst-case scenario of France leaving the EU off the table.
The reluctance to blast off to even higher highs can be largely attributed to valuation concerns.
According to FactSet data, the S&P 500 is trading at a 25% premium over the 10-year averages for both forward twelve-month earnings and trailing twelve-month earnings. Meanwhile, the S&P 500 dividend yield is near a 10-year low.
How did the market get to that point?
The Cliffs Notes version reads as follows: easy monetary policy for a long, long time; low market rates; compressed valuation; renewed earnings growth; performance chasing; and an ascendant belief that stronger economic and earnings growth will be the offshoot of tax reform, deregulation, and infrastructure spending implemented by the Trump Administration.
Tough Argument to Sell
There have been a lot of favorable influences driving the stock market since the lows of 2009, the most prominent of which in recent months have been the expectation for pro-growth tax reform and the end of the earnings recession for the S&P 500.
This isn't "new" news to anyone, which gets to the point that the stock market has been stalling in part because the news itself is sounding like a broken record.
Day after day we hear how the market is hanging onto the eventual passage of tax reform legislation as a source of support, and, day after day, we also hear that such passage isn't likely to come easily or perhaps at all, which in turn creates a point of resistance.
The news cycle isn't the only stuck gear. There has been some trading action beneath the hood that has kept the market idling. In particular, the financials have been weak, the transports have been weak, commodities have been weak, and the Russell 2000 has underperformed of late.
That isn't the type of action one would expect to see given all of the talk about growth picking up. Fortunately, there has been some offsetting strength in the mega-cap technology stocks -- and Apple (AAPL) in particular -- that has provided a more encouraging distraction.
Alas, we don't want to go too far afield here on specific performances, yet that mixed disposition is all part of the risk-reward assessments investment committees are now making.
It is our conclusion, based on how range-bound the stock market has been since March, that the near-term reward potential has been the tougher argument to sell at those committee meetings. Below we review the context of some popularly-held assumptions for why we think as much.
Assumptions and Risks
Assumption #1: Tax reform will get done and earnings growth will accelerate
The idea of passing tax reform, which includes a sharp cut in the corporate tax rate, has been driving the market since the election. The basic premise is that the cut in the corporate tax rate will fuel increased earnings growth that has yet to be priced in -- or has it?
On November 4, 2016 -- just days before the election -- the S&P 500 was trading at 16.0x forward twelve-month earnings or a 13% premium to its 10-year historical average of 14.1x. Today it trades at 17.6x forward twelve-month earnings, which is a 25% premium to the 10-year average.
The P/E multiple has increased 10%, which, coincidentally, is roughly what analysts are modeling for an increase in the earnings per share growth estimate should there be a cut in the corporate tax rate.
Accordingly, a case can be made that the expected pickup in earnings growth has been priced in already, which is why the stock market has struggled to blast off despite a first quarter earnings reporting period that has featured the strongest growth since the third quarter of 2011.
For the sake of argument, if the tax cut were to happen today and EPS growth estimates increased 10%, the S&P 500 would be trading at roughly 15.9x forward twelve-month earnings, which would still be a 13% premium to the 10-year average.
Therefore, if one stops to consider the possibility that tax reform does NOT happen, considerable downside risk can be assumed. It is a risk that cannot be dismissed at this juncture, particularly when the reward of a tax cut happening looks priced in already.
Assumption #2: North Korea will remain a headline nuisance, yet a military conflict will be avoided
So, what's the upside of a diplomatic solution with North Korea? It would help from a sentiment standpoint, but economically-speaking, it is pretty much nil since North Korea does very little for the global economy in general -- and the U.S. economy specifically -- as it is.
What's the downside, though, of a military conflict with North Korea? It is potentially massive for several reasons: (1) it is not expected (2) North Korea could potentially launch a nuclear weapon against South Korea and/or Japan (3) it could lead the U.S. into a direct military confrontation with China (4) it would be a major disruption for global trade channels and (5) it would unleash a major wave of uncertainty.
A military confrontation with North Korea might still be seen as a low probability, yet there is little question that it is a high-risk event for the stock market.
That understanding must be accounted for more closely by investment committees at this juncture since the rhetoric (and threats) between North Korea and the U.S. has gotten more heated at a time when the stock market is trading with a stretched valuation.
Assumption #3: The market's valuation isn't as stretched as it is made out to be, because interest rates are low
If interest rates were to remain as low as they are now or increase only modestly for the next 10-plus years, then stocks are dirt cheap -- or so said Warren Buffet at his recent shareholder meeting.
It is hard to argue with the greatest value investor of all time, yet the key word in the aforementioned observation is "If."
What we know today is that the Federal Reserve has turned less dovish, which isn't the same as saying it is outright hawkish. Nevertheless, the Fed is inclined to push the policy rate higher and the Fed has also been more vocal of late about beginning the process of normalizing its balance sheet.
Both actions should ultimately push market rates higher; and even further upward pressure on long-term rates might apply if the European Central Bank, the Bank of England, and the Bank of Japan ever try to start distancing themselves from their own easy-money policies that feature ultra-low policy rates and asset purchase programs.
It's a big leap to take for granted that market rates won't move much over the next 10-plus years, especially when there is a simultaneous expectation that the passage of tax reform, deregulation, and infrastructure spending is going to accelerate the pace of growth (and budget deficits) in the U.S.
Investment committees probably aren't ready to make that leap just yet; hence, investment decisions are being delayed by relative value arguments revolving around whether stocks are "dirt cheap" now or "filthy rich."
Assumption #4: China will effectively manage its economic slowdown without any contagion effects
Remarkably, China's slowdown has been on the back burner for the market for a while now -- certainly since the election at least, which thrust the prospect of an acceleration in the U.S. economy to the forefront.
In recent weeks, however, China's efforts to rein in property and financial market speculation have won renewed attention since they have spilled over to the commodity markets and have manifested themselves in some softer than expected manufacturing PMI, producer price, and trade balance data for April.
Simultaneously, China's stock market has deviated from most major markets with a 6.9% decline over the last month.
Thus far, China's latest entanglement with itself has been an isolated affair, yet past experience has shown that an upheaval in China's stock market and a slowdown in its economy can have a contagion effect on global markets.
Such a contagion has not been accounted for in the market's run to a new high, which certainly creates a near-term risk should one come to fruition. It is not out of the question, which is why investment committees must answer for the possibility as their next investment moves are considered.
Assumption #5: The relative strength of the technology sector will persist and act as a mainstay of support for the broader market
The S&P 500 information technology sector is up 17.1% year-to-date versus a 7.2% gain for the S&P 500.
The move in the information technology sector has been forged on the back of gains in its largest components. Apple (AAPL), Alphabet (GOOG), Microsoft (MSFT), and Facebook (FB) are up an average 23.1% year-to-date, with Apple leading the way with a 32% gain.
Apple, Alphabet, and Facebook, in particular, have been on fire and have often been joined by Amazon.com (AMZN) out of the consumer discretionary sector as driving forces for the broader market.
They are favored issues to be sure, with just about everyone it seems singing their praises these days. Money managers benchmarking against the S&P 500, or the Nasdaq 100, can't afford not to own them because they have been the key to the performance of each index.
Still, the thing that has been rising along with their stock prices is concentration risk. If they start to act poorly, the broader market will, too, unless funds rotate out of these names and into a heavily-weighted sector like financials (which could use the rotation).
The aforementioned stocks have been an important sentiment gauge, as their continued outperformance has helped support the broader market at a time when the financials, the transports, and the energy stocks have not acted well.
A lingering question is whether they can keep running like they have been. It would be a tall order in the near term.
That doesn't mean necessarily they will soon collapse, only that they will soon stop exhibiting such relative strength, and, if that happens, what might that mean for a broader market that has been restrained by relative weakness in the financial, transport and energy stocks?
What It All Means
There isn't a lot of "new" news to consider these days, yet there is a lot to consider in the context of near-term, risk-reward dynamics.
The assumption that the good times will keep rolling has been reflected in the CBOE Volatility Index, which touched its lowest level in the past week since December 1993.
The implication of that low reading is that market participants aren't finding much incentive to hedge against downside risk.
That viewpoint in and of itself is something that should give investment committees some pause at this point as it suggests a lot of people will be offside with their positioning in the event something bad happens to upset that quiescent view.
The bull market just entered its ninth year, it has more than doubled from its 2009 low, and it sports a valuation that is high by historical standards. Those fine points are to be appreciated, because they have led to many rewards for equity investors. At the same time, though, they have elevated the stock market's near-term risk profile.
Investment committees know it and they are debating it, which is why the celebratory noise and animal spirits at new record highs have been stifled.