There is no mistaking from the performance of the stock market that investor optimism is running high in terms of the economic outlook. That optimism stems from a variety of factors, the most prominent of which is the faith in the notion that tax reform, deregulation, and infrastructure spending will soon be implemented.
That faith has been reinforced in recent weeks and months, too, by a slate of economic data that has been better than expected.
While some people want to connect the dots between the election outcome and the positive economic surprises, it is fair to say that connection cannot be made in a straight line.
The Chicken or the Egg?
The chart of the Citi Economic Surprise Index below shows that positive economic surprises started to pick up before the election. The chart also shows, however, that there has been quite a bit of upward momentum in the positive surprises since the election.
This distinction has created a bit of a chicken-and-egg debate, which we don't intend to engage in here. The simple point to be taken from the chart above is that economic data has been more prone of late to surprise on the upside than on the downside.
To be clear, a high reading for this index doesn't necessarily mean the economy is strong. Rather, when the index goes above zero, it simply suggests the economic data have generally been better than expected.
For example, if industrial production was expected to decline 2.0%, but it only declined 1.0%, that would be counted as a positive surprise. That might help push the Citi Economic Surprise Index higher, but a 1.0% decline in industrial production certainly isn't equated with a strong economy.
Hype and Circumstance
The latter point notwithstanding, positive economic surprises can go a long way toward boosting investor sentiment as they suggest things are not as bad as feared or, in some cases, are actually much better than expected. That can promote a belief that economic conditions are improving, and, by extension, that earnings prospects are, too.
Using that framework, it is not surprising to see cyclical sectors attract buying interest when economic data is surprising to the upside. Lately, though, cyclical sectors have been helped even more by the thought that economic growth will be strong if, and when, tax reform, deregulation, and infrastructure spending all come to pass legislatively.
Since the election, the financial, industrials, materials, information technology, and consumer discretionary sectors have been among the best-performing sectors.
|Sector||Since Nov. 8, 2016|
The risk today for those sectors -- and the broader market -- is economic growth not living up to its hyped potential. That could happen for a variety of reasons, some of which were touched on in last week's column, "What Could Go Wrong?"
What It All Means
One of the roadblocks for living up to the high growth expectations could be the positive economic surprises themselves.
When the data keep surprising on the upside, economists start to ratchet up their expectations as well. In doing so, they create a higher hurdle rate that, in turn, can trip up the market if the data start surprising on the downside.
It is important to remember that downside surprises don't necessarily equate to a weak economy any more than positive surprises equate to a strong economy, as noted above.
There have been a lot of positive surprises in the fourth quarter, and yet the advance fourth quarter GDP report showed economic output increased at a lackluster annual rate of 1.9%.
What negative economic surprises could do is prompt an understanding that the market, and the cyclical sectors in particular, have gotten ahead of themselves in pricing in stronger growth and invite a period of consolidation as valuations get adjusted.
We call this to our readers' attention for two reasons: (1) the cyclical sectors are all sporting forward 12-month P/E multiples in excess of their long-term averages and (2) the Citi Economic Surprise Index is entering a territory where history indicates it has proven difficult for the data to keep surprising on the upside.
There could still be more room to run with the positive economic surprises, yet the form of economists' estimates often follows the reporting function, which creates an opening for disappointment, as the chart above shows.
If the data start to disappoint relative to consensus estimates, that could take some wind out of the sails of the highly-valued cyclical sectors; however, if there is added disappointment over the tax reform plan itself, or the timing of its implementation, the sails could see a rip in them that leaves the broader market adrift in choppy waters.
That may not happen, yet it's a risk to be appreciated when the cyclical sectors and the broader market are priced for a continuation of positive surprises.