Coming off such a horrible finish to 2018, not many investors were overly bullish last year. Most breathed a sigh of relief when the markets started to bounce back, but didn’t cheer the continued rally that ultimately turned out to be a hugely positive year for financial markets. To wit, the S&P 500 Index posted its 2nd best annual return in the last 22 years! Usually bonds don’t fare as well in a year when stocks are up big, but the Agg bond index also posted its best year in 17 years. Quite surprising.
As such, even conservative investors with well balanced portfolios still enjoyed solid returns last year. Stocks climbed steadily higher throughout the year even without the underlying corporate profit growth that usually drives prices. So, investors were willing to pay more and more for each dollar of underlying earnings, such that valuations became more stretched as the year progressed. At the start of 2019, the S&P 500 was trading at less than 15x forward earnings. By the end of the year the P/E multiple had expanded all the way to 18.5x forward earnings – a multiple expansion of nearly 25%. That is a phenomenon that is unlikely to be repeated in 2020.
Given the outsized rally witnessed in stocks, it shouldn’t be all that surprising that investor sentiment has grown complacent on several fronts, and the appetite for risk has seen a noticeable pickup. We monitor several different areas of the market to gauge investor sentiment and get a good cross-sectional view of risk behavior. One example is the CNN Fear & Greed Index, which encompasses seven different market-based indicators. As you can see in the chart on page 2, it recently hit a multi-year high, reflecting extreme bullishness on the part of investors.
Several of the weekly investor surveys (Investor’s Intelligence, AAII, NAAIM, etc.) are also reaching levels that in the past couple of years have marked extreme levels of bullishness. Additionally, in the options market the 5-day put/call ratio recently hit a 5-year low, indicating excessive speculation on the part of option traders. Lastly, we can also look at the bond market and see that spreads on junk bonds (relative to safe Treasury bonds) have also compressed to multi-year lows, reflecting a pronounced lack of fear in the high-yield bond market (read: extreme complacency).
The extreme levels of bullishness and complacency currently exhibited in the markets don’t necessarily portend the end of the bull market. But if past is prologue they do point to near-term upside exhaustion and a likely pullback for stocks. We are still bullish toward this year, but the recent pace of the advance has become unsustainable and a correction would likely reset expectations to more rational levels.
In the fixed income market, a pronounced downtrend in interest rates last year provided a strong tailwind for bonds and fixed income investments. The trend started with the Fed reversing its stance on raising rates. This, coupled with growing expectations for an economic slowdown, started the downtrend in rates. The yield on the 10-year Treasury note peaked around 2.80% last January, but by September had fallen all the way to 1.45% as recession fears peaked.
It wasn’t just the Fed cutting interest rates. This was a global trend last year. For its part, the Fed cut rates in the U.S. three times last year. But if you look at the total number of rate cuts among global central banks the tally skyrockets to 55. That is a lot of monetary easing, with the hope that all that liquidity will spur a pickup in economic growth. Let’s hope so.
Part of the Fed’s concern was the persistent trend towards lower inflation expectations. For many years, the Fed has stated its goal of achieving a level of inflation near 2.0%. But as the TIPs spreads chart below shows, the Fed has been unable to get inflation to stay at or above its stated target. And last year as inflation expectations started moving lower, the Fed had little choice but to cut interest rates and once again use aggressive monetary policy to stimulate the economy.
As for the economy, while growth has slowed from the pace achieved after the large tax cuts, it has not fallen off a cliff. Rather, growth has slowed to what appears a more moderate but sustainable pace, at least for the time being. The pillar of strength in our economy has been the consumer. Record low unemployment combined with record high asset values has emboldened the U.S. consumer to keep spending. This has buoyed the services sector (which is the majority of our economy), while the manufacturing sector continues to struggle.
Part of said struggle has been the escalation of tariffs as a result of the ongoing trade war, and fears that the proposed “Phase One” trade deal with China would fall apart. But the deal is finally set to be inked January 15th, which should help diminish some of the uncertainty overhang in the manufacturing sector. It should also help China, whose economy has been slowing, spurring the government to enact several of its own stimulus measures to reignite economic growth.
In sum, we remain upbeat in our outlook for the coming year, but with realistic expectations that a repeat of 2019 is unlikely. Stocks are off to a strong start, but the pace seems unsustainable such that a correction of some sort is in the cards. Election years tend to be positive ones in the market, albeit it with higher volatility than normal. And with the Fed on hold, and inflationary pressures well contained, fixed income markets should have an average year.
Jordan L. Kahn, CFA
Chief Investment Officer
Seeking Alpha; Raymond James; Briefing.com; Standard & Poors; Barron’s;
Charles Schwab; CNBC.com
*This Market Monitor is provided for informational purposes only and should not be interpreted as investment advice.