Reality Catching Up With Expectations

The stock market is a major leading indicator that rallies on optimism in the economy. Stocks represent the sum progress of companies in the present with a premium for what is expected in the future.  Often these economic expectations mirror stock prices, but eventually the stock market leans ahead of its skis requiring commensurate “realized” economic growth and profits to avoid faltering. With economic sentiment surging to 11 year highs despite 8 years of slow GDP growth, we are now witnessing signs of economic acceleration to justify some of this ebullience. 

Global trade is one way to view the ebbs and flows of the actual economy. US exports and imports fell sharply during the global fossil fuel recession from 2014 to 2016. As Oil bottomed at $26 in early 2016 and ballooned back above water to $56, the forward looking stock market and trade flows also rebounded. As we often say, strong moves in Oil and Copper are good leading indicators for our economy.

The euphoric Trump sentiment elevating stocks is also being supported by real numbers coming out of Europe. The Eurozone has been a significant drag on global growth since 2011 and now could be considered a leader. Unlike our Fed, their Central Bank has kept its foot on the gas with continued Quantitative Easing (QE) in spite of an accelerating manufacturing sector that may be exceeding the robust US performance. Virtually all of Europe has kicked into a higher gear since November reaching 70 month high expansion rates in new orders, backlogs and production. Even France has turned from perennial laggard to one of the leaders of the important Eurozone. Japan, UK and China are also showing signs of actual growth that justifies rising expectations coincident. 

Among the hallmarks of the past 8 years has been slow growth composed of an average consumer oriented service sector and stagnant manufacturing growth in a world of excess capacity and low productivity. Consumers had slowed during the energy recession, but have expanded more rapidly since November approaching 6% retail sales growth. Auto sales will need to remain near record levels along with higher energy prices in order to exceed this consumption pace,  but so far economic euphoria is being matched to some degree by improved consumption. 

Large and regional banks are seeing strong loan demand which hints of further growth especially for small businesses and consumers even before expected Dodd-Frank repeal efforts are complete.

The economy is picking up speed, but stocks and expectations continue to accelerate even faster as prices move ahead of earnings. Factoring inflation and forward price to earnings expectations we see the prices are near Fair Value despite yet another sharp leg up in stocks this month. During the 1990’s Tech Bubble we saw valuations move to extremes for 4 years beginning in 1997. Valuations are nearing a more volatile phase this year. Should earnings fail to keep pace with earnings forecasts then the Rule of 20 will again move to overbought extremes of the late 90’s, but thus far its too early to panic over the long term outlook. 

Shorter term, sentiment has reach optimistic extremes seen at the “start” of Bull markets in 2003 and 2009. Investors Intelligence has Bullish leaning advisors at 61%, within a few % of decade highs. However, these advisors missed the post election price explosion and continue to sit on the sidelines waiting with most investors and money managers for a modest 4 to 6% correction. We can see this better in more nimble sentiment measures of small investors and traders. AAII surveys investors and invariably generates potent Buy signals when Bulls fall below 30% and over exuberance occurs when Bulls move into the upper 50’s. The fact that investors are closer to being Bearish than Bullish currently at just 33% Bulls, reflects the hefty skepticism crossing their fingers in hope of lower stock prices before they joining the Bull camp. Such doubt in a powerful up trend is good for the stock market.

Nimble option traders buy more puts as they become negative and buy call options when more optimistic. While there was an optimistic call option buying surge during the first month ensuing Trump’s November election as would be expected, the shocking move higher in stocks caused traders to buy puts in hopes of a correction. Traders, like investors and money managers failed to add significantly to their equity allocations during the last 3,000 point 15% rally in the Dow. All corrections have been less than 2% as the market has done its job well keeping buyers  sitting on their hands wanting to buy, but at a lower price. As prices move higher investors will keep buying ever smaller dips until its time for a more serious correction. After 6 weeks of tight consolidation, stocks in December and January stocks have renewed their assault higher in February and finally we are seeing signs of sentiment moving closer to overbought levels short term.

Our outlook since mid-December has been for unusually mild corrections of 2% until we are ready for a 10% type of correction – a pullback that scares those investors looking to climb on board the Trump rally. The recent pattern of rapid appreciation with small corrections frustrating new buyers is typical of new Bull markets. Expect an alarming correction before mid-year from higher levels that offers bargain prices once again for those with the courage to catch a falling knife. Dow 22,000 and SP 500 Index mid 2400’s are our primary 1st half of 2017 target areas. 


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