Stocks are once again nearing all-time highs, which is understandably making investors nervous about a repeat of the fourth quarter occurring. While that fear is healthy, the reality is that the underlying conditions of the market are a world different now. Not only are valuations lower, but the economy is looking robust, and perhaps most importantly of all, the Fed has let off the gas pedal with hikes, which puts recession risk much lower. All of these factors seem to conspire to make a perfect environment for stock price appreciation.
FINSUM: Anyone who reads FINSUM knows we lean towards bearish news, but the truth is that our better judgment is telling us that now is probably a time to be optimistic, as the trifecta of reasonable valuations, a solid/strong economy, and a dovish Fed, are in place.
There have been a lot of bullish indicators lately, and not just in share prices rising. However, there is a big warning sign that investors need to be paying attention to. One of the challenges of assessing corporate earnings is to get a feel for where things are really headed when the whole Wall Street reporting mechanism is stacked to make you think companies are always outperforming. One way to do so is to look at spreads between GAAP earnings and so-called “adjusted earnings”, or the doctored earnings companies love to show to make themselves appear more attractive. The wider the spread, the more companies are reaching to appear as though things look good. This, therefore, makes it a bellwether for how earnings and the economy are really trending. The spread between the two types of earnings stood at $200 bn for year-end 2018, the highest level since 2010.
FINSUM: This is not a perfect proxy, but it is certainly indicative, and the indication right now is not positive.
Every investor seems to assume that this bull market is nearing its expiration date. Good things must come to an end, after all. However, Barron’s is arguing (rather adamantly) that this bull market could perhaps go on for another ten years. Reminding us of the old adage that bear markets don’t die of old age, Barron’s says there is just no sign of real weakness. “As far as the U.S. economy is concerned, there is no obvious sign that it has deteriorated”, says the publication. What about the yield curve? They say that is just an adjustment to tighter monetary conditions and not predictive of a recession in this case.
FINSUM: There is undoubtedly an element of superstition/intuition which is making investors feel like this bull run must come to an end soon. But the reality is that the underlying conditions for that to happen may not be in place.
The end of the bull market could be near, and with that in mind (and really any time), it is a good idea to have a preparation plan in mind. Markets have risen sharply this year, and are back near their peak from 2018, explaining why hedging activity is growing. So how to hedge? Defensive sectors and bond markets are popular, but what about things like options and the VIX? Well, that latter has been diminishing in popularity recently, as the CBOE’s VIX did not respond to Q4’s volatility the way many expected. This has led to claims the market is fixed, and in any case, it has not performed well as an S&P 500 hedge. That leaves S&P 500 hedges themselves, such as 30-day SPX put options.
FINSUM: If you understand and are comfortable with options, use them. If you don’t, stay away and stick to sector and asset class-based hedging.
Big bank Credit Suisse thinks the stock market rally will keep going. They say the big gains this year are mostly because of improved investor sentiment on the back of a more dovish Fed, weaker inflation, and the better prospects for a US-China deal. Further, the bank’s chief US equity strategist says “Our work indicates that investors have not fully re-risked portfolios following 4Q’s turbulence—despite a sharp decline in volatility and spreads—and that valuations will drift higher as they do so”.
FINSUM: We have to tentatively agree with this view. Sentiment is up, and combined with lower valuations and the fact that investors have not fully re-entered the market, there does seem to be a good runway higher.