HIGHLIGHTS
• Stock prices have surged to start 2018 as both investor sentiment and market fundamentals have improved.
• We think warning signs are growing and cite rising bond yields and inflation as the chief risks for equities.
• We also think this bull market still has room to run and that investors should stick with a progrowth bias.
The risk-on theme continued for a third straight week, as the S&P 500 Index rose 0.9%.1 Once again, Treasury prices fell while the yield curve flattened.1 Investor sentiment appears to be improving, with some moving money into the stock market based on fears that they may have missed the rally. Tax reform continues to push markets higher, but we think improvements in corporate earnings expectations have been the primary driver of returns.
Weekly Top Themes
1. The “melt up” in equity prices has been driven by both sentiment and fundamental improvements. Expectations for corporate earnings in 2018 were high before the tax bill and are now moving even higher.1
2. Companies have several equity-friendly plans for their tax windfalls. When asked in a recent survey how they would use their cash, the top answers were: 1) increase capital expenditures, 2) pay down debt, 3) increase dividends, 4) hold more cash and 5) raise wages.2
3. Wage rates appear to have room to rise before pressuring corporate profit margins. Wages usually grow about 4% year over year before they cause margin pressure.3 With wage growth only at 2.5%, there appears to be room for this business cycle to continue.3
4. Rising Treasury supply may put upward pressure on yields. Rising budget deficits and the Federal Reserve’s balance sheet unwinding may cause U.S. Treasury supply to nearly double this year.4 Yields have been rising as investors priced in better economic growth, and increased supply may accelerate this trend.1
5. Stocks may be fairly valued, but that doesn’t mean this bull market is over. At the beginning of the year, we pegged 2,800 as a fair value for the S&P 500 Index. The index has already reached this level before the end of January.1 But that doesn’t mean prices can’t still rise, since bull markets rarely stop at fair valuation.
6. Growing market breadth is supportive for stocks. At the midpoint of January, 41% the S&P 500 companies reached a new three-month high, the broadest reading of the new-high list since 2013.4 Historically, such broadening has been associated with a continuation of bull markets.4
7. Rising inflation remains the chief risk facing equities. Rising investor optimism, sustained synchronized global growth and a tightening labor market all point to inflation moving higher.
We are not yet seeing warnings signs that would signal a correction
Over the past 18 months, investor sentiment appears to have come full circle. In mid-2016, deflation fears reigned and investors seemed eager to embrace negative news. Since that time, however, optimism toward economic growth, earnings growth and stock market prospects have become the main investment themes. The most recent example of this trend is the incredibly positive reaction to last month’s tax bill, which has caused investors and analysts to forecast increasingly higher earnings results even as valuations are growing less attractive.
Such an environment causes us to take pause and examine the risks. Earnings expectations are quite high. While we think they can still be met, the higher expectations rise, the harder it will be for results to beat estimates.
More worrisome for us are developments in the bond market. Short-term yields have already been rising quickly and longer-term yields are starting to follow. We don’t see warning signs yet, but as the 10-year Treasury yield approaches 3%, the more concerned we would be that rising yields could cause negative pressure on stock prices. Similarly, we expect rising inflation could cause problems, especially if the pace of economic growth improvements is interrupted.
But while these risks are rising, we do not think they have reached critical levels. Market fundamentals remain sound, breadth is improving and valuations are not yet stretched. As such, we think investors should stick with a pro-growth investment stance, but should increasingly be on the lookout for warning signs.
Bob Doll is chief equity strategist at Nuveen Asset Management.
1 Source: Morningstar Direct, Bloomberg and FactSet.
2 Source: ISI Evercore survey, 16 Jan 2018.
3 Source: Deutsche Bank Research
4 Source: Strategas Research