With the exception of May, 2019 is probably surprising most everyone in the investing community in quite positive fashion. Despite the realities that both economic and corporate earnings data appear to be in a trend of slowing, AND continued tariff/trade and political uncertainty both the S&P500 and Dow busted through respective round-number levels of 3,000 and 27,000 last week. So far in July, the S&P500 is up another +2.1% bringing the YTD climb to more than 20%. About 86% of the S&P500 constituents trading above their 50-day moving average. In the short-run, this probably means the market is overbought and due for a pause – that idea is also significant when one considers we are entering what is traditionally a weaker seasonal period. But more important is the message it tells about momentum present under the surface. Interestingly, all of this has happened at the same time the yield curve has remained troublingly flat (or inverted depending on the maturities inspected).
From an economic perspective, there is no denying that the fundamentals of the US and global economy are slowing and less attractive than a year ago. To be clear, none of the data looks recessionary (economic shrinkage) at the moment, but the pace of change is slowing… and public companies are suggesting their profits are under pressure. Trade uncertainty is keeping international economies soft; Germany for example, considered the engine of Europe, is printing some outright weak numbers. And it is these figures along with stubbornly low inflation that are giving the US Fed (and other global central bankers) the cover to convey their next moves will be rate cuts despite an unemployment rate that is a historically low 3.6%. To reiterate, this is a huge pivot compared to just 7 months ago when the market was questioning how many more hikes the US Fed would follow-through on in its quest to normalize interest rates and monetary policy in general.
Despite landmark highs on US indexes being achieved, it is hard to recall a time where the mood felt so indifferent or investors so unwilling to celebrate. But those in-tune with the market’s currently complicated undertones don’t need to work hard to come up with reasons justifying why. Perhaps it is the low/negative bond yields implication that fixed income investors are quite pessimistic on the outlook. The inverted yield curves across many sovereign issuers confirm this caution (although the US curve did manage to steepen last week as the prospects of a Fed rate cut look all but certain with their meeting next week). Historically, investors are also acutely aware that yield inversions lead recessions by roughly 18 months on average. In concert, equity markets are signaling some internal skepticism too with smaller-size companies lagging larger brethren by almost 10% YTD. Yet with both stock and bond markets signaling caution under the surface, perhaps that gives the contrarian view room to run.
Thought provoking perspective on small-cap underperformance YTD: due to the dramatic underperformance of smaller-size companies and value in particular, it might seem a logical bet that the sector is ripe for catch-up. Another interesting explanation may be that the most attractive and successful small-size companies already grew out of the small-size category, now residing with mid-size or even large-size companies. Are companies remaining in the small-cap space following a 10-year economic cycle those with business models or growth trajectories that are structurally impaired? Is there inherent survivorship bias present in this area of the market, and the companies remaining in small-value are cheap for a reason – because they truly are significantly more risky than other areas? Certainly a case for pause before getting too excited about small-company investing at this stage!