Research.LeutholdGroup

Stock market manias thrive on buzzwords, and if there’s a single one that captured the essence of the late 1990s’ boom it was “productivity.” In today’s version, our top candidate is “liquidity”—and we doubt anyone would argue.

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Long before policymakers’ extreme response to the COVID collapse, we feared that the Fed’s interventions were suppressing important signals from the stock and bond markets. But we now suspect that hyper-expansionary policies are suppressing price signals from the “real” economy as well.

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The Fed is hell-bent on generating inflation of 2% or higher in an over-supplied world that we think should probably be experiencing mild deflation. Their success or failure at this mission will be critical for asset allocators. For equity managers who must remain fully invested, however, the more important question might be not whether the Fed can generate higher inflation, but where.

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Several measures of U.S. economic “surprises” have soared to all-time highs in the last couple of months, showing that even economic forecasters have finally learned to play the corporate game of  “under-promise then over-deliver.” Mind you, that’s only 30 years after most industrial firms eliminated the role of “staff economist.”

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In 2019 and 2020, our regard for time-tested valuation tools resulted in tactical portfolios being underexposed to stocks during a pair of tremendous rallies. Now, the critique is that we don’t appreciate the brilliance of today’s policymakers and their miraculous ability to pivot just when the stocks (and, in the latest case, the economy) need it most.

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There’s an underlying faith that bureaucrats at the Fed and Treasury will keep good and bad businesses, alike, afloat—and overvalued. We’re still trying to unearth a single historical analog that merits such confidence.

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Officially, those quick to pronounce the move off March lows as a new bull market have been proven correct with new S&P 500 all-time highs. Fundamentally, though, there’s enormous risk in Large Cap valuations, regardless of where one believes we are in the economic cycle.

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A truly skilled writer would attempt to build up a little suspense before revealing the central theme of this section. But in this makeshift world of sixty-game baseball schedules and seven-inning doubleheaders, who has the time or patience for that?

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While most economic numbers have been positive, the fly-in-the-ointment was the latest Senior Loan Officers’ Survey. Banks have tightened their lending standards across the board.

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The S&P 500 and NASDAQ have lately traded as if the hybrid “Fed/Treasury put” entails no cost at all. But dollar alternatives—like forex, precious metals, and crypto-currencies—are saying, “Not so fast!”

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The weekly covers of The Economist do a pretty good job of capturing the zeitgeist of global financial affairs, but there’s so much packed into every issue (and enough to do around our shop) that sometimes all we see are the covers. But we have to admit we’re disappointed in The Economist for the week ended July 31st. The “Free Money” theme is at least four months too late!

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Market perma-bulls deserve high marks for their persistence, yet, despite all that’s transpired in 2020, their case is exactly the same as six months ago: Extreme stimulus won’t “allow” a significant stock market drop, nor any further economic deterioration.

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News that the Bureau of Labor Statistics may have undercounted the May unemployment rate by six percentage points should remind investors of the danger of taking government economic reports too seriously. Regardless of the figure, though, unemployment is no doubt near its peak for the downturn.

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From now ’til eternity, bullish market pundits will always be able to argue that the global spread of the coronavirus “caused” the current global recession and bear market. While the pandemic was certainly the final catalyst, these pages had been detailing the emerging cracks for over a year.

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We can’t count the number of times in the last week we’ve heard analysts worry about “what the Fed might know that we don’t.” In the words of John McEnroe, “You cannot be serious!”

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Super-easy monetary policy has been blamed for the rise in income and wealth inequality in recent years, and more recently we’d fault the Fed for performance inequality within the stock market.

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Bulls who fashion themselves as contrarians argue that the public is nowhere near as infatuated with the stock market as they were in the late 1990s. It may come as a shock to our readers, but we agree with them.

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Based largely on the bearish trends in our monetary and liquidity measures, we were correctly negative on stocks throughout most of 2018. It’s therefore especially painful for us that 2019’s market rebound has been credited almost entirely to the “pivot” in most of those measures.

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After last year’s spectacularly successful pivot following the December 2018 plunge, the thinking is that future rate hikes are the bull market’s only threat. Perhaps that will be the case; the belief is certainly well-supported by postwar U.S. economic history, but it also reveals a shocking lapse in short-term memory.

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Last year the Federal Reserve dumped historic stimulus onto a full-employment economy and an already richly-valued stock market. The stock market obviously loved it.

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Among six major monetary gauges, five are now graded bullish, compared with just three a few months ago, and zero at the end of 2018.

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Despite an economy operating “beyond” full employment for the past seven quarters, more than one-fourth of the companies in the Leuthold 3000 universe are losing money on a 12-month trailing basis. The Fed has subsidized what’s truly become irresponsible behavior.

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Earnings results for the second quarter have so far "beaten" expectations (as they always seem to), but that hasn’t changed the calculus for Small Cap companies. About one-third of them have negative earnings over the last twelve months.

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The recent rate cut managed to bring policy uncertainty back into the market by two seemingly harmless words—”mid-cycle adjustment.”

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Beware of those who write about stock market history, especially when they speak of cause and effect. The truth is that the “why” can never be known.

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Signs of spring are popping up everywhere in the Financials sector. S&P Financials was easily the top- performing sector in April and several sub-industries have been bubbling higher in our Group Selection discipline.

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The Fed not only signaled no rate hike for the rest of 2019, but also committed to unwinding its balance-sheet reduction program, starting in May and ending in September. The market took it one step further and priced in a rate cut in the second half of 2019.

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The “Expectations” component of the Consumer Confidence survey has been wobbly in the last few months, but the latest report, released on Tuesday, showed the first meaningful hit to consumers’ “Present Situation” since the stock market first began to struggle 14 months ago (Chart 1).

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With all the excitement over the Fed’s shift in rhetoric and the excellent subsequent market action, there’s a danger of losing sight of the broader cyclical backdrop for U.S. stocks. Remember, the economy is still operating beyond government estimates of its full-employment potential, and it’s not as if the Fed has actually eased policy—as it did successfully at a similar late-cycle juncture in the fall of 1998 and (ultimately unsuccessfully) in the summer of 2007.

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The Fed’s “Christmas capitulation” seems to get most of the credit for the stock market rebound, but we’re not exactly sure how, or even if, the Fed capitulated at all.

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Just a few months ago, Fed Chairman Jerome Powell boasted a reputation as a straight-talking, sound-money banker.

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In September, the percentage of S&P 500 stocks outperforming the S&P 500 index fell to 40.7%, the lowest reading since mid-2012. Breadth has followed a conventional path over the course of this unconventional bull market; in the current phase, the odds of outperformance are steadily diminishing.

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It’s been amusing to watch the narrative surrounding Fed policy evolve as the market has rallied.

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The Fed has long claimed itself to be “data dependent” while providing less and less information on those data points it considers most relevant. We can’t know what’s on that list, but we certainly know what isn’t: the ISM Manufacturing Composite, which (prior to the current cycle) provided an excellent gauge of the Fed’s policy bias.

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We don’t think the current stock market upleg is over.

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The S&P 500 has labored beneath its March 1st bull market high for the last two months while underlying breadth and leadership trends have remained mostly favorable.

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In recent years the Fed has been more forthright than ever about the importance of the wealth effect as a transmission mechanism of monetary policy. But this (or any) policy effect hardly exists in a vacuum, and the Fed would do well to recognize that stock market swings have played an increasingly important role in the country’s fiscal balance.

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We considered the launch of the QE tapering program in January 2014 as the formal onset of the Fed’s tightening campaign, and that view seemed to be on the mark when High Yield bonds, and then stocks,  unraveled over the next couple of years—although the final losses in the DJIA and  S&P 500 fell short of what we expected.

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While the Dow Jones Bond Indicator has stood the test of time, history shows that rising bond yields are not always a bearish stock market phenomenon.

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Bull markets seem to create their own moods that lead to fundamental developments being viewed in a mostly favorable light.

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