The stock market meltdown at the start of the year has been almost completely reversed by a melt-up.
The S&P 500 plunged 10.5% from the closing low at the end of last year to this year’s low of 1829.08 on February 11. It is up 9.3% since then, rising above its 50-day moving average and nearing its 200-dma. It is only 2.2% below where it ended last year and 6.1% below last year’s record high of 2130.82. Among the 10 sectors of the S&P 500, five now are above where they ended last year: Telecommunication Services (11.0%), Utilities (8.2), Consumer Staples (2.7), Energy (1.1), and Industrials (0.6) (Fig. 3). Five remain below last year’s closing prices: Financials (-6.9), Health Care (-6.7), Information Technology (-3.0), Consumer Discretionary (-2.1), and Materials (-0.4).
Fears that weakening global economic growth might pull the US down into a recession have dissipated as the latest batch of US economic indicators mostly has surprised to the upside. Indeed, the Citigroup Economic Surprise Index — which had fallen from last year’s high of 1.5 on November 16 to a recent low of -55.7 on February 5 — rose to -12.9 on Friday. Fluctuations in this index can sometimes influence the movement in the S&P 500 forward P/E, as they have since late last year.
Fears that the plunge in commodity prices in general and the price of oil in particular might cause a 2008-style financial crisis and contagion also have diminished. Commodity producers have scrambled to restructure their operations and reduce their output. As a result, commodity prices seem to have bottomed.
There undoubtedly will be plenty of defaults ahead, but a financial crisis seems unlikely. Money is coming back into the high-yield market, attracted by higher yields. The corporate junk bond yield has declined from a recent high of 10.1% on February 11 to 8.6% on Friday. Its spread relative to the 10-year Treasury has narrowed from 844bps on February 11 to 668bps on Friday. The S&P 500 Financials stock price index is up 13.0% since February 11, while the EMU Financials MSCI stock price index is up 16.9% over the same period.
Since Joe and I are secular bulls, we are happy to see stocks rebounding. However, we did lower our target for the S&P 500 this year to 2000 and pushed out our target of 2200-2300 into next year. Wouldn’t you know it? The S&P 500 closed at 1999.99 on Friday! That’s well ahead of schedule. However, consistent with our view that the year still could be choppy, we wouldn’t be surprised by a near-term retreat. As we’ve observed lately, the earnings outlook during at least the first half of the year is likely to remain challenging. In addition, valuation multiples aren’t cheap, with the S&P 500 forward P/E back at 16.1.
Then again, we can’t rule out a continuation of the latest melt-up either. If so, it would continue to be led by a melt-up in the forward P/E since the forward earnings of the S&P 500 is likely to continue flat-lining, as it has since late 2014 (Fig. 9). Why might valuation multiples move higher? One possible scenario would be if Fed officials indicate that despite achieving their unemployment target and coming close to doing the same for inflation, they’ve decided to postpone raising the federal funds rate again for a while.
Let’s consider why they might do so:
US Economy: Fed Has Slack
Fed officials must be very pleased to see that the unemployment rate is under 5.0% and that the core PCED inflation rate is approaching 2.0%. However, the doves among them, especially Fed Chair Janet Yellen, might justify slowing the pace of monetary normalization so that they can be more certain that the economy has normalized for sure.
They can argue that there is still slack in the labor market. The recent rapid increase in the labor force suggests that workers are coming back because they’ve heard that there are plenty of job openings and they are finding jobs. The influx of reentering as well as new workers seems to be keeping a lid on wage inflation, which is another sign of slack in the labor market.
With regard to inflation, as Melissa and I observed last Wednesday, a few Fed officials recently have signaled that they prefer to target the headline rather than the core inflation rate since the plunge in oil prices seems to be having a depressing impact on inflationary expectations. Using the PCED measure, the former was 1.3% y/y while the latter was 1.7% during January. We wouldn’t be surprised if Fed officials started to suggest that they wouldn’t mind if the core rate overshot their 2.0% target for a while. Now let’s have a close look at all the recent data that members of the FOMC are likely to depend on when they meet on March 15-16 — and most likely decide to do nothing and to signal nothing about another rate increase at the next meeting on April 26-27:
(1) Earned income. Friday’s employment report for February was sweet and sour. Payrolls rose solidly (0.2%), but wages edged down (-0.1) and weekly hours worked declined (-0.6). As a result, our Earned Income Proxy, which tracks private-sector aggregate wages and salaries, declined by 0.5% m/m.
(2) Employment. Payroll employment rose 242,000 last month, and the previous two months were revised up to 172,000 during January and 271,000 during December for a total gain of 685,000. Even more impressive is that the household measure of employment jumped by 1.6 million over the past three months, while the labor force surged by 1.5 million. With the significant influx of reentering and new workers in the labor force, the civilian labor force participation rate finally seems to be turning up.
(3) Wages. This is Yellen’s dream scenario. However, it is only starting to play out. The rise in the labor force confirms her view that there is plenty of slack still in the labor market as previously discouraged workers who dropped out come back into the labor force. The slack thesis is also corroborated by the relative weakness in average hourly earnings, which rose only 2.2% y/y last month for all workers. Yellen has previously said that she would like to see wages rising between 3% and 4%.
(4) Trade. Also on Friday, the Commerce Department reported that the US trade deficit widened more than expected in January as a strong dollar and weak global demand helped to push exports to more than a five-and-a-half-year low, suggesting that trade will continue to weigh on economic growth in the first quarter. On an inflation-adjusted basis, exports fell 2.2% m/m and 3.8% y/y to the lowest since February 2014. West Coast ports’ outbound container traffic fell 8.1% y/y through January.
The trade-weighted dollar is down 3.0% from its recent peak on January 20, but remains up 19% since July 1, 2014. That’s clearly weighing on exports. This is yet another reason to postpone further rate hikes so that the dollar doesn’t move still higher.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs,
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