How much does 3% matter to stocks?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

 

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities
• Trend Model signal: Bullish
• Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
 

The 3% question

The US equity market took fright last week when the 10-year Treasury yield rose above 3%. Stock prices recovered when yields retreated. How much should equity investors worry about a 3% 10-year yield?
 

 

Rather than focus on any single level, investors would be advised to concentrate on the interaction between stocks and bonds. Consider the P/E ratio. The factors that drive equity prices are:

• How fast is the E in the P/E ratio likely to grow?
• What is the outlook for interest rates and how does it affect the E/P ratio?

It’s really that simple.
 

The history of rates and stock prices

When the stock market sold off last week, I pointed to the historical analysis from JPM Asset Management that “when yields are below 5%, rising rates have historically been associated with rising stock prices” (see Is good news now good news, or bad news?)
 

 

I also referred to the BAML Fund Manager Survey which indicated that fund managers were not overly worried about equities until yields approached 3.5%.
 

 

Those are all simplistic explanations that relate to valuation, but they don’t matter very much in the short run.
 

Good news is still good news

What really matters to stock prices is growth, and interest rates. The Q1 GDP report was an important test for investor psychology. Is good (economic) news still good (stock market) news, or bad news?

In other words, have investor focus from the bullish factors behind positive growth changing to a fear about the bearish effects of higher growth and inflation on interest rates?

As it turns out, the bulls squeaked out a narrow win on market psychology based on the results of the Q1 GDP report. Q1 GDP growth came in at 2.3%, ahead of market expectations of 2.0%. Bespoke observed that the Employment Cost Index was showing signs of acceleration. The acceleration was not just confined to higher management bonuses, but salaried staff as well.
 

 

Q1 GDP growth has historically been depressed by seasonal factors. When we unpack some of the unusual conditions, we can see that Q4 to Q1 was distorted by hurricane-driven Q4 spike in auto sales and home repairs. GDP growth ex-hurricane effects was 2.7%. YoY GDP growth, which sidesteps the seasonal issues, came in at 2.9%.
 

 

All in all, it was a strong GDP report. Moreover, inflationary factors were ahead of expectations. Core PCE prices rose 2.5% (vs. 2.4% expected), and the Employment Cost Index printed 0.8% (vs. 0.7% expected). These results should give the Fed hawks further ammunition to push for four rate hikes this year instead of three. Indeed, the latest market expectations from CME shows that the probability of four rate hikes this year has been rising, while the probability of three hikes fell. The market implied chances of three and four rate hikes are now roughly equal.
 

 

What did the market do after the GDP report? 2-year yields spiked initially but steadied to roughly flat at the close, and the yield curve flattened. Stock prices ended the day with a small gain.

Good news is still good news. It could have been a lot worse. Score one for the equity bulls in the category of market psychology.
 

Earnings, earnings, earnings!

What about earnings growth? The results from Q1 earnings season has been solid. The latest update from FactSet shows that both the EPS and sales beat rates are well above their historical averages. Consensus EPS estimates rose in response to the upside earnings surprise. From a longer term perspective, forward 12-month EPS changes are roughly coincident with stock prices. While upward earnings revisions are not bullish signals in isolation, they do serve as a confirmation of the direction of Street expectations.
 

 

The market was spooked last Tuesday when Caterpillar, which is a major global cyclical bellwether, report blow-out results. In the subsequent call, management deflated expectations by stating that Q1 earnings “will be the high-water mark for the year”. That remark sent the stock’s price down, and the announcement went on to pull down the market as well. Investors should relax. CAT’s problems are likely specific to the company due to higher raw material prices from steel tariffs.
 

The CAT episode prompted some traders to panic and state that the market was not reacting to earnings beats. Analysis from FactSet shows that perception to be incorrect. On average, stocks are rising on earnings beats, and falling on misses. That said, the magnitude of the market reaction during this earnings season has been muted when compared to the historical average.
 

 

Score one for rising growth expectations in the E of the P/E ratio.
 

Watch the real economy

What about the problem of rising yields? 2-year Treasury yields have been rising steadily since the Fed began its tightening cycle, and 10-year yields are near the 3% level. When do higher rates start to hurt stock prices?
 

 

While rising yields does create competitive pressures on holding stocks, the continued dominance of the “good news is good news” narrative suggests that investors should instead focus on the secondary effects of rising rates on the real economy.

There are two likely reasons for the E in the P/E ratio to fall. Either the the Trump White House plunges the global economy into a slowdown with a trade war, or the Fed over tightens the economy into a recession. The latest news indicates that trade tensions are easing. Trump reported sounded optimistic and stated that there was a “very good chance” that a trade war could be averted. Treasury Secretary Mnuchin is on his way to China for a round of negotiations.

That leaves the Fed. The Fed is undergoing a tightening cycle. Instead of asking when rising rates are likely to hurt the stock market, the better question is when rising rates is likely to slow economic growth. Historically, recessions have followed whenever the YoY changes in Fed Funds rates have exceeded the YoY change in employment. This indicator is getting close to a recession signal, and I will be watching the April Jobs Report closely Friday to see how it is evolving.
 

 

In addition, the combination of higher interest rates and quantitative tightening will have the effect of slowing money supply growth. In the past, a recession has followed whenever either M1 or M2 growth has fallen below the inflation rate. Money supply growth is decelerating rapidly, and real M2 is on pace to go negative later this year.
 

 

Watch the effects of rising rates on the real economy, not just the stock market.
 

Too early to get bearish

Still, it is too early to get too bearish on equities just yet. There are few signs of a bull market killing recession in sight. Initial jobless claims provide a timely high frequency pulse of the American economy. There was much excitement last week when initial claims fell to the lowest level since 1969. For a better perspective, initial claims adjusted for population has been steadily declining and making all-time lows in this expansion cycle.
 

 

Initial claims have been inversely coincident with equity prices during the past few expansion and provides real-time confirmation of stock market trends. The bull is still alive, according to this metric.
 

 

New Deal democrat monitors high frequency economic data, and he helpfully categorizes them into coincident, short leading, and long leading indicators. His analysis indicates that there are no immediate signs of recession, though the long leading indicators are deteriorating:

The nowcast remains positive, as confirmed again by the monthly data. The short term forecast has decelerated from strongly to normally positive. The long term forecast continues to tiptoe towards neutrality, but as of now remains weakly positive, with housing, as indicated by purchase mortgage applications being the chief reason for continued positivity, although the GDP report suggests housing may be weakening slightly as well.

The exuberant reception of WeWork junk bond issue (see the details of financial analysis from FT Alphaville and Bloomberg) shows that the animal spirits are alive. The company originally tried to raise $500 million in debt, but the issue was 5x oversubscribed and upsized by 40%. The bond was priced at 7 7/8%, thought it sank to below par soon after the offering.

The WeWork offering is an indicator of low stress levels in the financial system. In general, high yield (HY) bonds have been flashing a positive divergence against stock prices, though the risk appetite of investment grade bonds is roughly tracking equity movements.
 

 

Tiho Brkan recently highlighted SentimenTrader’s AIM composite sentiment model. Readings are at levels that have produced short-term bounces. At a minimum, downside equity risk is limited at these levels.
 

 

Despite the prospect of rising rates, the combination of a strong growth outlook, robust economic nowcast, lack of financial stress, and washed-out sentiment are signals that it is too early to get intermediate term bearish. While there is no doubt that the equity bull is mature, the day of reckoning is not at hand – yet.
 

The week ahead

Looking to the week ahead, New Deal democrat‘s comment that the “short term forecast has decelerated from strongly to normally positive” may be setting the tone for the stock market’s outlook for the next few weeks. While the short term forecast remains positive, its deceleration has provided the impetus for the current correction. Stock price are likely to consolidate and remain range bound until some of the uncertainties that overhang the market are resolved.
 

 

That said, the S&P 500 may be in the process of staging an upside breakout from a bull flag, which would higher prices ahead. However, the market is approaching overbought readings from a short-term (1-2 day) time frame.
 

 

On a longer (3-5 day) time frame, breadth readings are neutral but exhibit positive momentum tendencies, which is bullish.
 

 

While the bias is bullish, expect lots of event driven volatility next week. From a macro perspective, the FOMC announcement on Wednesday, and the Jobs Report on Friday will undoubted create some choppiness. As well, Q1 earnings season is in full swing, and remember how AMZN, CAT, and FB created both upside and downside market swings last week?
 

 

My inner investor continues to be bullish on equities. My inner trader had taken a small long position, and he is prepared to add to his longs should the opportunity present itself.
 

Disclosure: Long SPXL