The summer is winding down. Corporate-earnings season is just about through. Federal Reserve policy makers have thoroughly aired their thinking at the annual Fed research conference last week.
And after seven months of retrenchment, repair and recovery, the broad stock indexes have notched a hard-won breakout to a record high.
In other words, the markets have reached a "now what?" moment, on the cusp of a consequential mid-term election and an approaching climax of a global-trade reordering.
Looking strictly at the market's behavior, the setup is fairly encouraging. A breakout to a new high by definition means the bull market remains intact and, by extension, no past buyer of stocks at the index level feels anything but smart for having played the game.
Over the past 90 years, when the S&P 500 makes its first 52-week high in six months or more — as it did on Friday — the index has been higher over the ensuing year 94 percent of the time, according to Jonathan Krinsky, chief market technician at MKM Partners.
And in prior years when the S&P was up between 5 percent and 10 percent mid-way through August, the returns for the remainder of the year have typically been positive, with gains better than the average of all years.
Traders might also be feeling the muscle memory of 2017, when the S&P 500 was up a good but unspectacular 8.3 percent into the third week of August before accelerating to surge another 15 percent over the next five months — culminating in the peak at 2,782 on Jan. 26.
The market doesn't always make it so easy as to play the same late-year melt-up script two straight years, but one can't ignore the chance that something similar could unfold.
Yet the very good news reflected in stock prices a year ago could be difficult to top — and perhaps explains why the market has been, and could remain, relatively hard to please. The big corporate tax cut was rounding into shape just as Europe and Asia economic data started to pick up and oil prices began to ramp, creating a rare array of positive forces that led to an unheard-of surge in S&P 500 earnings growth nine years into an economic expansion.
The sheer brute force of the good news that it's taken to squeeze the S&P 500 to its 8.3 percent gain this year – that 20 percent profit eruption, a Fed stressing patience, tame Treasury yields, pliant credit markets and a $1.5 trillion pace of combined cash dividends and stock buybacks handed to shareholders of S&P 500 companies – is notable.
Bullish observers will likely point to the overhang of the president's decision to wage "trade wars of choice" to explain why stock prices have lagged earnings growth so dramatically. Perhaps.
But it's perhaps just as likely that the anxiety generated by tariffs and trade disruptions has served a helpful purpose: to restrain the runaway investor optimism of January, keep the "wall of worry" in place and trigger a needed valuation adjustment in high-flying global industrial stocks.
The main threat of an aggressive trade posture toward China is likely a panicky capital-flight from emerging markets that would send the U.S. dollar soaring and upend the global capital markets. For the moment, this threat seems diminished, with China stocks stabilizing a bit and the ICE U.S. Dollar Index off nearly 2 percent in the past couple of weeks.
The market's failure to climb in lockstep with corporate profit gains makes sense if one considers this to be a mature economic expansion and financial-market cycle. How much economic activity has been pulled forward or temporarily goosed by the tax package, repatriated foreign corporate cash and boost in government spending this year? And how much will earnings growth fall off as these forces wane and cost pressures build into 2019?
The surface indicators lean positive. According to FactSet, analysts' consensus earnings forecasts for the next 12 months continue to climb, and estimates for 2019 are holding up better than usual. Yes, the growth rates will drop dramatically, and the growth will likely become spottier across sectors. But right now the support from corporate profitability doesn't appear to be wobbling.
But how much room for improvement is there across the array of factors that drive stock prices?
Leuthold Group strategist Jim Paulsen this week cooked up a novel way of capturing this, computing how much of the stock market's capacity for appreciation has already been "used up." He tracked where we are in terms of equity valuation, bond yields, corporate profit margins, unemployment and consumer confidence on a scale stretching back to 1952.
On average, these indicators right now exceed 80 percent of all prior readings of the last 66 years. To Paulsen, this suggests little room for the markets to be pleasantly surprised by the fundamental backdrop from here.
This doesn't imply the market is peaking, simply that — from this perspective — forward returns will be unimpressive over the next few years (in the 5 percent a year range, say).
But the market delivers its returns in big servings, often when least expected, and then takes some back without much notice, as we've seen in the past year.
It's possible that the rush higher in January represented the moment of peak momentum, maximum valuation, cresting optimism and greatest ease for bullish investors, and yet this doesn't mean it was a decisive high in prices. The market is somewhat more selective and operating, for now, at a more defensive, slower pace of advance.
Not necessarily better or worse than the melt-up that culminated seven months ago — just different.
