Q3 2019 Review and Outlook: Climbing a Wall of Worry
An old Wall Street proverb says that the stock market “climbs a wall of worry” as it marches into bullish territory. A rising market is often surrounded by an atmosphere of gloom and skepticism, when all sorts of reasons why prices should not rise steal the headlines. This old cliché has resurfaced as of late 2019, as investors continue to get caught up in the laundry list of negative headlines and potential issues. Despite the fog of seemingly bad news, the S&P 500 Index finished the third quarter less than two percent from its all-time high. This type of market environment is ripe with potential pitfalls for the average investor. In this paper we highlight some of the top concerns and give our view on why many of these might not be so worrisome after all.
LONGEST ECONOMIC EXPANSION IN U.S. HISTORY
This quarter, the U.S. economy expanded for the 123rd month in a row, surpassing the expansionary cycle that began on March 1991, as illustrated in Figure 1. On the surface, the longest expansion in U.S. history might seem positive, but the concern is that a recession or an economic slowdown could be around the corner. It is important to note that economic expansions do not end just because a certain length of time has passed. Historically, recessions are preceded by a slowing labor market and a decline in business investment and spending. In addition, consumer confidence often rolls over from a high level and the market is often in a high interest rate environment. This is a very different environment than the one we are in now. For example, the unemployment rate is near an all-time low. The Federal Reserve continues to be extremely accommodative, even as the 30-Year U.S. Treasury trades near an all-time low. Right now, leading indicators of recessions are not flashing any major warning signs.
LONGEST ECONOMIC EXPANSION IN U.S. HISTORY
As Of September 30, 2019
Figure 2 illustrates that while it may be the longest expansion in history, when comparing it to other expansionary periods since 1948, it has been the weakest. This chart looks at cumulative real GDP growth since the prior peak on a percentage basis. While this recovery has been longer, it has also been much slower and steadier. Perhaps this steady pace lends itself to lasting much longer than some of the previous expansions. It is also important to note that, when you look around the world, many economic recoveries after financial crises tend to last a little longer and the post-crisis growth rate is slower. This is exactly what we are experiencing with this current expansion.
THE SLOWEST RECOVERY ON RECORD
Strength Of Economic Expansions
Source: JPMorgan Asset Management, NBER
There are some economic indicators that generally weaken ahead of recessions. Figure 3 illustrates the Leading Economic Index (LEI). This index tracks data such as labor market metrics, manufacturing trends, interest rates, and many others. Although the leading indicators have slowed during the past couple months, the July result reached a new high. Until these indicators demonstrate sustained weakness, we will not be significantly concerned about a near-term recession.
May 1960 - September 2019
Source: NBER, Bloomberg
One of the components in the LEI that has drawn concern from investors is the ISM Manufacturing PMI Index. The Institute for Supply Management publishes its Purchasing Managers Index on a monthly basis. This Index provides valuable insight on key aspects of the U.S. economy, such as production, employment, as well as imports and exports. Figure 4 illustrates the ISM Manufacturing PMI over the past 70 years. As you can see, the index has declined over the past several months and recently dropped below 50.
ISM MANUFACTURING PMI
This is important because readings below 50 indicate that there is an economic contraction within the manufacturing sector. As you can see, it has dipped below 50 at different times during the past 10 years with no recession occurring. Contrary to conventional belief, our research shows that the time for investors to worry is when this index exceeds 60, as illustrated by the red line. This level indicates that the economy may be overheating, and the rate of growth may slow down if the economy faces a gradual tightening in monetary policy.
Our research in Figure 5 shows that, during the past 70 years, when the Manufacturing ISM level has been below 50, the S&P 500’s average 12-month return was 13.6%. When the ISM was above 50, the average 12-month return was just 6.8%. This might seem counterintuitive, but it makes sense. When the economy is weak, both monetary and fiscal policy are typically utilized to stimulate the economy. These accommodative actions are generally viewed positively and demand for U.S. equities increases ahead of the future economic recovery.
MARKET RETURNS BASED ON ISM LEVELS
The S&P 500 Price to Earnings ratio is currently 19.6 versus its 20-year average of 18.9. We continue to believe that valuations are reasonable relative to historical averages. While they are not cheap, they are not extremely expensive. The other thing to keep in mind is the stock market’s valuation at the end of the last secular bull market in March 2000. At that time, the P/E ratio nearly reached 30. U.S. equities remain attractive when compared to other major market tops throughout history.
Equities are even more attractive when considering the low interest rate environment that we are currently in. Figure 6 compares the S&P 500 dividend yield and the 30-year Treasury yield. In the 1980s, the U.S. experienced a period of higher interest rates and higher inflation. The dividend yield on the S&P 500 was above 4% at that time, but for the past decade it has remained around 2%. Let’s contrast that to the 30-year Treasury yield. This quarter, it reached an all-time low of 1.9%, which is less than the dividend yield of the S&P 500. It is the first time this has happened since December 2008, which was a drastically different environment. The only other time we’ve seen levels that are similar is in the Spring of 2016. Both time periods proved to be attractive buying opportunities for investors. U.S. equities that pay dividends look much more attractive when considering this low interest rate environment.
S&P Dividend Yield Equals 30-Year Treasury Yield
The chart shown in Figure 7 represents the percentage of stocks in the S&P 500 Index with dividend yields greater than the 30-year Treasury yield. Currently, that percentage sits at 47% and is the highest it has been since 1990, eclipsing the December 2008 period. This high percentage indicates that there are a wide variety of U.S. stocks paying attractive dividends. The current level of dividend yield relative to interest rates reflects positively on equities.
DIVIDEND YIELDS VS. TREASURY YIELDS
Percent Of S&P 500 Stocks With Dividend Yield Greater Than The 30-Year U.S. Treasury Yield
YIELD CURVE INVERSION
The dreaded inverted yield curve is now upon us. In Figure 8, the blue line illustrates the difference between the 10-year Treasury yield and the two-year Treasury yield. When the 10-year yield is greater than the two-year yield, this blue line will be above the 0% line and that would represent a normal, upward sloping yield curve. When the line on the chart is below 0%, that indicates that the 10-year Treasury yield is below the two-year and the yield curve is inverted.
The 10/2-year Treasury yield curve inversion, which most recently occurred in August, has preceded each recession since 1976. It is important to note that the lag time between the inversion and a recession is usually significant, lasting between 6 and 18 months. For instance, prior to the Great Recession (12/07–6/09) the first inversion of the yield curve occurred in December 2005, which was two years before the official start of the economic slowdown. What has this meant for stock market performance? During the 12 to 24 months ahead of the recession, the market actually outperforms other periods during the expansionary cycle. A yield curve inversion is not always the most accurate when used as a timing signal for the stock market.
10/2-YEAR U.S. TREASURY SPREAD
September 30, 1976 - September 30, 2019
Source: Bloomberg, NBER
Figure 9 shows how the U.S. Treasury yield curve can shift as markets evolve. The blue line shows the normal upward sloping yield curve from September 30th, 2017. The following year, the Federal Reserve increased interest rates four separate occasions and you can see the impact of these rate hikes on the yield curve one year later. Short-term rates increased dramatically due to the Fed’s interest rate increases. On the right side of the chart, long-term rates also increased, but not by nearly as much. The yield curve began to flatten at that point and in October 2018, Federal Reserve Chairman Jerome Powell stated that interest rates were “far from neutral.” The market did not like those comments and stocks experienced a lot of volatility during the fourth quarter. Powell was forced to reverse course at the Fed’s December meeting, where he said that the committee would “remain patient.” In 2019, the Fed cut rates at the July and September meetings. In response to these Fed rate cuts, the short end of the curve dropped, but the longer-dated maturities dropped even more. This resulted in an inversion of the yield curve, with the 2-year Treasury yield exceeding the yield of the 10-year Treasury.
U.S. TREASURY YIELD CURVE
2017, 2018, & 2019
Source: U.S. Treasury
While the inversion has created a lot of concern, there are a couple reasons why this inversion is unique. Figure 10 shows the interest rates of central banks from around the world. As you can see, some countries are even offering negative interest rates. The European Central Bank continues to keep interest rates at 0%. Japan, Sweden, Denmark and Switzerland all have negative interest rates, while the U.S. continues to offer one of the more attractive interest rates around the globe.
A TRIP AROUND THE WORLD
Central Bank Interest Rates
Source: Central Bank Interest Rates, Trading Economics
Despite the historically low interest rates in the United States, they still look attractive relative to the rest of the world. This is significant because the longer end of the yield curve is being pushed down due to strong demand from bond investors around the world. Remember, when the price of a bond increases, its yield decreases. The demand for the relatively attractive yields in the U.S. is a primary reason for the yield curve inversion. Although we do not want to dismiss the yield curve inversion as meaningless, it is important to understand that the dynamics leading to this yield curve inversion are quite different than other times.
A lot of ink has been spilled over tariffs during the past year and there’s no denying that it has significant political and economic consequences. Figure 11 illustrates the overall effect of tariffs in relation to the overall U.S. economy. The total gross domestic product of the U.S. is over $20 trillion. The total projected costs of all tariffs with China through 2019 is approximately $120 billion. Now, $120 billion is not a small number, but in relation to the U.S. economy, it only amounts to 0.6% of GDP. In addition, this number is almost completely offset by the various stimulus measures that have been put in place this year at the federal, state and local levels, including the effects of deregulation and increased government spending. This does not even include any of the positive economic impacts of individuals and corporations refinancing debt due to lower interest rates which could free up additional dollars available for spending. So, tariffs alone should not push the U.S. into a recession.
TARIFFS: PUTTING IT IN PERSPECTIVE
2019 Projected Costs Of Tariffs Relative To Stimulus
Source: Bloomberg, Forbes
Let’s look at one last concern; political uncertainty. Our job is not to take a political stance, but rather look at historical events and determine their impact on the markets. Only two U.S. Presidents have been impeached and a third, President Nixon, resigned before certain impeachment, Figure 12 shows that during the time between President Clinton’s initial impeachment inquiry and his ultimate acquittal, the S&P 500 Index rose 27%. In contrast, the timeframe between President Nixon’s initial impeachment inquiry and his resignation showed the stock market declining 26%. Andrew Johnson’s 1868 impeachment did not move the markets significantly, but stock market movements before the invention of the automobile or electricity are not particularly relevant today.
IMPEACHMENT RETURN OUTCOMES VARY
S&P 500 Index Price
Source: CNN, Bloomberg
Looking at the Leading Economic Index during the two respective impeachment periods, you can identify two very different economic environments. In Figure 13, the U.S. was in the middle of a recession during Nixon’s impeachment process, primarily due to rampant inflation, rising interest rates, and an Arab oil embargo. However, the economy was very strong during Clinton’s impeachment process and the stock market was nearing the end of a long secular bull market. Our conclusion is that political events like these have historically had little impact on the economy and the stock market. Rather than focusing on potential headlines and decisions made in Congress, we find that the analysis of fundamental, technical, and economic factors will prove to be more impactful.
ECONOMY DURING IMPEACHMENT PROCEEDINGs
Source: NBER, Bloomberg
THE MEEDER DIFFERENCE
We reviewed many of the headlines that continue to grab the attention of investors in this dynamic market. Having analyzed and explained the data, we believe that things may not be as bad as they may appear.
For over 45 years, Meeder continues to serve its clients with a singular focus. We are dedicated to keeping clients committed to their investment strategy throughout a full market cycle. We believe that investors often make the biggest mistakes when they become emotional, rather than utilizing data when making investment decisions. Each day, we strive to help investors take the emotion out of the investing process by utilizing investment models to analyze data to make fact-based decisions when allocating our portfolios.