Is the Market Pricing in Perfection?

The S&P 500 made four fresh new record highs over the past two weeks recovering the near bear market losses from 4Q18 in 146 trading days. That is the third quickest turnaround when the S&P 500 drops 15% or more outside of a recession, behind the 1998 and 2010 S&P 500 recovery. However, at this time it is the second strongest rebound, behind 1998. There have been several factors driving the equity market this year including:

    • 1Q19 earnings season strong: The S&P 500 earnings for 1Q19 are coming in much better than the beaten down estimates. With nearly 80% of the S&P 500 companies having already reported earnings, the fears of an earnings recession are proving overblown. Earnings are coming in ~6% better than expected and are set to grow ~2% (YoY). In addition, revenues are growing ~5% (YoY).
    • IPOs bring euphoria: As the market has recovered, the number of companies going public is also increasing. Current estimates see over 200 IPOs in 2019 which would be the most since 2014. The resurgence of IPOs has increased risk appetite and has driven broad equities higher. While the performance has been mixed, the euphoria around big names like Lyft and Pinterest has supported equities. Beyond Meat, a plant based food company, surged 163% on its opening day, the best IPO showing since 2008. The calendar still remains busy for IPOs like Uber and Airbnb set to price this year.
    • Global growth stabilizing: Global growth is expected to be weaker this year but there are signs of stabilization and even improvements. U.S. 1Q GDP came in much better than expected, China manufacturing rose to a nine month high and Eurozone GDP rose modestly in 1Q19.
    • Fed accommodative: The Fed funds rate remains well below the historical average and highly accommodative. With inflation muted, the Fed is likely to remain accommodative through 2019 at least. This has depressed interest rates and fueled the rally in risk assets.

While these factors keep us optimistic on equities, at current levels many areas of the equity market are looking expensive (e.g. growth, tech). As a result, we are patiently holding a solid cash position until further opportunities arise. The question remains, what could be the catalyst to result in another opportunity to enter the equity market.

    • Technicals – complacency a concern: Complacency looks to be setting in as bulls are outpacing bears in the AAII bull-bear sentiment survey by almost 2 to 1. In addition, on April 30th the relative strength index of the S&P 500 rose to the highest level since January 29, 2018. When it hit that level back in 2018, it was followed by the S&P 500 experiencing its first 10% correction in two years and first 5% or more correction in more than 405 trading days.
    • Seasonality a risk? While the age old adage “sell in May and go away” has not been a consistent phenomenon in this bull market, it is still something to be aware of. When using history alone, the period of May-Aug is the weakest period for the equity market of any other four month time period in the calendar year. Since 1945, the S&P 500 has been positive ~65% of the time but the average return has been ~2%, compared to ~4% in the Jan-Apr and Sept-Dec time frame.
    • Valuation correction. While the broad S&P 500 P/E has moved almost 10% above its historical average, growth at all three market cap levels (i.e. large, mid and small) are seeing P/E’s trading 20% or more above the past 15 year average. In contrast, value, especially at the small and midcap level is trading at a discount to its historical average. With the market pricing in perfection and earnings season winding down it is not abnormal to see a valuation correction as investors take profits on the most expensive names/sectors.

In summary, we remain optimistic on equities but believe the market at current levels may already be reflecting the positive news on the economy and earnings. We are holding an above benchmark cash level until a better opportunity arises. We believe the market is due for a correction but timing is difficult to pinpoint so we are patient. As seen in overnight trading, investors were pricing perfection on trade and this is still an unsettled risk.


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