The market continues to get tossed around by the uncertainties of trade, Brexit, global interest rates and anything else you want to throw in there. Some data points flash warning signals (yield curve & manufacturing sector), while the consumer/services sector continues to be supporting the expansion. 10 years into this expansion, and with 2008 still fresh on many investors' minds, its not surprising to see and feel the angst among the crowd.

Long story short, risks are higher than they’ve been at any point during this expansion. But we aren’t yet near the point of imminent recession, earnings are decent, and valuations are much better now that interest rates have cratered. We may well be in the late stage of this expansion, but oftentimes the point between the late stage and peak of the business cycle can produce some generous returns.

The Data:

Long rates have fallen to all-time lows due to trade uncertainty and the global slowdown its caused, along with negative interest rates around the world.

As a result, the major yield curves continue to flatten and invert. As noted in the chart above, three of the four have inverted, leaving only the 30/10 spread positive. Inversions have been a reliable (although long-leading) indicator of recession. The last time an inversion gave a false signal was in 1998, although that inversion was brief and only about 13 basis points. Today, the inversion is 50 basis points and has lasted for much of this year.

This week’s ISM manufacturing number came in below 50, signalling a contraction. As seen in the above chart, there has been a number of readings below 50 without it pushing the economy into recession. But it should be noted that this is the first manufacturing contraction after an inverted yield curve. So there is some cause for concern.

Thankfully, the services side of the economy is picking up the slack. This weeks reading came in at 56.4, well above expectations. Per the Institute of Supply Management, “The past relationship between the NMI® and the overall economy indicates that the NMI® for August (56.4 percent) corresponds to a 2.7-percent increase in real gross domestic product (GDP) on an annualized basis.” (Emphasis mine)

On the jobs side, unemployment claims and the UE rate continue to remain low. The consumer/services side of the economy remains alive and well.

Fed Implications:

This weeks jobs report is the last one before the Fed meets and announces policy changes on the 18th. The fact that services and employment data remain fairly solid leads me to believe a 25 bps cut is the most likely outcome.

With a Fed funds rate at 2% and the 10 year at 1.50% means the Fed would need to cut 50 bps just to get back to the flat line. I think the 50 bps cut on the 18th was on the table only if the jobs numbers came in bad. There is the risk the Fed fails to engineer the soft landing if the long bond continues to fall. Some positive results on the trade side, or at least a deescalation, may be enough to stabilize the long end again. Then again, if the ECB is determined to drive rates deeper into negative territory, even that may not be enough.

It will be interesting to hear the Fed’s projections and the markets reaction on the 18th. I have my doubts about this, but am keeping an open mind as long as the data supports it.

Market Implications:

Earnings growth hasn’t been immune to the slowdown. 2019 EPS projections have come down from 9% in December 2018, to about 2% today. 2020 EPS estimates remain above 10% for now. Declining estimates aren’t unusual by any means, it reflects the uncertainty about the future. Even though 2019 growth is slow, it comes after 2018 earnings growth of 20%. Tough comps, not unusual.

The key to valuation is incorporating interest rates and inflation. The forward PE on the S&P 500 is 17, which is lower than the 19 times earnings the market traded at the highs of last year.

When we include the effect of falling interest rates, we find the equity risk premium (earnings yield – 10 year treasury yield) is as high as its been since the 2018 lows (some 20% lower than current prices). So even though the S&P is near all-time highs, the valuation is about the same as it was last year when the market was about 20% lower. The effect of falling interest rates makes stocks more attractive, especially if a recession can be avoided.

The chart above plots the income component, showing the S&P dividend rate is now 36 bps greater than the 2 year treasury rate. Clearly, the risk profile between stocks and short treasuries is quite different. But just judging from the income produced between investments, stocks are providing more income for the first time in a while.

The Advance – Decline line continues to be strong, making all-time highs even though the index hasn’t quite got there yet. This bullish divergence is not something you see before major market highs. As a market cap weighted index, the largest stocks in the index will account for a majority of the gains. But we can clearly see the participation rate is solid. Despite the endless claims to the contrary, this is not a market being held up by a handful of stocks.

The market has been range bound for much of the last two years. There is now a trend line above that comes in as resistance around 3050 on the S&P. Each higher high has been about 70 points higher. A break above resistance puts 3500 in play as a logical upside target. Below the rising 200 day puts the 2700 level as a target for support.

Summary:

While this is probably not the time to chase the market higher, it’s not the time to panic either. The divergences in the data are likely to increase the amount of extreme market opinions in order to persuade investors into making emotional decisions. The key is to put the blinders on and stay the course for now.

A recent statement from Honeywell’s CEO Darius Adamczyk during their latest earnings conference call summarizes the current situation better than I ever could.

“I actually think that things could take off … economies and the animal spirits return and the investment profile…As much as there could be a risk of recession, there’s also an opportunity for an acceleration in investment.”

As I stated in the synopsis, oftentimes the ending of bull markets can produce quite generous returns. If anything, this environment proves a textbook example why you never want to rely on any single data point to arrive at a conclusion.