Stock Prices & Economy Don’t Compute

Stock Prices - What Is Priced In?

The biggest question investors need to answer is “what is priced in?” The current market is particularly perplexing because of the extreme rally despite the global economic weakness. The S&P 500 has been above its 10 day moving average for 35 days. That's the longest streak in over 9 years. This is while global growth is slowing; Ned Davis Research states there’s about a 96% chance the global economy is in a recession. Investors need to figure out if the bear market in late 2018 was enough to price in this economic weakness.

Is the stock market 2 steps ahead of the economy as it prices in an economic recovery? Even though there have only been small green shoots? The more stocks rally, the more confident investors are saying they are in the economy. Personally, I see the U.S. economy improving modestly in Q2. Sentiment indicators have picked up because stocks have rallied, and the government shutdown ended. However, I don’t have much confidence in a strong economic rebound in the 2nd half of 2019. The ECRI leading index and the Conference Board leading indicators are showing growth will weaken further.

Normally, stocks reach a euphoric state at the end of the cycle. In this cycle, many people think that the euphoric peak was in January 2018. Now stocks are rallying in the face of a weak economy. This is partially because of the trade war ending and the Fed becoming dovish. Investors can’t see the S&P 500 breaking out to a new record high. At least not until the economy shows more improvement besides a few good sentiment indicators.

Stock Prices - Trailing S&P 500 Earnings Set To Fall

The chart below compares the global manufacturing PMI pushed ahead 9 months with the S&P 500’s trailing 12-month earnings. As you can see, the global manufacturing PMI fell to 50.7 in January. Based on the recent manufacturing weakness, I expect this to be below 50 in February. That indicates trailing S&P 500 earnings growth will fall. To be clear, everyone already knows earnings growth will be low in the first 3 quarters of 2019. That makes it confusing as to whether it’s priced in. Is the consensus priced in if the consensus is poor while risk assets explode higher? The chart shows trailing earnings growth isn’t perfectly correlated with the global PMI. However, it’s not a huge prediction to say earnings growth will fall in the next 3 quarters; it is the consensus as I mentioned.

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