Confusion Reigns

Economic data and financial-asset prices don’t always paint the same picture about the health of the economy. In fact, there can be extended periods in which the economic data tell you one thing and asset prices (for our purposes, stocks and bonds) tell an altogether different story. Why? Well, most people will tell you it’s because asset prices are forward-looking while economic data generally cover some period in the recent past. In theory, stock and bond traders should not care much about the fundamentals of the recent past. Rather, they are more concerned with the economic backdrop in the future as financial-asset prices are supposed to represent the present value of expected future cash flows. This is Finance 101.

In most cases, the timing lag is a perfectly valid explanation for minor or even moderate discrepancies between economic data and asset prices. Accordingly, asset prices can be a fairly good predictor of future economic conditions. When you hear a pundit on TV say things like, “the market is telling us that inflation is not a concern” or “stocks are discounting sharply higher profits”, they are simply saying that markets are better prognosticators than individual economists. In general, I don’t disagree. The bond market, given its depth and liquidity, has an especially strong record of signaling turns in economic cycles. The stock market, for its part, has much more dubious predictive ability.

But there are times when markets simply get it wrong. And there are times when different asset markets contradict each other. The reality is that stock and bond prices are influenced by numerous different factors besides the present value of expected future cash flows. This has always been true, but it seems like we are in a period of magnified outside influence. So below we discuss some of the possible reasons for the false indicators that markets can sometimes be.

  • First, and most obviously, markets can be heavily influenced by monetary policy. In our view, the Fed’s aggressive monetary support since the financial crisis has been the single-biggest reason (by far) for the bull market in stocks and bonds. In the case of bonds, the Fed’s massive asset purchase program (“Quantitative Easing”, or “QE”) has provided direct price support to bonds of all stripes. The suppression of interest rates has also forced yield-starved investors into riskier assets like stocks, lending strong support to those markets as well. The Fed’s notorious power over the markets coined the phrase “Don’t fight the Fed.” I think we’ve all learned that lesson.
  • Markets are also very susceptible to emotion. By now, we’ve all heard about how just a handful of very expensive stocks are responsible for a huge chunk of overall market gains this year. These “momentum” stocks have wide appeal for both institutional and retail investors simply because they seem to do nothing but go up. Stocks have the dubious distinction of having a positive correlation between price and demand. In other words, as stock prices rise, so does demand (and vice versa). This makes little economic sense, but it’s happening as we speak.
  • A third consideration is that the corporate profits are not always heavily dependent on strong economic growth. Since the recession ended in 2009, economic growth has averaged only about 2.0%-2.5% per year. During that time, operating profits for companies within the S&P 500 have nearly doubled. Obviously, companies have figured out ways to generate earnings growth in a backdrop of lackluster economic growth. Among these earnings drivers are layoffs and other cost reductions, mergers with other companies, deferral of investments, lower interest expense, stock buybacks, and lower tax rates. While these profit improvements have been great for stock prices, profit margins are now historically high, and the failure to invest in growth may have longer-term consequences for corporate profits.
  • There are also some factors, more technical in nature, that can influence demand for financial assets. As mentioned above, the Fed’s suppression of interest rates has forced investors into stocks, driving up valuations in the process. Strong demand for US stocks and bonds has also been driven by the perception that the US economy is in much better shape than many foreign economies, and therefore the Fed is much closer to raising interest rates than most other central banks. The perception that the US economy will (or already has) “decouple” from the rest of the world and enter a period of outsize growth has led to a surge in the value of the dollar versus the other major foreign currencies. And this notion that the US is the “best house in a bad neighborhood” has led to heavy investment flows into US financial assets. Said more simply, the money has to go somewhere. If the US looks like the best alternative, then money will flow into the US, many times without consideration of valuation levels.

This list of influences is not meant to be comprehensive, but it does provide some color into why stocks seem to hold up so well despite some disappointing economic data of late. Because asset prices have been such a large and explicit goal of the Fed’s aggressive monetary policy, we continue to believe that the Fed will either defer interest-rate hikes until next year (or possibly even later), or that they will do one symbolic hike and move very, very slowly from there.