Key Points

  • Stocks have moved higher over the past month, with this rally marked by better participation and breadth, but it has stalled recently. We believe the bull market will continue, but that risks remain and bumps are inevitable.
  • The US economy has perked up but manufacturing remains sluggish and 2Q growth was disappointing. The Federal Reserve noted the seemingly improving environment, but remained noncommittal as to future action.
  • Earnings season has been largely better than expected, helping to support the recent rally but caution remains.

Can stocks maintain and extend recent gains

Stock indexes have moved out of the range they were stuck in for over a year, but was this recent rally justifiable and will it resume? In short, our answer is yes on both accounts, with some caveats of course!

The recent rally appears to us to be healthier than previous runs we’ve seen in recent history. This move has been characterized by improved breadth, meaning a greater number of individual stocks participated in the rally. Ned Davis Research (NDR) notes that during the rally since June 27th advance/decline measures have reached levels not seen since 2009. Breadth doesn’t mean that the rally can’t fail or that it will necessarily continue for a certain amount of time, but it does indicate to us greater staying power as the gains are spread out among a broader range of companies. Additionally, to us it is also encouraging to see what has the led the recent move higher in terms of sectors.

More cyclical sectors such as materials and technology, along with the economically sensitive financial sector, have been the leaders, while the more defensive groups such as consumer staples, telecom, and utilities have lagged. In contrast to some previous moves higher when defensives led the way, having sectors more exposed to economic conditions take leadership positions indicates to us greater confidence among investors and more willingness to move out the risk spectrum. To further differentiate this recent move higher from previous ones is the apparent decoupling between oil, which entered bear market territory after the recent fall, and stock prices that we may be seeing, which is positive to us as lower oil prices should help to bolster consumers, and thus stock prices.

Oil and stocks may be decoupling

Source: FactSet, Dow Jones & Co., Standard & Poor's. As of August 1, 2016.

Of course, we don’t want investors to move out of their risk tolerance ranges and we continue to maintain a neutral outlook on stocks, expecting modest gains over time but with bouts of increased volatility and pullbacks. Volatility has come down substantially, and to us and based on history, that doesn’t seem likely to last for an extended period.

Volatility has declined, but likely won’t stay this low

Source: FactSet, Chicago Board of Trade. As of August 1, 2016.

Risks remain. First, similar rallies have typically lead to investor optimism reaching excessive levels, as it did recently according to the NDR Crowd Sentiment Poll, which raises the risks for a near-term pullback. Additionally, according to ISI Evercore Research, August has been the second worst performing month since 1998. On a more fundamental basis, valuations still appear modestly elevated to us amid uncertainties that include the impact of negative interest rate policy being conducted by central banks in countries that make up 30% of the global stock market . Finally, we are slightly concerned by the level of household net worth as a percentage of disposable income, which has reached a level at or above the last two asset bubbles (tech and housing). We’re not saying we’re in for the same kind of blowup that we saw after those two occurrences, but it does warrant attention.

Level of relative asset appreciation may be cause for concern

Source: FactSet, Federal Reserve Bank. As of August 1, 2016.

Economic support

But we remain relatively optimistic the current bull market will continue for the foreseeable future in large part due to the improvement in economic data that we’ve seen. The housing market is continuing to look healthy, with new home sales rising another 3.5% in June.

Housing market looks healthy

Source: FactSet, U.S. Census Bureau. As of August 1, 2016.

Additionally, consumer confidence remains relatively healthy according to the Conference Board, likely due at least in part to a continued healthy job market. Initial jobless claims remain low, while the labor report showed another 255,000 jobs were added in July while the previous two months were also revised higher, and the unemployment rate remained at a low 4.9%. This has helped to move wages higher after years of largely tepid or nonexistent gains according to the Atlanta Fed Wage Tracker, which could have aided the recent move up in the retail sales estimates for 2016 by the National Retail Federation.

Wage gains are starting to take hold

Source: FactSet, Federal Reserve Bank of Atlanta. As of August 1, 2016.

This doesn’t mean the economy is off to the races as the business community remains relatively cautious, despite a largely better-than-expected earnings season, more on this below. We saw this illustrated in the recent 2Q GDP report which showed growth rose a disappointing 1.2% on an annualized basis. However, personal consumption rose a healthy 4.2%, the best since 4Q of 2014, but business fixed investment fell 2.2%. One potential positive development for the future that hurt this reading was a drop in inventories of 1.2%, which could bode well for the current quarter’s growth.

Manufacturing remains especially tenuous, with a stronger dollar not aiding the situation. While there have been some nascent signs of improvement, with non-defense capital goods ex-aircraft orders (a cumbersome name for what amounts to core orders for business equipment) rising a very modest 0.2%, while the Institute for Supply Management’s (ISM) Manufacturing Index continued to hover near the contraction/expansion mark, coming in at 52.6. However, these are modest positives and the much larger service side of the economy looks to remain relatively healthy with the ISM non-Manufacturing Index dipping only slightly to a still solid 55.5, while the new orders subcomponent, often a leading indicator, rose to a strong 60.3.

Fed remains on hold, but keeps potential for a rate hike on the table

In the midst of this cacophony of data, as well as ongoing global uncertainties, the Federal Reserve chose to keep monetary policy unchanged, matching investor expectations (read more on this decision here). However, they did upgrade their assessment of the financial situation through their statement, and had enough positive things to say about the economy to put the possibility of a hike at some point in 2016 firmly back on the table. And that possibility, along with the uncertainty that is a hallmark of the Fed as of late, will likely contribute to the bouts of volatility mentioned above. And while we are going to try to refrain from talking about the U.S. election in every edition of this publication between now and November, we’d be remiss if we failed to give credit to the two most disliked candidates in U.S. history for adding to the potential for an increase in equity volatility.

Earnings respect

Getting back to earnings, during the second quarter reporting season, companies both in and outside the United States are generally exceeding analysts’ estimates. Of course, since earnings per share estimates largely came down over the course of the quarter, the pattern of most companies beating estimates as results have been reported is typical of most earnings seasons. More interestingly, when we step back from the seasonal pattern we can see that after about two years of declines a rising trend in earnings estimates appears to be emerging. This rising trend is evident not merely over the past three weeks of earnings reports, but over the past five months, as you can see in the chart below.

Analyst’s earnings outlook for the global stock market continues to improve

Source: Charles Schwab, Factset data as of 8/1/2016.

In fact, analysts’ outlook for earnings per share of global companies over the next year is the brightest it has been so far this year and may be helping to support stock prices (for more insight on this trend see Earnings estimates are rebounding: what it means for stocks).

While corporate earnings calls are full of details about the company’s business, there are a few macroeconomic themes across many companies that have stood out this season. We have highlighted ten of the major macroeconomic themes along with how many companies mentioned them on their second quarter earnings call in the chart below.

Major macroeconomic mentions

Based on 785 second quarter company earnings call transcripts.
Source: Charles Schwab, Factset data as of 8/1/2016.

In general, when companies mention macroeconomic developments it is usually to cite a negative factor impacting results. However, most of the references by business leaders this quarter were a bit more balanced, perhaps supporting the brighter outlook also increasingly captured in analysts’ estimates.

  • Brexit – Most companies have noted that there has not been any material impact on demand, but some have noted an impact on earnings from the resulting drop in the British pound. One of those was Delta airlines noting that “when the pound devalued 12% versus the pre-Brexit levels, our revenues were reduced by $40 million from currency alone. Since the leave decision, we haven't seen a material impact on volumes.” While some companies based in the United Kingdom noted the currency move as a boost to earnings such as British drugmaker GlaxoSmithKline noting that the weak pound delivered “a currency benefit of approximately £340mm.”
  • China – Some mentions of China noted weak construction demand such as Finnish elevator company Kone that cited “a significant decline in orders due to China”. But most referenced strong consumer demand such as toy maker Mattel stating “on a year-to-date basis, we continue to see strong growth in key emerging markets like China and Russia.” And, beverage maker Pepsico, highlighting “double-digit organic revenue growth in China, Mexico, Turkey and Egypt.”
  • Oil – Mentions of oil by corporate leaders were generally negative, but some noted a potential bright spot in oil prices stabilizing during the quarter. Outside of the energy sector, financial services provider Wells Fargo noted that “While oil prices have risen from where they were a year ago, there continues to be pressure in the oil and gas sector. We had $263 million of net charge-offs in this portfolio in the second quarter.” Advertising company Omnicom cited oil price driven weakness in communications,“Earlier in the year, we saw – when the oil prices fell, we saw some Middle East countries that we had done events for cancelled those events in an effort to not knowing their future, that's – that oil seems to be stabilizing, so those may come back next year.”

While the macroeconomic themes emerging from this earnings season are more balanced than usual and earnings may finally be getting some respect from analysts, global economic growth remains below average and vulnerable to shocks—that applies to growth in earnings per share, as well.

So what?

The recent rally has stalled a bit but we think the make up of recent gains bode well for the potential for a continuation. Earnings both here and around the world have bested estimates but they are vulnerable to potential economic growth slowing. There will be pullbacks and an increase in volatility in our view, with August being a typically tough month for stocks as of late, so investors should remain patient and stick with their long-term asset allocations.

Important Disclosures

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