Key Points
  • U.S. stocks indexes have moved within striking distance of record highs on quiet summer trading. However, we see some signs below the surface that risks are rising and the potential for more volatility and pullbacks is growing.

  • Earnings season was stellar but the risk is that the expectations bar is getting set too high. Economic growth continues to be solid, but the rate of improvement may be leveling off, while trade/tariff concerns and the Fed inject more uncertainty for investors.

  • Central banks remain in focus globally, with yield curves being closely watched. The Fed has expressed little concern, but financial conditions have gotten tighter this year, which has implications for markets.

“I skate to where the puck is going to be, not where it has been.”
- Wayne Gretzky

Summer calm finally arrives

It took a little longer than usual perhaps, but once earnings reporting season was in the rear view mirror, the summer doldrums set in, before being jolted by geopolitical concerns (see below). U.S. equity indexes drifted higher, approaching record high territory in very quiet fashion, as volatility recently dipped to near the lowest levels of the year. But the recent (short-lived) pullback in stocks and uptick in volatility could be harbinger of things to come.

Stocks again pull back from near-record territory…

S&P 500 Composite Index

…as volatility bounced off of extremely low levels

VIX Index

Risks appear to be rising

We never want to put too much into a few days of trading, up or down, but we also don’t want investors to get lulled into a false sense of security. There are some developments bubbling a bit below the surface which have raised our concern about risks to the stock market. Remember, as the “Great One’s” quote illustrates above, it’s important to look where things might be headed, not where they are right now. The stock market is a forward-looking indicator. As we often say, when it comes to connecting the dots between the economic/earnings fundamentals and the stock market, “better or worse tends to matter more than good or bad.” We’re concerned that some economic indicators are showing signals of “second derivative” (rate of change) inflection points; even if many of them remain healthy in terms of their levels. In terms of the stock market, over the past three months, the defensive sectors of health care, utilities, telecom and consumer staples have outperformed according to the S&P 500 sector breakdown, indicating some growing caution among investors. We believe it’s prudent for investors to review the risk profile of their portfolios and make sure they’re not above the comfort zone. In fact, for the more tactical investors among you, we have reduced the risk profile of our sector recommendations by downgrading our view of the technology and financial sectors to neutral, while upgrading our recommendation to the utilities and real estate sector, also to neutral (read more at Sector Views ).

Additionally, we’ve seen the U.S. Citi Economic Surprise Index move into negative territory. This doesn’t mean that the economy is contracting, just that economic data is increasingly missing elevated expectations.

Economic surprises now negative

Citigroup Economic Surprise Index - US

“Don’t fight the Fed” still relevant?

Few investors would argue against the notion that the massive quantitative easing (QE) coming out of the financial crisis helped to fuel stock gains. We are now in an era of quantitative tightening (QT)—through both balance sheet reduction, but also interest rate increases—and it’s naïve to assume the move toward monetary policy normalization won’t bring some significant jolts to market performance.