A Market Melt-Up vs. a Market Blowup Top
Currently, the S&P 500 is hitting new record highs. What is truly amazing though is the fact that in 2017 there has never been a day when the index closed below its starting value on 12/31/2016 according to a report from the Bespoke Investment Group. The same report noted that when the market is up from 10% to 20% at this point, which 2017 qualifies, the median return for the rest of the year has been 2.50%, with gains over 80% of the time.
When confronted with such news, the question that is beginning to be asked is - Are we experiencing a stock market “melt-up?”
First, let’s try and define what a melt-up is. A melt-up is a slow and steady move upward, with few pullbacks along the way, low volatility, and new highs that are incrementally higher than the previous mark, says Nicholas Colas, co-founder of DataTrek Research. “You get a lot of negative chatter” in both a melt-up and a blowup top. However, a blowup top is an eruptive rise in the market, and this bull market shows little evidence of a bubble top, adds Jason DeSena Trennert, CEO of Strategas Research Partners. The current bull market melt-up, is driven mostly by institutional stock purchasers, as opposed to individual investors in the 1999-2000 blowup top.
Stronger earnings growth supports what this bull market has done, says Edward Yardeni, the chief investment strategist at Yardeni Research. “Valuations are high, but not irrationally so,” he asserts, especially when compared to interest rates, inflation, and bond yields.
A bubble is based on enthusiasm, not earnings, and as such isn’t sustainable. For those investors who didn’t live through the 2000 dot-com bubble and the ferocious bear market that followed, here’s one signpost: The Nasdaq Composite—led by technology, media, and telecom, the old TMT—recorded four separate 15% to 20% advances, each in a matter of a few weeks. Something we’re not seeing in this bull market.
Bears have been deriding this bull for years, and those who’ve listened and became overly defensive missed a big rally. So far, this doesn’t look like a blowup top. Of course, that doesn’t rule out a run-of-the mill correction or bear market in the future.
Yes, equity valuations aren’t cheap, at about 18 times consensus earnings per share (EPS) expectations of $146 per share next year. That’s higher than the historical average price-to-earnings ratio (P/E) of 15-16, but not lofty. Along this line, S&P 500 companies are recognizing that stock prices have become elevated and, as a result, they are repurchasing shares of their companies’ stocks at the slowest pace since 2017. I believe this is a sign of common sense and good business practices. Oftentimes in the past, companies would ramp up stock buybacks once their shares have hit multi-year highs. Hopefully this is a sign that companies have learned from the past and realize buying high is not a good business practice, nor is it in the best interest of their shareholders.
Unlike a correction or a bear market, the term melt-up has no widely accepted definition, notes Robert Doll, the chief equity strategist at Nuveen Asset Management. Although investors and market pundits often associate a melt-up interchangeably with the “blowup” top seen in the 2000 dot-com bubble, there are important distinctions.
Similarly, in a recent blog post, Jurrien Timmer, director of global macro for Fidelity Management and Research, tried to calm nerves regarding concerns that there may be declines in 2018 as the long-running bull market starts to come to an end. But Timmer says for that to happen there must be rising inflation and high levels of leverage – or borrowing money to pay for assets on the part of companies and households.
But with both of those things relatively low, investors don't have to worry about a severe downturn in the new year. In fact, it may be more of the same, which should be good news for stock investors. Inflation remains very low, and if you assume the Federal Reserve is right and inflation will gradually increase to 2%, there will be no negative implications.
As for leverage (i.e., debt), Timmer said leverage has increased on the balance sheet of the central banks, government debts and bond funds. However, leverage in the financial and household sectors has declined since the financial crisis, with financial sector leverage moving 40 percentage points lower and household leverage reducing 20 percentage points.
"When I add it all up, I do see pockets of excess leverage but certainly not a widespread excess. Plus, it should be remembered that neither the central banks nor the government will likely be forced to sell anything," wrote Timmers. "The bottom line is that with neither inflation nor widespread leverage present in the system, I do not believe we have all the ingredients for a downturn in the economic cycle."
Along this line, many analysts have been surprised by the stock market’s strength this year and returns have exceeded their expectations. However, there is belief that synchronized global growth, an expanding U.S. economy, and companies’ strong profit reports can extend the rally further. Supporting this optimism is the expectation that Black Friday sales will increase 4.80% over last year and for November and December, holiday sales are expected to increase 4%. In addition, home sales were up 8.90% in the first 10 months of this year as compared to last year at this time. A strong job market and other positive economic factors has consumers opening their wallets and spending with confidence.
Investors haven’t paid much attention to emerging markets, especially since they badly trailed U.S. stocks over the past decade. However, the trend is beginning to change. About $85 billion has poured into emerging market stock funds so far this year, and this is the biggest net flows since 2010, according to EPFR Global. The draw is valuations: Even after the sharp gains, the MSCI Emerging Markets Index still trades at 12 times forward earnings, far cheaper than U.S. stocks’ 18 times, or Europe’s 14 times.
U.S. stocks have done quite well since the market bottomed in March of 2009. However, international and especially emerging market stocks overall are trading at much better prices. As a matter of fact, half of the 35 major indexes representing the world’s biggest stock markets by value have hit all-time new highs this year, which is the most since 2007. As such, we have been and continue to be opportunistic in adding international and emerging market stocks to portfolios when we feel the situation arises.
Bottom line, the current economic environment domestic and globally is still quite favorable for the stock market, and we can see continued upward movement in stock prices globally for the foreseeable future.
Tony Moeller, CPA
The information listed in this commentary is a compilation of various publicly available sources and is for informational purposes only. It is not a recommendation or solicitation of any investment or strategy. A risk of loss is involved with investments in the stock and bond markets.
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