Judging by the behaviour of Wall Street in recent weeks, it’s fair to say that traders are suffering from a case of selection perception.
If you’re not up on psychology, selective perception is a bias in reasoning in which we tend to only focus on information that supports our pre-existing views – and discounts the rest.
What information am I referring to? The run of US economic data in recent weeks has well and truly scotched overly pessimistic fears that the economy could be tumbling into recession. For some reason, over January until early February, analysts viewed the slowdown in Chinese economic growth, the implosion in America’s shale oil sector, and rising corporate bond spreads as a portend of recession. Wall Street slumped and traders priced out any risk of a rise in US interest rates this year.
But since February 11, the S&P 500 has rallied back almost 10% to be just shy of the critical 2000 level. Indeed, last week the S&P 500 busted through its 50-day moving average resistance and now face its next set of challenges – the 200-day moving average and the downtrend line from the price peaks late last year.
US S&P 500
Source: Incredible Charts
Traders have been buoyed by reassuringly solid US economic data. US manufacturing and non-manufacturing surveys have continued to hold up better than feared. Retail sales are ticking over and durable goods orders (a proxy for business investment) rebounded strongly in January after a surprise fall in December.
Only last Friday we had yet another stronger than expected payrolls report, with the US economy adding 242,000 jobs in February. Although the unemployment rate held steady at 4.9%, it would have dropped were it not for a further solid lift in the labour force participation rate as more Americans feel confident enough to start looking for jobs again.
To be sure, despite strong employment growth the economy is not roaring along. The economy grew at only a 1 per cent annualised pace in the December quarter, and at this stage does not look likely growing at more than a 2 percent annualised pace in the March quarter.
But given the strength in employment growth and now quite low rate of unemployment, the hard reality is that the economy does not seem capable of sustainably growing by much more than 2 per cent in any case – due to weak productivity, America’s potential rate of economic growth seems to have shifted down a gear.
Given the tightening of the labour market and the fact that stock prices have rebounded so smartly in recent weeks, this obviously brings the Federal Reserve back into the game. Recall that the Fed raised rates for the first time in nine years last December from practically zero – and it latest official projections suggested it planned to raise rates a further four times this year, taking the Fed funds rate to almost 1.5%.
Yet at the first sign of market volatility in January, traders promptly priced out any risk of further rate rises this year. And here’s where selection perception kicks in: despite the good run of US economic data and the rebound of Wall Street, markets have not taken the logical next step and prices in Fed rate hikes.
As it stands, the market now thinks we may get one further Fed rate hike – but not until December, and even that is not a done deal. It’s a blinkered view: the market can’t rejoice at America’s better economic outlook without also factoring in higher US interest rates, and accordingly, a higher US dollar.
Meanwhile, due to the tightening labour market, still modest overall GDP growth, and a firmer US dollar, corporate earnings are still under pressure. According to FactSet, bottom-up estimates for March quarter earnings of companies in the S&P 500 index dropped by 8.4% over January and February – much largest than usual.
Over the year to end-March, earnings are now expected to decline by 8%. Falling earnings yet rising prices has resulted in the S&P 500’s price- to-forward earnings ratio pushing out to 16.1 – or near the highs which halted the market’s uptrend earlier last year.
Indeed, my hunch remains that while the US economy will continue to eke out sufficiently strong growth to have the Fed raising interest rates this year, it may not be strong enough to cause a decent rebound in corporate earnings.
Accordingly, while there may not be an economic recession, an “earnings recession” remains a distinct possibility. It’s for all these reasons I fear the current rebound in equity prices still soon run out of oxygen.
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