While the U.S. stock market hits all-time highs, it’s worth asking if is the rally for real…

 

The U.S. equity market has hit all-time highs following signals from the Federal Reserve that it could soon cut interest rates - in addition to the U.S. and China stepping back from some of their trade rhetoric.

 

The market has not yet reached what I would classify as a strong, clear breakout. As long as the domestic economy avoids slipping into recession, I think the bull market can persist. The following provides some clarity and other questions that investors should consider.

 

Is the economy skating on thin ice?

There’s little doubt momentum in key trade-oriented sectors, such as manufacturing, has weakened. Business confidence has pulled back for the same reason. And recently consumer confidence began to retreat. There is a wide gap between how consumers feel about their “current” situation compared to what they “expect” in the future —not a good sign. The economy is vulnerable to further slowing in the months ahead, however, only one of our six key recession indicators (i.e. yield curve) is signaling caution at this stage.

 

Are interest rate cuts always in stocks’ best interest?

Stocks tend to respond positively to Fed rate cuts when they are used as “insurance” to keep the expansion going rather than as an attempt to put out a fire from a looming recession. For example, in the mid-to-late 1990s when growth was at risk, the Fed’s “insurance” rate cuts helped prolong the recovery and the market rallied.

 

However, when the Fed overstepped by raising rates too much during two periods from 1999 to 2006, and then subsequently shifted into rate cutting cycles in an attempt to undo the damage, it was too late. The economy contracted and bear markets materialized on both occasions.

 

Currently our economic indicators are pointing toward the former “insurance” scenario rather than the latter. Therefore, I think the old “don’t fight the Fed” mantra still applies.

 

China trade dispute

Trade disputes and sanctions are about more than the U.S. trade deficit and manufacturing jobs. The Trump administration is also attempting to hold back geopolitical rivals, address domestic challenges, and contain or suppress foreign corporate competition. This means once a trade or sanctions dispute is “resolved” another one may pop up somewhere else. And even when a trade deal is supposedly sewn up, tariff threats can come right back to bite countries that seem to be in the clear. Mexico knows this all too well. While some of this has been factored into the U.S. market already, persistent tariff and sanctions risks could continue to generate volatility episodes and weigh on industries and companies in the crosshairs. This is a headwind for global growth.

 

Iran

The difficulty of budgeting for geopolitical risks is that they are often unquantifiable and include multiple, complex scenarios that can be outside of the market’s ability to recognize or grasp. In 17 acts of war since WWII, the S&P 500 fell 6.3%, on average, surrounding the event. In nine high-profile terrorist attacks it fell 2.6% on average. But, if you segment out the market’s five worst reactions from the combined 26 episodes, the S&P 500 fell by an average of 14.3%, with a 16.1% decline being the most extreme reaction surrounding the Yom Kippur War and related Arab oil embargo in 1973.

While I think the market would view any serious conflict between the U.S. and Iran as quite problematic, perhaps it has refrained from reacting so far because it is in both countries’ interests to avoid this scenario.

 

2020 election

It’s too early to start factoring the presidential race into equity portfolio positioning. We’re still months away from the Iowa Democratic caucuses in February 2020, which will mark the unofficial campaign kickoff.

 

In my opinion, economic momentum—specifically, whether the economy is expanding or contracting—is the main driver of corporate earnings and stock prices. There have been expansions and contractions and bull and bear markets regardless of which party wielded power in Washington. Given that emotions are likely to run high this presidential election cycle, it’s prudent for investors to focus on the economy.

 

Conclusion: Stay invested

Until recession risks escalate, I believe the U.S. equity market deserves the benefit of the doubt. It’s too soon to become overtly defensive, but upgrading the quality of holdings is strongly recommended.

 

Tim