Schwab Market Perspective: Sell in May…or Settle In?

Key Points

  • U.S. stocks are again trading near record highs and despite entering a traditionally soft seasonal time of the year, the investing landscape remains healthy.
  • Economic data has improved since the seasonally-weak first quarter; on track for a June rate hike by the Fed (and at least one more after that this year). Meanwhile, earnings season has bested even elevated expectations and the fiscal stimulus remains on the horizon to the cheers of business leaders.
  • Chinese economic indicators are showing signs of slowing, which could lead to a near-term retrenchment in emerging market equities.

Sweet spot for stocks?

After some weakness in March and early April, due to slowing growth fears and political uncertainty both here and abroad, U.S. stock indexes are again trading at or near record highs. Growth concerns have faded and investors are becoming more accustomed to the "unique" way that the new administration approached issues. Markets used to move "bigly" on a Presidential tweet or off-the-cuff remark, but investors have increasingly tuned out the noise. A case in point—the President mentioned in an interview with Bloomberg that he might look into breaking up big banks; yet the stocks shrugged off the comments and banks finished the day roughly where they were before the comments were made.

Although we are entering a period that has at times ushered in weakness for equities, perpetuating the oft-heard "Sell in May, go away" phrase, we caution against trying to trade around the phenomenon. First, you would have to get two decisions right—the sell and the buy—which is extremely difficult.  Second, there have been multiple time periods, according to S&P data, that have shown good returns during the summer months, even though past performance is no guarantee of future results. Finally, it appears that we could hit a sweet spot for equities where economic growth is good but not overheated, corporate profits are strong, inflation is tame, global political risks are fading, and fiscal tailwinds are developing. It doesn't mean we won't see pullbacks, especially given ongoing uncertainty around monetary policy and the Fed’s balance sheet; geopolitical risks; and investor sentiment. But the underlying foundation of the secular bull market looks solid.

Economy moving past soft spot

We believe the weak first quarter real gross domestic product (GDP) growth rate of 0.7% annualized understates the longer-term trend rate. Recently we've seen some signs of the economy perking up  since the first quarter's soft patch, although there are still some areas of concern. The so-called "soft" data (confidence- and survey-based) remains historically elevated; which is a bit of a surprise given the ongoing turmoil in Washington and the likely delays in getting tax reform done. In the meantime, the "hard" data (actual measures of growth) has played a little catch-up. After falling a bit last month, the Institute for Supply Management's (ISM) Non-Manufacturing Index rose again to 57.5, while the forward looking new orders component jumped back to 63.2. And while the ISM Manufacturing Index fell modestly to 54.8, it still remains well above the 50 mark that separates expansion and contraction. 

Surveys remain optimistic

Surveys remain optimistic

Source: FactSet, Institute for Supply Management. As of May 9, 2017.

Actions are backing up higher business confidence as jobless claims, a forward-looking indicator, remains historically low; while employers added another 211,000 jobs in April, rebounding from a soft March reading, according to the Bureau of Labor Statistics. And the unemployment rate fell to a decade low level of 4.4% with the underlying drivers suggesting it can go lower still.

Jobs continue to be added

Jobs continue to be added

Source: FactSet, U.S. Dept. of Labor. As of May 9, 2017.

And unemployment remains historically low

And unemployment remains historically low

Source: FactSet, U.S. Dept. of Labor. As of May 9, 2017.

This is how sweet spots develop. Wages are rising at a modest pace; but not enough to trigger higher inflation and a more aggressive Fed. And despite higher labor costs, first quarter earnings season has largely bested elevated expectations; with year-over-year profit growth for the S&P 500 expected to come in at roughly 14%, up from about 11% expected at the beginning of the season according to Evercore ISI Research.

We're also seeing some healthy signs for the consumer side of the economy, with Consumer Confidence as measured by The Conference Board remaining elevated.

Consumer confidence remains elevated

Consumer confidence remains elevated

Source: FactSet, Conference Board. As of May 9, 2017.

After a long downturn, we're also starting to see an encouraging uptick in both home ownership and household formations. This suggests that consumer confidence is starting to translate into some economy-boosting action, notwithstanding the recent drop in auto sales.

Household formations have been generally improving

Household formations have been generally improving

Source: FactSet, Bloomberg. As of May 9, 2017.

While home ownership levels may finally be rising

While home ownership levels may finally be rising

Source: FactSet, U.S. Census Bureau. As of May 9, 2017.

But auto sales are a bit of a concern

But auto sales are a bit of a concern

Source: FactSet, Bloomberg. As of May 9, 2017.

Fed remains on track, for now

The Federal Reserve is likely to remain methodical in its approach to tightening monetary policy. The May Federal Open Market Committee (FOMC) meeting came and went with no action, as expected, but the accompanying statement was seen as more hawkish—noting that first quarter weakness was likely "transitory." Odds of a hike at the Fed's June meeting rose to (and remains at) nearly 100% right after the statement release from about 70% right before the meeting. We also believe we’ll see a hike at the June meeting.

Hope for swift action by politicians in Washington, however, is waning. With Congress still embroiled in the effort to repeal and replace the Affordable Care Act, the potential for tax reform is likely no earlier than late this year, or even into 2018. But while many can quibble with the spending bill that was passed, it did ensure that the U.S. government will continue running for the next several months, removing at least one near-term concern for the market.

Much has been made of the extremely low level of market volatility, as typically measured by the CBOE Volatility Index. As we've noted, the changing investing landscape—notably the increased use of exchange-traded products (ETPs) and algorithmic trading—may be more to "blame" than investor complacency. It's also worth noting that in the 1990s and 2000s the VIX remained low for several years in both expansions, yet the stock market continued to rise for extended periods. As such, it hasn't proven to be a timely contrarian indicator for stocks.

Rolling over?

Another potential concern for the market is coming from overseas in the form of a potential Chinese slowdown. Earlier this week, as we quickly typed out a message that over the past 10 years China's financial conditions, China's purchasing managers' index and industrial commodity prices "have moved tightly together;" it was auto-corrected to "had a movie night together"—which is kind of a nice thought. But we've seen this movie before and it wasn’t very nice for investors.

As China's economic indicators all started to turn down together it's reflecting worsening financial conditions, sliding demand, declines in production, and falling input prices. Looking back at the 10 years prior to the current downturn, these indicators rolled over four times, and each time the global stock market, measured by the MSCI World Index, rolled over and suffered losses following a 12-month gain of 20% or more:

  • In 2008, the stock market plunged amidst the global financial crisis.
  • In mid-2010, as Greece's 10-year government bond yield climbed to over 10% as the European debt crisis began to intensify, global stocks fell 16% peak-to-trough.
  • In mid-2011, as Europe's debt crisis neared its peak and the U.S. debt-ceiling debacle led to Standard and Poor's rating agency stripping the United States of its triple-A credit rating, global stocks fell 20% peak-to-trough.
  • In mid-2014, as oil prices began to crash, global stocks fell 9% peak-to-trough.

Rolling over again?

Rolling over again?

Source: Charles Schwab, Bloomberg data as of 5/9/2017.

What makes the latest sequel of this downturn unique is that while these indicators have started to slide, the slide isn't yet accompanied by an event outside of China that has acted as the primary catalyst for the stock market declines in the past. If the one- or two-month decline in these indicators leads to a more prolonged slowdown, the global economy may become more vulnerable to a policy mistake or developing crisis, and stocks may suffer a pullback.

Even without a potential global catalyst for a global stock market pullback, a lingering slowdown in China's pace of growth, combined with a slump in commodity prices, could mean an intermission in the performance of emerging market stocks after blockbuster gains of more than 20% over the past 12 months.

So what?

Subscribing to the "sell in May" theory has not always been financially rewarding, so be cautious about trying to trade around any likely volatility. The U.S. economy is growing, but not too fast, earnings have accelerated sharply, and fiscal tailwinds are still blowing. There is the potential for a retrenchment in the gains in emerging market stocks in the near term, but sticking with a diversified portfolio is important. Pullbacks are possible but stay focused on fundamentals and your long-term goals.

 

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