Reading the Economic Tea Leaves: What to Expect

There’s a fair bit going on in global markets right now. But none of it is decisive. There are many cross-currents at play.

Let’s take a look at a few of them…

Firstly, we’re in the thick of quarterly earnings announcements in the US. Earnings growth has been very strong, a combination of solid underlying growth and the impact of tax cuts.

A common refrain is that many companies ‘have smashed’ analysts’ forecasts, meaning that earnings have been much better than expected. But keep in mind this is a bit of a Wall Street game. On balance, earnings are always better than expected. It’s Wall Street’s way of creating positive investor psychology.

Are Earnings Really Better Than Expected?

But are earnings really better than expected? It’s one thing to game the analysts who cover and issue research and price targets on stocks. It’s another thing entirely to game the market as a whole. In fact, it can’t be done.

For this reason, it’s much better to look at the market’s response to earnings, rather than make a judgement from an article that simply states that earnings ‘beat expectations’.

When you look at it from this perspective, it’s hard to argue that US corporate earnings for the first quarter are better than expected.

Why? Because the market rallied so strongly in the lead up that much good news was already priced in. The failure of stocks to rally again as this news hit the market is something to keep in mind.

You can see this in the chart of the S&P 500, below. Stocks peaked in late January. At this point, a lot of good news was in the price, including the outstanding results you’re seeing flow through now.

Money Morning 30-04-18

Source: BigCharts

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Then, panic hit in February. This was the first dent in the armour of bullish market psychology. Stocks attempted to rally back to the highs, but more selling kicked in.

In the past few weeks, as solid earnings results hit the headlines, stocks haven’t been able to sustain a decent rally. That’s a worry.

Even Amazon’s strong result last week couldn’t pull the market higher.

That’s not to say the market is going down from here. But for the bulls pointing to a strong economy and earnings, you have to ask why stocks aren’t rallying. 

Perhaps we’re just in a consolidation period before the next leg higher. If that’s the case, strong earnings growth will need to continue for the next few quarters. But if there is any hint of a slowdown, indicating earnings are at a cyclical peak, stocks will decline sharply and we’ll enter a bear market.

With that in mind, the performance of the US dollar is also worth watching. It’s rallied strongly over the past few months. Here’s what the Wall Street Journal has to say about it:

The dollar is rallying again after floundering for most of the past year, another sign that global growth momentum may be shifting back to the U.S. and away from other major economies.

Signs of stronger U.S. economic growth and inflation are becoming a central focus of financial markets, helping lift the dollar to its highest level since January. Yields on the U.S. 10-year Treasury note last week crossed over 3% for the first time since 2014, evidence that part of the economy is returning to more normal conditions after a long stretch when bonds yields had hovered near historic lows.

In other words, the dollar is strong because the economy is strong. This in turn, leads to rising inflation.

While that makes intuitive sense, I don’t think it’s the correct interpretation, at least as far as the stock market is concerned.

To explain, have a look at the chart below. It shows the US dollar index. As you can see, the dollar has been weak for a while, and this weakness peaked in January, along with the stock market.

Since then, it’s rallied. This has occurred at the same time as stocks prices have come under pressure. In other words, stocks and the dollar have recently had an inverse correlation.

Money Morning 30-04-18

Source: Optuma

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So I’m not sure the Wall Street Journal’s explanation holds water. Or if it does, it’s more about rising inflation leading to rising interest rates, which stocks don’t like too much.

Interestingly though, the US dollar index rallied strongly in Friday’s trade, but couldn’t close above resistance, marked by the green line. This failure to break through resistance suggests the US dollar could turn back down in the short-term.

Will that give stocks the green light to rally? Maybe. But as I said, there are many cross-currents in the market right now, making the economic tea leaves particularly hard to read.

This is a reason to think we may be at the peak of cyclical expansion, or ‘peak goldilocks’ to put it another way. If inflation is beginning to raise its head in the US economy, it will come with a whole bunch of other issues to consider. And most of those issues aren’t friendly to stocks.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

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