• U.S. equity markets off to best start since 2006
• December’s Employment Report missed consensus but delivered positive message to investors
• African American unemployment rate falls to a 45-year low, 6.8% (U.S. Dept. Labor)
• Strong economic data and rising earnings estimates continue to underpin U.S. equity market rally
• Global equity indices continue to climb to record highs in lock step with U.S. markets
• President Trump ‘absolutely’ willing to talk with Kim Jong Un—under certain conditions (Fox News)
The week in economic data
This week’s economic calendar starts off with a whisper and ends with a bang—particularly for those looking closely at inflation and the follow-through impact on monetary policy. Today, the NFIB Small Business Optimism Index for December fell a bit short of expectations at 104.9, but the 2017 average reflects the best year in the index’s 45-year history. On Wednesday the all-important Atlanta Fed Business Inflation Expectations report is released. On Thursday the PPI-FD for December is released. If recent trends are any indication of what to expect, we should see further modest signs of inflationary pressure. In the August PPI-FD release, the reading for July was 1.9% while the more recent release for November was 3.1%. The December CPI and retail sales figures come out on Friday along with November’s Business Inventories data.
What is on the horizon that could threaten the equity market rally?
If there is a theme that could bring this equity market rally to a halt, it is not currently evident. As I have pointed out in recent notes, earnings estimates are once again on the rise for the S&P 500 (^GSPC, SPY), economic data is providing a solid underpinning to markets and global economic expansion is not only on track but also seemingly well synchronized. In addition, the Trump tax code legislation appears to be lifting expectations for further earnings growth and economic expansion.
We have to ask ourselves if there are any warning signs or telltale signs of stress on the horizon that could potentially upend the markets. Several factors that have historically acted as precursors to a significant pullback in equity prices have been extended periods of subdued volatility, stretched valuations, and an inverted yield curve.
Volatility, as measured by the Volatility Index (^VIX, VXX) has been remarkably subdued for several quarters, as we have discussed. Friday’s close at 9.22 was fractionally above a multi-year low. That could potentially be a source of concern. However, without any indication that the trend will reverse, it could well remain at the low end of its historical range for an extended period of time.
The current S&P 500 P/E ratio is 26.36, well above its historical mean of 15.69 and median of 14.68. The earnings component of P/E ratios is based on the previous quarter’s earnings. Given the run-up in prices that has materialized over the past quarter, this earnings season, which is about to get underway, will need to provide for significant revenue and EPS growth to support prices. Many are calling for precisely that. (One example being Sam Stovall’s CFRA Research Report included in this weekly note.)
Concern over a potential inversion of the U.S. Treasury yield curve has been widespread. Historically, an inverted yield curve does speak to longer term investor caution. With the 10-year yield (^TNX) standing at 2.546% and the 30-year (^TYX) yielding 2.887%, there clearly is a degree of dysfunction present in pricing. I believe the lack of more meaningful spread between the 10-year and 30-year actually has more to do with portfolio protection given the elevated valuations of U.S. equities, duration of the rally, global demand, and the lack of inflationary pressures in the economy. If inflation measures begin to reflect more robust acceleration in coming quarters and if U.S. equities remain in trend, which I suspect will be the case on both counts, look for the spread between the 10-year and 30-year to widen in the second half of 2018.
A subdued Volatility Index and extended equity valuations are worth watching closely, but the U.S. Treasury yield curve has not inverted and is not likely to in coming quarters. I expect the VIX may remain subdued and that corporate earnings will support equity valuations. Ultimately the U.S. Treasury yield curve will once again widen. I would like to make a counter argument to that, but I just don’t see it … yet.
Commentary by Sam Stovall, chief investment strategist at CFRA Research
CFRA’s year-end 2018 price target of 2800 for the S&P 500 is based on our projection for S&P 500 operating EPS growth, combined with the year-on-year rise in core CPI. Specifically, we think the recent tax cut will boost S&P 500 EPS to $155 per share, versus the current Wall Street consensus estimate of $145 per share, as compiled by S&P Capital IQ. In addition, Action Economics (AE) forecasts core CPI to rise 1.9% y/y by Q4 2018 from the current 1.7% reading. AE also projects U.S. real GDP to rise by 3.1% this year, versus its earlier estimate of a 2.8% advance, as compared with the 2.3% GDP growth likely seen in 2017.
7:00 AM MBA Mortgage Applications
8:30 AM Import and Export Prices
10:00 AM Atlanta Fed Business Inflation Expectations
10:00 AM Wholesale Trade
10:30 AM EIA Petroleum Status Report
Charles Evans, 9:00 AM
James Bullard, 1:30 PM
8:30 AM Weekly Jobless Claims
8:30 AM PPI-FD
9:45 AM Bloomberg Consumer Comfort Index
10:30 EIA Natural Gas Report
William Dudley, 3:30 PM
8:30 AM Consumer Price Index
8:30 AM Retail Sales
10:00 AM Business Inventories
1:00 PM Baker-Hughes Rig Count
Eric Rosengren, 4:15 PM