Tuesday, April 19, 2016

The New All-Time High in SPY That Was Considered Impossible

Summary: SPY made a new all-time high on Tuesday despite falling margin debt, the end of QE, negative household fund flows, flat profit growth and a host of other reasons. In other words, exactly as a rationale and objective investor should have expected.

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SPY closed at a new all-time high (ATH) on Tuesday. Recall that SPY pays a 2% dividend, so a new ATH in SPY is equivalent to a new ATH in the S&P 500 index on a total return basis. The Dow Jones Industrials index has also made a new ATH on a total return basis (enlarge any chart by clicking on it).

Is this the top?

That has been the opinion of many nearly every week for several months and, in some cases, for several years. True, SPY is now at prior resistance from 2015 and there is the potential for an evening star to be forming. But the evidence for this to be a long-term top is no more compelling now than it was last week or last month.

The more important point about Tuesday's new ATH is that it occurred despite a long list of reasons a new high has been considered unlikely, if not impossible.

First, Tuesday's ATH comes 19 months after the Fed ended it's quantitative easing program. The end of QE3 in October 2014 was widely believed to herald the start of a bear market. A post on why this was likely to be wrong from November 2014 is here. Instead of dropping to 1500 as expected by Zero Hedge (first chart), the S&P gained more than 8% over the next 9 months (second chart). Even at the February low, the S&P was nowhere near 1500.

Second, Tueday's ATH comes 13 months after margin debt peaked. That SPY fell into a bear market within 3-5 months after a drop in margin debt in 2000 and 2008 amounts to an analog with a sample size of just two (chart from Doug Short).

Third, Tuesday's ATH arrives with negative equity fund flows by households. Two months ago, this was a rationale for a new bear market: "households are selling, this is all just corporate buybacks." But household flows have been negative for most of the past 20 years, during which the S&P has risen 380%. Whatever relationship between this data series and equity returns was imagined to exist simply does not (data from Yardeni).

Fourth, Tuesday's ATH came during the heart of the corporate buyback blackout that lasts until companies have reported their earnings. That equities are rallying in the absence of significant buybacks makes clear that there is much more to equity appreciation than just buybacks (rising cash flow, for example; first chart from Jonathan Golub). A post on this from November 2015 is here.

Fifth, Tuesday's ATH comes in the context of the Atlanta Fed's "GDP Now" forecast falling from 2.7% to 0.4% during the past month. But this is not unusual: since 2011, the model's growth forecast has regularly oscillated between 0% and 4% growth while the economy has been chugging along at 2.5%(from Bloomberg).

Moreover, 1Q GDP growth is typically the weakest of the year, averaging just 0.2% in the past decade. A weak 1Q16 would be normal (from Jeroen Blokland).

Sixth, the new ATH is coming when earnings and revenue growth are especially weak. We'll have more to say about corporate financials in a future post. For now, recognize that the heart of the 1990s bull market took place while GAAP earnings were flat (first chart, from S&P). Outside of energy, S&P margins have similarly been flat over the past 3 years (green line, second chart, from Yardeni).

Seventh, only a few months ago, a credit crisis (and therefore a new equity bear market) was considered assured given the widening spreads in high yield. But those wider spreads existed due mostly to low energy prices; non-energy high-yield spreads were not alarming and overall defaults remained low. So, not surprisingly, high-yield spreads have recovered with the rebound in oil. The non-crisis has been averted (from JPM).

Markets climb a wall of worry, but that's not our main message. In real-time, none of the "worries" presented above were valid. That markets shrugged them off is exactly what a rationale and objective investor should have expected.

Why have markets rallied the past two months? There are many reasons but here some of the most salient:

First, equities normally decline and then rebound in the aftermath of the first rate hike from the Fed. That is exactly the pattern we have seen since the first Fed rate hike in late-2015. A post on this from August 2015 is here (chart from BAML).

Second, bear markets rarely take place outside the context of a recession. In those cases that they have, it was a result of a rapid rise in rates or exuberant investors, neither of which applies to the current environment. A post on this from January 2016 is here.

Third, the US economy is doing fine. It's not growing fast, but it is growing and an imminent recession appears to be unlikely. A series of posts on this over the past two years is here (chart from MarketWatch).

Fourth, investor pessimism reached an extreme in February and there has not been much of an improvement since. A post on this from the week of the February low is here and one from last week is here (chart from BAML).

Fifth, corporate earnings were dragged lower in the past 18 months by a combination of falling energy prices and a surging dollar. Both of those seem to have reversed and continued improvement could become a tailwind for earnings in 2016 (chart from Yardeni).

Finally, while it seems clever to list reasons for equities to plunge, the boring reality is that equities rise 70-80% of the time. The natural inclination of the equity market is to go higher over time (table from Schaeffers).

SPY's new all-time high on Tuesday arrived despite falling margin debt, the end of QE, negative household fund flows, flat profit growth and a host of other reasons. In other words, exactly as a rationale and objective investor should have expected.

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