The Dow’s Big Rally Was Scary. And Not in a Good Way.
It has been a while since a massive stock market rally has frightened us this much.
On first glance, there seems no reason to be scared. The Dow Jones Industrial Average gained 1,168.90 points, or 4.7%, to 25,983.94 this past week, while the S&P 500 rose 4.4%, to 2873.34, and the Nasdaq Composite advanced 3.9%, to 7742.10. It was the best week for all three indexes since November 2018.
Credit for the rally could be given to headlines about trade—the U.S. might not raise tariffs on Mexico on June 10, after all—and hopes that the Federal Reserve will cut interest rates, even if those hopes were fueled by disappointing economic data such as this past Friday’s payrolls report. But, as Nicholas Colas, co-founder of DataTrek Research, noted after the S&P 500’s 2.1% rise last Tuesday, “happy markets don’t surge 2% in a day. Worried markets do.”
That was certainly the case back in November, which preceded a very bad December. It’s hard to see an imminent repeat of December’s market slide, however, as the latest advance didn’t attract as much buying.
The market, at its most basic level, is a math problem: The level of the S&P 500 is a function of earnings expected from S&P 500 companies multiplied by how much buyers of stocks are willing to pay for those earnings. Right now, S&P 500 companies are expected to report earnings of $168.01 a share in 2019, according to FactSet, up 3.1% from 2018. The consensus estimate for 2020 is $186.52. Dividing the S&P 500’s latest closing price by 2020 earnings estimates yields a price/earnings ratio of 15.4.
Dow Jones IndustrialAverage
Source: FactSet
Jan. ’19
July ’18
21000
22000
23000
24000
25000
26000
27000
S&P 500 Index
Source: FactSet
Jan. ’19
July ’18
2300
2400
2500
2600
2700
2800
2900
3000
NASDAQ Composite Index
Source: FactSet
Jan. ’19
July ’18
6000
6500
7000
7500
8000
8500
Barron's 400 Index
Source: FactSet
Sept. ’18
Jan. ’19
May
550
600
650
700
750
800
The trade war, however, has made relying on those numbers nearly impossible. On May 31, Citigroup strategist Tobias Levkovich introduced his 2020 earnings target of $178.50, which would mean that either the S&P 500’s P/E multiple would have to rise or the index would have to fall. But even Levkovich acknowledges that his number may be wrong. “It is extraordinarily difficult to measure the potential repercussions from a full-on trade war,” he writes.
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Even trying to get 2019 right isn’t going to be easy. Analysts expect earnings to fall by 2.3% during the second quarter, and stay basically flat during the third before a 7% rise during the fourth quarter produces any growth at all, observes DataTrek’s Colas. That seems like a lot to ask.
The Fed’s move toward easier monetary policy, which began in January, could give stocks a boost. But those kinds of shifts take about six months to work through the system, so we won’t know for sure until third-quarter earnings season. “In the third quarter, we will start to find out whetherthe easing policies are starting to work and whether they prove to be more than enough to offset the negative impact from the trade wars,” explains Leuthold Group’s Jim Paulsen.
Don’t be surprised if there are more frightening moments between now and then.