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, economic data is providing a solid underpinning to markets, and global economic expansion is not only on track but seemingly well synchronized. In addition, the Trump tax code legislation appears to be lifting expectation 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, among others, 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) 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, but 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 US Treasuries yield curve has been widespread. Historically an inverted yield curve does speak to longer term investor caution. With the 10-year yield standing at 2.476% as of Friday’s close and the 30-year yielding 2.81% 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 US 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 US 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 (VIX) and extended equity valuations are worth watching closely, but the US 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 US treasury yield curve will once again widen.
Honestly, I would like to make a counter argument but intellectually I just don’t see it – yet.
Flickr photo: SouthernWI
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