The Question of Stock Market Leadership – Marc Sutin

Last week we discussed the Fed’s new monetary policy framework. In my view it implies that the Fed will not tighten policy in anticipation of inflationary pressures that may not materialize as that could result in an unwarranted loss of growth. The Fed hopes the result will be a sustained period of stronger economic growth. This would most likely be accompanied by higher interest rates further out on the yield curve which the Fed does not control. This combination of faster growth and higher interest rates should not be an impediment to higher equity prices as long as inflation expectations remain anchored.

An extended period of better economic growth increases the chances of a virtuous circle developing as economic growth closes the output gap (the difference between current and potential GDP growth). See the chart below of the output gap for perspective. Currently we can see that except for the early 1980’s the gap is about the most negative it has been since 1950. Given all the fiscal and monetary stimulus being applied this year it is expected to close rapidly.

Many investors believe that closing the output gap will be inflationary. I want you to consider that in this economic cycle closing the output gap should be viewed as a positive for both economy and investors.

When companies fear that the Fed may move preemptively to tighten financial conditions as the economy nears capacity constraints corporations will not increase capital investment.

The recent change in the Fed’s policy framework could change this mentality and encourage a stronger capital spending cycle. In effect the economy would be chasing the closing of the output gap but never quite get there. This should help eliminate bottlenecks and reduce price pressures. It could also be the catalyst for a virtuous cycle of consumption and capital investment.

A look at the chart below of new orders for non-defense capital goods x-aircraft & parts (a proxy for business capital investment) suggests this may already be happening.

The recent rise by the series shown above, in ‘technical terms’, can be viewed as an upside breakout from a 20-year consolidation. The Fed’s new policy framework should encourage a continuation of this uptrend.

What does this virtuous cycle imply for the investment environment?

For the broader market, this combination of earnings growth and higher interest rates may slow the upward trajectory of equity prices, but the uptrend should continue.

We know that equity prices are included in the index of leading economic indicators. This is because when the economy is in recession and the Fed increases liquidity to stimulate growth the liquidity initially finds its way into the financial markets as the real economy has little need for it. But when the real economy develops upside momentum it competes for that liquidity lifting interest rates. At the same time, we see strong earnings growth so while P/E ratios may be pressured by rising interest rates earnings growth acts as an offset. On balance stocks continue to rise.

We know that broadly speaking a higher growth, higher interest rate, modest inflation environment would likely not favor the relative outperformance of growth stocks.

Such an environment suggests portfolios should have a greater weighting in sectors more leveraged to economic growth. At a minimum portfolios should have a balanced weighting between growth and value or growth and more economically sensitive sectors.

Flickr photo: Kevin Baird

This week’s  commentary provided by Marc Sutin, the very highly regarded technical analyst and founder of Intuitive Analysis LLC, former partner of mine at Knight Capital Group, and dear friend for many years.

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