Stocks Don’t Suffer From the Summertime Blues

Here is a thought exercise. Imagine at the start of 2016, we told you presumptive presidential nominees Donald Trump and Hillary Clinton would fill headlines with bombastic rhetoric, Britain would vote to leave the EU and stocks would suffer a correction. Meanwhile, bank fears would run rampant, high-yield bond defaults would rise and Energy earnings would continue to circle the proverbial bowl. How do you think global stock markets would be faring in mid-July, approximately halfway into the year? Maybe down a bit, or perhaps even a lot? Well, all those things happened, and markets are actually up year-to-date! This is a timely reminder that during bull markets, stocks rise more than fall, and those returns often come in unpredictable spurts-frequently rebuking the fear du jour. Despite these recent gains-and US stocks reaching new highs-folks are already doubting stocks' rally. In our view, this skepticism is another sign of dour sentiment-negativity that should fade as uncertainty continues abating this year, allowing investors to realize reality is better than they perceive.

After a volatile yet overall flat stretch lasting more than a year, the S&P 500 clawed its way to a record high last Monday, surpassing its May 2015 high, and has continued climbing. Other US indexes grabbed headlines, too. The Dow Jones Industrial Average also made a new record, and the Nasdaq turned positive for the first time this year. Globally, the MSCI World isn't quite at new highs,^[i] but it too is positive for the year.

Now, new highs in and of themselves are mostly trivia-there is nothing special about reaching a specific index level. They simply represent stocks' tendency to rise higher over time. However, rather than embrace the good news and cheer stocks' resiliency, the reaction has largely been skeptical and/or worried.^[ii] Pundits have offered an array of flawed explanations for stocks' recent hot streak. Some believe stock buybacks are pumping up the rally, while others say markets are rising on stimulus hopes from central banks. Dour interpretations suggest markets aren't properly pricing in recent events (e.g., Brexit) or are getting ahead of themselves (e.g., overheating valuations). However, these doubtful rationales are off base, in our view.

Let's start with buybacks. This isn't the first time folks have credited buybacks with fueling this bull market. The argument: Companies are the only parties buying stocks, and if they stop, the bull is doomed. Yet this logic is flawed since it conflates supply and demand. Buybacks are a supply driver, and they bullishly reduce total equity supply. However, the act itself doesn't tell you anything about the state of the market overall. With or without buybacks, investors are still choosing to bid prices higher.

Similarly, valuations aren't telling about what's going on with stocks. It is normal for price-to-earnings (P/E) ratios to expand as bull markets mature, so being slightly above their long-term averages doesn't mean stocks have risen too quickly and are due to fall back a bit-natural laws don't apply to markets. Valuations-especially the popular but flawed cyclically adjusted P/E (CAPE) ratio-reflect past performance, which doesn't forecast forward-looking stocks. At most, the forward P/E ratio gives you a rough sense of current sentiment, and nothing here suggests sentiment is at rampant euphoria-a mix of guarded optimism and persistent skepticism seems about right.

Another outright misperception is the notion stocks are rising because they're confident policymakers the world-round will assist with additional stimulus. These programs' effectiveness in boosting stocks is questionable-see Japan, the poster child for proponents of fiscal and monetary stimulus. Since Prime Minister Shinzo Abe's term began in 2013, the country has unleashed a vast amount of "easing" through its "qualitative and quantitative easing" (QQE) monetary program. Yet Japan's economy remains stagnant, bobbing in and out of technical recession throughout this global expansion. Japan's equity markets have largely struggled, too. Year-to-date, the MSCI Japan is down -3.0%. Over the past year, it has fallen -6.2%, and over the past three years, it is up a tepid 5.2%.^[iii] Compare that to the US-based S&P 500's returns over the same periods: 7.1%, 4.9% and 37.0%, respectively.^[iv] The US enjoyed these gains as the Fed tapered, then ended its QE program while Japan added an extra Q: a huge counterpoint to stimulus' allegedly stimulating effects. Moreover, many expect Japan to announce even more stimulus measures to goose growth^[v]. We find this odd since it has yet to work and does little to address Japan's actual structural issues, but one country's moribund prospects aside, the global bull doesn't need help from central banks or lawmakers.

Brexit has been the major story over the past several weeks, and with markets mostly up after an initial pullback following the referendum, experts are debating whether stocks are irrationally dismissing risk. We believe they aren't-stocks digest all widely known information in real time, and they don't wait for resolution to move. Now, many bigwigs cite recent UK market activity (e.g., different FTSE indices) as evidence of Brexit being a good or bad thing. Though the FTSE 100-which holds the UK's 100 biggest companies-is up since Brexit, some say this is misleading because the index is heavily tilted toward multinationals and Energy/Materials firms, whose fortunes are tied less to the UK economy. Instead, they say FTSE 250 is more valid because it better represents domestic activity post-Brexit, since only a third of companies derive their sales internationally. This doesn't hold water, in our view, because Brexit's biggest economic impact would be on trade deals, and uncertainty on that front would logically impact multinationals more than domestically driven businesses. We suggest looking at the broader FTSE All-Share (excluding investment trusts), which includes the FTSE 100, FTSE 250 and 286 other firms. This index is also up since the Brexit vote. Now, we don't interpret that as a sign Brexit is a positive for markets. Rather, stocks' rise in the UK and abroad likely reflects some investor realization that the doom so many warned about in the lead up to the referendum was way overwrought-particularly since the UK remains in the EU pending exit talks, so nothing changed economically.

Most important for investors to remember: The drivers underpinning this bull market remain, as stocks have plenty of reasons to rise from here. Economic drivers, like US corporate earnings and global growth in general, are positive and underappreciated. The fact new highs are seen as warning signs shows investors are far from euphoric. People see bubbles everywhere, not realizing bubble talk is self-deflating. Though short-term pullbacks are always possible, we expect this little-loved bull to keep charging higher overall.