Why Stocks Keep Rallying

The political circus in Washington has kicked it up a notch lately, yet stocks in the US and globally are calmly ticking up. Skeptics say the quiet rise is a sign of investors' complacency, presuming chaotic politics should bring chaotic markets. Yet that's a misnomer. In our view, markets are doing what they regularly do in bull markets: Looking past political noise and sociological bluster, and focusing on a growing global economy and improving corporate earnings.

Volatility is indeed down. February 17 was the 49^th straight trading day the S&P 500 moved less than 1% up or down.^[i] The VIX, which measures expected market volatility (based on options prices), is currently 11.5,^[ii] which is about the lowest it has been in years. The old saw says "when the VIX is high it's time to buy," so the low reading-using faulty opposite logic-means it's time to sell. However, none of this says anything about investors' actual mindset. Nor is it predictive.

The lack of big intraday moves is trivia, and the VIX doesn't foretell future performance. It's just what a bunch of options traders think will happen (or want to hedge against) over the next month, which is usually influenced by what just happened. There is no law saying stocks must be volatile when politics look topsy-turvy. Bluster isn't a meaningful market driver. Politics do influence stocks, but what really matters is whether actions with a sweeping economic impact come to pass. Tweets, press conferences, nearly all Executive Orders and golf outings don't qualify. These are sociology, which stocks look past. Sometimes volatility accompanies them, as stocks can swing on sentiment in the short term, but not always. True complacency would involve markets overlooking radical, market-impacting legislation or deteriorating economic fundamentals. Neither is the case today.

While backward-looking, recently released January economic data suggest 2017 started strong. Retail sales were up 0.4% m/m (0.8% ex. autos)^[iii] and manufacturing production rose 0.5%.^[iv] Moreover, mining output jumped 2.8%^[v] (helped by reinvigorated shale drilling and crude oil exports), a sign oil's nascent recovery remains a small economic tailwind. More forward-looking data suggest further positive economic performance. January Institute for Supply Management Manufacturing and Non-Manufacturing purchasing managers' indexes were strong, with new orders expanding nicely. The yield curve is positively sloped, incentivizing banks to lend and businesses to invest, and the US Leading Economic Index (LEI) rose 0.6% m/m in January, extending a solid run. No recession in LEI's nearly 60-year published history began while the index was high and rising.

Meanwhile, earnings growth is accelerating. With over four-fifths of S&P 500 companies reporting, Q4 earnings are on track to grow 4.6% y/y.^[vi] Consensus Q1 estimates are for that to accelerate to 9.6%, while full year 2017 growth is expected to be 10.2% as Energy flips from a big minus to a plus. Folks think rising stocks might be missing something, but they aren't. They see the growth those distracted by political noise miss.

Sentiment is starting to shift, but not toward complacency or irrational optimism. This improved mood is the normal warming sentiment accompanying maturing bull markets. Dogged skepticism, pervasive during most of this widely hated bull market, is finally giving way to a sunnier outlook, and investors are gaining the confidence needed to keep bidding stocks higher. Where folks once feared recession around every corner, they can now fathom continued growth. John Maynard Keynes, the British economist, called this process the awakening of "animal spirits-a spontaneous urge to action rather than inaction."^[vii] Rising confidence in maturing bull markets has historically coincided with big returns, and it can last a while before bubbling into bull-ending exuberance. In the 1980s' and 1990s' bull markets, animal spirits lingered for years before investors got too far over their skis.

Stocks are making new highs because the sky has not fallen, despite a constant media barrage to the contrary. Sure politics could derail the expansion-and euphoric sentiment could eventually upend stocks-but the likelihood of those occurring at the moment is tiny. Stocks move on the gap between reality and expectations, and expectations still seem too low-fodder for more bull market.

[i] Source: FactSet, as of 2/21/2017. S&P 500 total return index daily percentage change, 12/8/2016 - 2/17/2017.