Greed has made a comeback on Wall Street. Just a few weeks ago investors were on the verge of full-blown panic. Fears about China’s economic turbulence and a vague Federal Reserve Policy gripped the financial markets. The deep concern caused the Dow to drop 1000 points on August 24 before sending the market into correction mode. But fear has quickly faded on Wall Street. The Dow is at a 2 month high and the S&P has clawed its way back also.
Furthermore, for the first time since early July investors have poured money back into both stock and bond funds globally, according to Bank of America Merrill Lynch research on weekly fund flow data. It clearly signals a turn in the “risk-off” sentiment that gripped Wall Street during August and September. The markets now seem to be betting on low growth, slow and steady rise in interest rates, but no recession.
While America is certainly doing better than Europe and Japan, it certainly hasn’t lived up to its 2015 potential that was clearly priced into the markets as the new-year began. Everyone from the Federal Reserve to the Wall Street banks have slashed their forecasts for growth this year. Job gains, while still positive, are slowing down. People still aren’t buying as much as retailers had projected, the manufacturing sector is getting hammered by the stronger dollar making American goods more expensive around the world, and the savings at the pump just has not trickled out into the rest of the economy as some had expected.
These cracks in the economy are feeding the sentiment that while the US economy is better than some it still isn’t even in the category of “good but not great”. Investors are willing to give the economy an “ok” grade. This could be a problem going forward as investors recalibrate what they are willing to pay for earnings.
While this does not mean that a recession or crash is on the horizon the general consensus is there will be a slow grind higher with some setbacks from time to time as economic data is likely to disappoint. The Fed decision, or one set of data, should not and probably will not drive the markets going forward. However stock prices always follow earnings. In good times, optimist take control and drive the price of stocks higher as measured by what they are willing to pay for earnings. This of course is the Price to Earnings ratio or PE. Lately the PE of the S&P 500 has been pushing toward the high side with the avg. being around 18. That means folks are willing to pay $18 for every $1 in earnings. Heading into the year end, investors will have to decide if they remain optimistic and are willing to pay 18 times earnings or, if the risk off trade comes back, folks may only be willing to pay 15 or 16 times earnings. Not the end of the world, not a stock market crash, but certainly an adjustment. One example of this is Chipotle Mexican Grill which traded at 39 times earnings recently. A bit of bad news, and bam, the stock now trades below 30 times earnings. Folks simply decided they were not willing to pay as much for the same earnings because they are not as optimistic about the growth of the company. The same adjustment could come into the markets again, then again, perhaps not. Only time will tell.
The bottom line is that while we had a bit of scare in August and September while investors attempted to digest “less than good news”. Once everyone had time to cogitate and digest the news trend, they decided all was not as bad as it appeared, and they came flocking back into the market. Going into year end, the market will continue to do “okay” if the news is as predicted. If the news is better the market will rally. If the news is worse, then the market will pull back again. Stay tuned.