Neither this year’s impressive corporate earnings results nor the synchronized pickup in global growth nor record levels of stock buybacks by companies has led to impressive gains in stocks. Despite a seven-day winning streak, the Dow Jones Industrial Average ended the May 11 trading session just 0.03 percent above where it started the year. It’s a similar story for the broader S&P 500 Index, which ended last week at about its Jan. 2 level.
The performances of the Dow and the S&P suggest the improvement in economic and corporate fundamentals has been accompanied by a derisking illustrated most vividly by the decline in market price-to-earnings ratios. Indeed, among the three most widely followed U.S. stock indices, only the year-to-date gain of 6.5 percent in the Nasdaq Composite Index seems consistent with the more generalized amelioration in the performance of the corporate sector, the overall economy and buybacks.
I can think of several hypotheses that could help explain this decoupling in 2018. Three notable ones have an important implication for what likely lies ahead for investors.
- Positive developments are already priced in, so there is no real decoupling: Viewed over a two-year period, the contrast between fundamentals and valuations is less striking. Having already outpaced the actual improvements in the economic and corporate landscape in 2017, this market is simply a reversion to the mean. The lag can easily be explained by the telegraphing last year of two of the important drivers of 2018: The tax cut approved in January that enabled the repatriation of corporate cash and increased share buyback potential, and favorable surprises in leading economic indicators that were reflected in realized data after a short lag. This interpretation is reassuring for investors for another reason. Less elevated, and therefore more durable valuations are being accompanied by a return to more sustainable volatility, from overly repressed to more normal levels. As I have argued, this is one of three important ongoing transitions that could place the global economy and markets on a more secure footing. And judging from the generally sound functioning of markets as they have operated with greater volatility, this shift has been handled well so far. According to this explanation, the recent action in stock markets could be a healthy pause, involving a better realignment of valuations and fundamentals, coupled with declining technical vulnerabilities and a general resetting of positions that is consistent with more normal conditions.
- Concerns about sustainability: Less reassuring for investors is the view that the pause in market prices this year goes beyond mean reversion and reflects mounting concerns about the durability of improved economic and corporate conditions. Parts of the global economy are already showing signs of losing momentum. This isn’t surprising: Too much of the recent pickup in growth in some systemically important economies other than the U.S. was driven by one-off effects. Sustaining the synchronized pick-up in growth, especially in Europe, requires policy progress that remains politically elusive. According to this interpretation, stocks are likely to languish as they continue to converge to the now-weakening fundamentals. This concern is amplified for those who worry about major disruptions to trade deals, including the North American Free Trade Agreement. For stronger stock investment performance to return, markets need a major, policy-driven improvement in the transition to more powerful and durable growth models.
- Losing artificial support: Those most concerned about sustainability also worry about the policy transition in central banking. It has become increasingly obvious to traders and investors that central banks have been stepping back from the practice of repressing financial volatility at the first sign of market instability. This accentuates a risk factor that requires some rerating of financial assets, especially stocks. It started with the Federal Reserve, which, after a prolonged period of reliance on unconventional policies, stopped its asset purchase program, raised interest rates several times and has started to reduce its large balance sheet under a gradual announced timetable. Also unlike previous years, this process has been accentuated by central bankers who have refrained from verbal intervention to counter sudden bouts of volatility (such as the one in February). And it will likely build further momentum late this year and early next year as the European Central Bank, then the Bank of Japan, step back from their large-scale asset purchase programs. This withdrawal of artificial support makes it even more important for markets to handle well the other two transitions. If not, the downward pressure on stocks could be more severe as insufficient support from fundamentals is significantly amplified by the unwinding of risk positions that resulted from excessive reliance on central banks.
I strongly suspect that all three hypotheses are in play today, with their relative contributions declining as you work down the list. Although this might not provide a sufficiently unique answer for many investors, it contains an important insight.
In a marked departure from recent years, investment values have grown increasingly dependent on a successful shift from liquidity-supported markets to those driven by durable improvements in economic and corporate fundamentals. Progress has been mixed so far on the policy front, with the required upgrades in pro-growth measures essentially limited to the U.S. And even there, recent steps need to be built on, including through bipartisan support for a multiyear upgrade of existing and new infrastructure. Without that, markets may find it hard to overcome the dual headwinds of adverse rerating and technical unwinds.
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Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”