The stock market is doing well in an environment of very slow growth and declining expectations. Pull up a long-term chart on the S&P 500 Index, and you see the large-cap stock market’s right shoulder continuing with its formation. As I’ve written before, it’s an ominous-looking chart pattern, especially when you think about how it might end. There’s certainly no robustness to the equities market today, but given all the investment risk out there, the stock market is holding up incredibly well.
Before the subprime mortgage meltdown, corporations were running very lean operations. After we almost lost the equities market and the entire global financial system, corporations became extremely risk averse and battened down the hatches. Then we got extremely low interest rates and huge increases to the money supply, as the Federal Reserve tried to re-inflate the U.S. economy and the stock market. The outcome was very good earnings results in a period of very slow growth and a stock market that, while choppy, has been trending higher.
Now the multi-year period of weak economic growth is beginning to catch up with corporations, and the lack of top-line growth is finally affecting earnings. This is why I think the equities market is doing so well, considering that earnings growth in the bottom half of this year is expected to be zero. It’s also why the probability of additional monetary stimulus by the Federal Reserve is going up. Ben Bernanke has acted so much before; it would be out of character for the central bank not to take action given the inability of the economy to accelerate. This is what the stock market is betting on.
The stock market’s been going up in the face of disappointing corporate earnings. Institutional investors are definitely expecting both words and action (perhaps later this year) from the Federal Reserve, and that’s all the equities market needs right now. If the stock market doesn’t get some reassurance by the central bank, a major selloff will ensue. More monetary stimulus by the central bank is unlikely to help the economy, but it sure will go a long way to helping investor sentiment on Wall Street.
I think it’s fair to assume that the equities market will hold up in this period of economic stagnation. We will get better economic news in some sectors, but there isn’t enough momentum in any one sector of the U.S. economy to spark a new business cycle. I think the equities market has made most of its gains for this year and would be surprised if it rallied another 10%. Right now, the equities market wants more certainty from the eurozone and the Federal Reserve. (See “Federal Reserve: Will It Act Soon to Jump Start the Market?”) If Ben Bernanke takes further policy action, we might, however, get another five-percent gain in the S&P 500.