Did The Consumer Just Top Tick The Stock Market?

Consumers Were Confident About Stocks

It’s interesting to see the amazing Conference Board consumer confidence survey after the recent two day selloff in stocks. The survey’s cutoff date was January 18th which means it doesn’t include the latest selloff. This recent report was historically optimistic which shows us that the sell off might continue. As you can see from the chart below, the last time this many consumers thought stocks would increase rather than decrease over the next 12 months was January 2000. That’s quite the comparison as that was right before the peak of the biggest bull market ever. I’m not saying the next bear market will start this year, but I think a 10%-15% correction which scares some of the bulls makes sense. It doesn’t matter if the consumers are more informed about stocks than in 2000 because of the advancement of the internet. They still don’t have the emotional checks that separate the successful pros from the unsuccessful retail investors.

The rest of the Conference Board survey was equally fantastic (which might be a bad thing). The overall index was up 2.3 points to 125.4. This was driven by the boost in the expectations index from 100.8 to 105.5. This is different from the University of Michigan survey which was down 1.6% in January. I ascribed the December expectations weakness from this survey to the consumers’ negative opinion on the tax cut. It doesn’t matter much now because we know the consumer spending in December was strong regardless of what the sentiment reading said.

Inflation Expectations Increasing

The stock market is very flippant. Last year, there were negative headlines about how inflation was decelerating. Now that inflation expectations have perked up, as you can see in the chart below, the stock market is selling off. That’s counter-intuitive. There’s clearly a reason to sell off if inflation gets too hot because it forces the Fed to raise rates quicker. However, I don’t think we’re near that point yet. The inflation expectations were higher in 2014 and stocks did well. Therefore, I think those blaming the sell off on rates are looking for an excuse. The reality is the market was extremely overbought which led to a minor cooling off period.

It’s foolish to take short term swings of a few percentage points in the S&P 500 too seriously because you’ll miss out on the bigger picture. I still think inflation has a bit more room to run before it becomes a problem. I’ll get nervous when inflation gets above the 2014 high. Some inflation is good if it’s in the right areas because it signals the economy is strong and the labor market is tight. The biggest worry is commodity prices, but that’s not a problem yet. The CRB commodities index is up 2.93% year to date and only up 3.62% in the past year.

For those who are concerned with the TINA trade where low rates perpetuate high valuations in stocks, the chart below shows what yield is optimal for the 10 year bond. As you can see, investors have payed higher multiples for stocks until the yield reaches 5%, using data from 1965 to the present. This chart shows an expectation that the peak will be lower which seems reasonable because the yield is starting at a lower rate, valuations are already high, inflation is relatively low, and nominal GDP growth is very low. If a 3.5% yield on the 10 year bond is the peak in stocks, we still have a long way to rally as the yield is currently 2.7124%. The recent speed at which the yield has increased is remarkable, but there will be corrections in the trend before it gets to 3.5%.

The Fed Is About To Cap Stock Market Gains

Even though most investors were worried about the first rate high and the tapering of QE a few years ago, the time to worry is when the Fed is done raising rates. The chart below shows the 2 year, 5 year, 10 year, and 30 year bond yields along with the Fed funds rate. It’s a simple chart, but it tells us a lot. The convergence of the colored lines shows us when the yield curve is flattening. When the Fed funds rate is higher than the treasury yields, it means the Fed is very hawkish and a recession is coming in the intermediate term. There has been some convergence in the bond yields in the past few quarters, but it’s not close enough to cause concern.

The current difference in the 10 year and 2 year bond yield is 59.41 basis points which shows there has been about 10 basis points of steepening. This is exactly what I mentioned could happen. It’s certainly possible that we’ll see an inversion in 3 months or less, but it’s doubtful because there are usually trend corrections. If the yield curve was flattening in the midst of this 2 day sell off, the bears would be having a field day predicting the next bear market.

The next Fed meeting is Wednesday. I’m expecting a ‘nothingburger’ meeting because it’s Yellen’s last meeting and the chance of a rate hike is low. The current odds of a rate hike are 4.6%. Powell’s first meeting is probably going to have a rate hike as the chances of at least one rate hike at the March meeting are 76%. If the jobs report on Friday is bad, it could lower the odds, but that seems like a doubtful proposition because the jobless claims have been strong outside of the report from the beginning of the month which was elevated because of the cold weather.

As you can see from the chart below, the probability of 4 or more rate hikes in 2018 has increased from 0% in September to 24% in January. If the Fed raises rates 4 times, the Fed funds rate will almost be hawkish. When you consider the $50 billion per month balance sheet unwind that will start at the end of the year, the Fed will be very hawkish in 2019 which could cause a recession in 2020 or 2021. I think the Fed will stop hiking rates in 2019. They might consider ending the unwind soon afterwards, which could be in 2020. That would be before the Fed reaches the $2.5 trillion goal, but a potential recession is more important than an arbitrary balance sheet size goal.

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