Stocks’ Rational Rally

What do you get when you combine US stocks at record high levels with recent economic data that appears weak? Some say this is a sign investors have adopted a "don't worry, be happy" attitude, writing off shaky fundamentals. They suggest this bodes ill for stocks, as unwarranted optimism tends to be a warning sign for markets. But near as we can tell, any nascent optimism isn't unwarranted-it's rational. The economy today is better than most feared when the year began, and stocks move on the difference between reality and expectations. When expectations are meh, stocks don't require amazing results. In our view, stocks simply reflect a brighter-than-expected reality, and the bull market should have plenty of room to run.

Stocks rising alongside perceived negatives doesn't necessarily mean investors are irrationally exuberant or even complacent. If that were true, then investors were exceedingly optimistic in 2009, 2010, 2012 and 2013-all years where stocks zoomed higher while investors stewed over all manner of allegedly bad news like record federal deficits, the so-called "fiscal cliff," government shutdowns and eurozone debt. Stocks tend to climb a wall of worry throughout bull markets, clichéd as that may be. It's just hard for many to fathom at the time, which is why too many people miss out. If leading indicators pointed toward worsening economic data, we'd agree with those inclined to raise an eyebrow. But a few dreary trade, manufacturing and earnings reports don't qualify. All are backward-looking, not forward-looking, and developed-world economies are predominantly service-based. Plus, stocks don't move in tandem with economic data. They move on the gap between reality and expectations, and a fair amount of these allegedly weak data beat even weaker expectations. Earlier this year, investors feared a recession loomed in the wake of weak manufacturing data, low oil prices and falling profits. Stocks thus reflected these fears. Recent data, while not astounding, suggest these fears were overstated. Now investors are readjusting their view for the better. Hence, stocks rise to reflect a much less dour outlook. Considering leading indicators point positively, that seems like a rational stance.

Many called stocks' performance following the Brexit vote a prime example of complacency-but here, too, folks feared the worst at first, then rationally reset expectations once they realized that worst-case-scenario probably wouldn't happen. While pundits use every seemingly bad isolated data point as evidence Brexit is already a disaster, there is plenty of evidence otherwise. None of it, on its own, is telling. But disaster is far from a foregone conclusion. Markets see all the data and surveys, good and bad, and form expectations accordingly. One recent survey provides a timely example. According to the Royal Institute of Chartered Surveyors, home prices slowed and home sales fell in July-something one could interpret as more Brexit bad news if they so choose. But the same survey showed sentiment has improved markedly, with most participants optimistic about home prices and sales over the next 12 months. Surveys aren't predictive, but what happens next is infinitely more important to stocks than what just happened. What many call complacency could just be markets realizing this whole Brexit thing won't be as bad as everyone thought seven weeks ago.

Nor do we see complacency in the eurozone-more like the opposite. The bloc may not be firing on all cylinders, but it has grown for 13 straight quarters, and forward-looking indicators such as the Conference Board's Leading Economic Index suggest more growth likely lies ahead. But you wouldn't know this by the narrative many weave about the currency bloc. They fear deflation, negative rates, and that the region's banks are facing a "Lehman Brother's moment," but these views are based on widely discussed misperceptions, not facts. If investors were drunk on optimism, their views about the current European landscape would very likely be much, much different.

Some point to recent low volatility as a sign of investor complacency, but this claim is questionable. Volatility, whether high or low, isn't predictive. Historically, stocks have rallied following periods of low volatility just as much as they've fallen. 2004 and 2005 were two of the least volatile years for US stocks in ages, but then the S&P 500 rose over 15% in 2006. Had investors sold stocks in 2005 thinking low volatility was a sign others were too complacent, they would have missed out on the gains that followed.

Even if, as some suggest, investors are becoming more confident stocks' underlying fundamentals are positive, this isn't something to fret anyway. It's normal and natural for investor optimism to grow in maturing phases of bull markets-this is why P/E ratios normally rise as bull markets age. Investors get happier and more willing to bid stock prices higher. Rising confidence becomes a problem for stocks only when optimism goes too far and reality can't live up to expectations, whether because folks are euphoric or complacent. If investors were truly complacent now, they would be ignoring big negatives. While not all is rosy in the world (Brazil, Japan), the positives far outweigh the negatives, and today's negatives seem overrated and widely discussed, not underrated. Therefore, there isn't anything big, bad and ugly for folks to be ignoring.

What we have today is budding rational optimism. Investors' expectations aren't grossly out of whack. Folks aren't overlooking bad news. Rather, they're slowly noticing improvement in some areas and relative strength in others. Outside the Energy sector, earnings resumed growing in Q2. Revenues rose, too. US GDP growth accelerated a bit in Q2, and The Conference Board's Leading Economic Index is high and rising. Broad money supply (M4) notched its fastest growth rate in years in June. Loan growth is solid. All point to a continued expansion, a fine reason for folks to feel comfortable bidding stock prices higher.