Market Analysis

The Stock Market’s Rational Rise

Stocks aren’t out of touch with economic fundamentals, in our view.

In recent days, a new presumption has quietly gained steam: Rising stock markets, pundits warn, are increasingly detached from a faltering economic recovery. Sure, most flagship economic indicators are still doing well, but slowing real-time data (e.g., restaurant bookings), supply shortages and the ever-present Delta variant have forecasters on edge. The implication: Euphoric markets are ignoring bad news and in for a rocky road once they wise up. In our view, this misunderstands how markets work, and even if the recovery does take a breather for whatever reason, it doesn’t render all-time-high markets irrational.

For one, to presume stocks should do X if near-term indicators do Y misunderstands how markets work. Economic data, no matter how timely, are backward-looking. They reflect what happened last week, month or quarter, depending on the statistic. Markets, however, are forward-looking. They generally look about 3 – 30 months out. Their focus within that span isn’t the precise economic trajectory, but whether the economic and political landscape in general look likely to keep corporate profits generally better or worse than expected. If economic data in the here and now wobble a bit, that could very well rein in expectations, making it easier for reality to beat—and fueling stocks.

It is true, of course, bear markets often begin when euphoric investors overlook deteriorating economic conditions. But that is generally about forward-looking economic indicators, not coincident and lagging data. For instance, if stocks were notching new highs while the US and other major yield curves were inverted, the Leading Economic Index was dropping and the new orders components of Purchasing Managers’ Indexes were contracting, that would be a strong signal that it is time for investors to take a cold, hard look around them. It wouldn’t be a call to immediate action, as getting out of the market is perhaps the biggest risk you can take if you need stock-like returns to reach your goals. That is why we generally think it is beneficial to wait at least three months after a peak to take action, lest you move hastily and miss more bull market if you are incorrect. But that sort of disconnect is something we would think it wise to watch very, very closely during that three month window.

Today, it isn’t forward-looking indicators that have pundits worried. The Conference Board’s Leading Economic Index is rising. New orders continue piling up faster than companies can fulfill them—that brings some headaches, given supply chain issues tied to reopening and new lockdowns in Asia, but it does point to growth. Yield curves may be flattish, but they aren’t inverted globally. Simply put, today’s backdrop doesn’t look contractionary.

Then too, the things pundits cite as evidence of a weakening economy don’t really pass muster. Take the aforementioned restaurant bookings, which are down over the past month according to OpenTable. Real-time indicators like this were helpful in February and March 2020, as they gave the first look at how lockdowns were hitting commerce, but that was because lockdowns were so sudden and unexpected that everyone was left reeling and fumbling in the dark for data. Those conditions don’t really apply now.

Plus, the vast majority of these indicators aren’t seasonally adjusted. Late August is back-to-school season, and it seems fairly logical to us that with summer ending and school nights a thing again families would be going out less. We also have long thought economic growth was likely to slow once pent-up consumers unleashed that initial burst of stored-up demand. Why is always harder to pin down than what, but suffice it to say, we think it is a stretch to say the Delta variant is the only thing driving slower activity right now. Even if it is, the biggest economic impact came from the lockdowns implemented in reaction to COVID, not the virus itself. There remains little indication that a return to those dark days is looming, and fears otherwise have proven false since last summer.

As for the supply shortages, those will probably continue impacting factory output in the affected industries. The jump in shipping costs will also affect profits. But these issues aren’t brand new—they have been a thorn in the manufacturing sector’s side for months now. They are baked into earnings expectations. Therefore, it would be very weird if stocks didn’t already reflect them. Markets’ being at all-time highs while some businesses are having logistical problems doesn’t mean stocks are out of touch. Rather, we think it means they have assessed the situation and determined that profitability over that 3 – 30 month window won’t suffer as much as folks fear.

When in doubt, trust the market. If you can’t see a valid, forward-looking reason for trouble that no one else is talking about, then the overwhelming likelihood is that the reigning fears are false, extending the proverbial wall of worry bull markets climb.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.