It’s hard to understate just how strong the economy and stock market’s fundamentals are right now.
- Year-over-year earnings growth is currently clocking in at 20%. The final year-over-year earnings growth for 2018 will probably be somewhere closer to 15%.
- The yield curve is still positive (remember: the yield curve is only bearish for stocks once it becomes inverted).
- Inflation growth is still muted. No “surging” inflation.
- There is no recession in sight. Leading economic indicators continue to improve and trend higher.
So why isn’t the stock market going up in the face of such bullish fundamentals? Is the stock market’s inability to rally in 2018 despite strong fundamentals a sign of “bearish price action”?
No. This is not a bearish sign for the stock market.
Don’t mix up the time frames
I stated in this post that the fundamentals determine the stock market’s long term direction. The fundamentals have little to do with the market’s short term direction and don’t always influence the stock market’s medium term direction.
- The stock market’s short term is mostly random (or “technical analysis”) and is driven by market sentiment.
- The stock market’s medium term is driven by a mixture of the market’s sentiment and fundamentals.
So just because the stock market doesn’t go up for a few months despite improving fundamentals doesn’t mean the bull market is over. It is perfectly normal for the stock market to swing sideways despite strong fundamentals. There’s nothing inherently bearish about this.
In fact, the longer the stock market swings sideways in the face of improving fundamentals, the fiercer the eventual breakout will be on the upside.
Think about the logic behind this. Fundamentals represent the market’s long term “fair value”. If the stock market keeps swinging sideways while the fundamentals improve, the market’s “fair value” is going to trail higher and diverge from the stock market’s price. The longer this continues, the bigger the gap between “fair value” and the stock market’s price. Eventually the price will snap back and reconnect with “fair value” by rallying.
Look at the S&P 500’s chart in 1994. The stock market swung sideways for 1 year while the fundamentals continued to improve. The longer the sideways consolidation, the fiercer the upside breakout. The stock market soared in 1995.
The following charts demonstrate that it’s perfectly normal for the S&P 500 to make a “small correction” while the fundamentals are improving (which is what’s happening right now).
We can use the year-over-year change in Industrial Production to demonstrate medium term “improving/deteriorating” fundamentals. Notice how it is improving right now.
Industrial Production improved in 1994 and 1996-1997. There were multiple 10%+ “small corrections” along the way despite the improving and strong fundamentals.
When will this “small correction” end?
Here’s the honest answer that most professionals don’t tell you: nobody knows. Trying to guess is hard, and the best estimates are merely “guesstimates”.
- The stock market’s exact bottom is probably already in (on February 9, 2018). See study.
- If I had to guess, I think the S&P 500 will make a new high sometime in Q3 of 2018, followed by more rallying in Q4 2018.
But here’s the more important point. Fundamentals show no signs of significant deterioration right now. The longer this correction/consolidation drags on, the more powerful the upside breakout will be eventually.
This chart demonstrates the stock market’s valuation (forward P/E ratio). Valuations tanked thanks to surging earnings + this stock market correction. The more the stock market consolidates, the more valuations will fall. That gives the stock market more room to rally when it eventually breaks out.