Why Investor Fears Are Trumping Bullish Economic Data

Investor psychology may be undergoing a reversal, from unabashed bullishness to increased anxiety, despite U.S. economic data that remains positive, The Wall Street Journal reports. Wen Lu, a U.S. rates strategist at TD Securities in New York, observes that there is “a lot of tension in the air," adding, “This pessimism is something that the market has been almost looking for," per the Journal. Some of the key positive factors are summarized in the table below.

Why Investors Should Be Bullish
U.S. GDP growth rate above 3% in each of the last two quarters
Outlook for consumer spending bolstered by reduced debt and rising wages
U.S. GDP growth forecasts of 2.3% in 2019 and 1.8% in 2020, in line with recent averages
Yield on 10-Year U.S. Treasury Note back below 3%, lowest since early September
Recent factory activity report above expectations
Sources: The Wall Street Journal, CNBC

Significance For Investors

The upbeat outlook for consumer spending should be especially encouraging, given that it accounts for more than two-thirds of U.S. economic activity. However, despite generally upbeat economic news, investors are increasingly focusing on the negatives. In particular, the anticipated deceleration of U.S. GDP growth is raising fears that the onset of the next recession is drawing closer. Moreover, the likelihood of achieving President Trump's target of 4% annualized GDP growth essentially has evaporated, disappointing those who had bought into this scenario.

The CBOE Volatility Index (VIX), often called an index of fear within the stock market, was 93% above its average value for 2017 and 15% above its long-term average as of the close on Dec. 6, per YCharts.com. Based on closing prices, the index is up by 17% so far in December, according to Yahoo Finance data. The VIX measures expectations of stock price volatility over the next 30 days, based on the trading of options contracts on the S&P 500 Index (SPX). Some reasons for investor anxiety are summarized in the table below.

Why Investors Are Anxious
Slowing U.S. GDP growth
Flattening yield curve
Reversal of quantitative easing (QE) by the Federal Reserve and other central banks
Lingering trade tensions between the U.S. and China
Reduced growth in business investment
Weakness in home sales
Source: The Wall Street Journal

The flattening of the yield curve, meaning that the gap between short term and long term interest rates has been narrowing, has sparked increasing concerns that an inverted yield curve is becoming more likely. This scenario, with short term rates higher than long term rates, normally is a reliable predictor of an upcoming recession.

Meanwhile, the Federal Reserve is proceeding with its stated plan to unwind its massive $4.1 trillion balance sheet gradually, by letting its bond holdings mature without reinvesting the proceeds, thus withdrawing liquidity from the financial system. This will place upward pressure on interest rates, thus depressing the valuations of financial assets, stocks and bonds alike. Other central banks around the world are reducing their own bond buying programs, called quantitative easing, which will have similar effects.

Looking For Trouble
"This pessimism is something that the market has been almost looking for." -- Wen Lu, TD Securities
Source: The Wall Street Journal

Yet another source of concern is that U.S. equity valuations remain high, despite the fact that the S&P 500 is down by 8.3% from its all-time high reached in September. A study by Goldman Sachs finds that seven of nine key stock market valuation metrics are at the high ends of their historic ranges since 1976, as discussed in another Investopedia article.

Ironically, so-called short vol trading, in which speculators bet on low stock market volatility in the future, recently returned as a popular trading strategy, also as detailed by Investopedia. This is despite the fact that this same strategy blew up spectacularly in February, producing massive losses for those involved, and possibly exerting further downward pressure on stock prices as speculators scrambled to raise cash and close their positions.

Looking Ahead

Even if the economy shows continued strength, confounding the pessimists, historically high stock valuations should remain a cause for concern. At some point, these valuations are likely to revert to historic averages.

At the most basic level, equity valuations rest on 2 pillars: expectations of future corporate profits, and the level of interest rates. With no realistic prospect for further corporate tax cuts in the U.S., earnings growth will be almost entirely dependent on economic expansion, which already is slowing down. Meanwhile, interest rates are on a generally upward path, as the Fed reduces its balance sheet while also being committed to keeping inflation in check with hikes in the fed funds rate. Both these trends will put downward pressures on valuations.

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