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In Stock Market Versus Sentiment, It’s All About Money Supply
The recent city and statewide lockdowns have shuttered countless businesses nationwide, leading to widespread unemployment.
As a result, consumer sentiment plummeted in April, according to the University of Michigan’s oft-cited index, before ticking up slightly in May, and a survey from the American Association of Individual Investors hit bearish lows.
Even so, stocks have soared after bottoming out in mid-March, up nearly 40% since that time.
Therefore, the million-dollar question on the mind of nearly every investor is: Why have markets climbed so high even as sentiment remains so low? To many, this decoupling is not just hard to reconcile; it’s impossible.
This dynamic, however, is not entirely unusual. Investor sentiment is frequently out of tune with the markets. Investors are impulsive and emotional, often selling when they should be buying and vice versa.
That, in part, helps explain what is going on. The other big factor is monetary policy.
Monetary Policies
As hard as it is to believe, now that states have begun easing lockdown restrictions, it is within reason that the S&P 500 will turn positive sometime this year or early next, and possibly even reach new highs.
If that happens, it won’t be solely due to improving corporate earnings or better consumption numbers. It all comes down to the current liquidity boom.
With the Fed purchasing Treasurys, agency mortgage-backed securities and, for the first time, corporate bond exchange-traded funds, M2 money supply – which is basically the amount of convertible liquidity that exists in the market – has shot up about 18% in two months.
That is a huge jump. For context, between the middle of 2008 and the middle of 2009 – during the height of the last economic crisis, when the Fed also went on an easing binge – money supply declined. It didn’t start growing until March 2010 and only grew at about half the current rate.
Federal Reserve Chair Jerome Powell and leaders in Congress are arguing for more fiscal stimulus. The fact that 2020 is a presidential election year makes additional aid far more likely.
Nevertheless, the existence of easy money, along with the promise of more of it, continues to be underappreciated.
It’s why stocks are currently exceeding expectations. It’s also part of the reason markets performed so strongly at the end of last year and into the first part of 2020.
At the time, most observers believed clarity concerning trade policy was driving the uptick. But what went somewhat overlooked was the fact that the Fed’s balance sheet grew by 11% between Sept. 4 and Feb. 12, as it embarked upon a mild version of quantitative easing to counteract a potential U.S.-China trade war.
This led to a period of outperformance for cyclical/value sectors at the expense of secular growth names like Amazon (ticker: AMZN), Microsoft (MSFT) and Salesforce.com (CRM). Notably, nothing happened that would cause anyone to question the fundamentals of these firms, yet that move signaled the beginning of a broad-based rally.
Cyclical/Value Stocks
More recently, as money supply has perked up once more, we’ve seen the exact same thing occur, with cyclical/value stocks outperforming secular growth ones. That could portend good things for financials, energy and materials companies, though it’s worth surveying the scene before jumping in with both feet.
Oil and natural gas prices remain muted and could be that way for a long time, meaning many energy firms would be a tough bet.
Financials tend to do best when they can borrow at low rates and lend at higher ones. While some believe new Treasury issuance will lead to higher bond yields in the future, it’s reasonable to assume that the Fed’s quantitative easing plans include purchasing nearly all new Treasury supply, at least until the economy normalizes.
That leaves materials as perhaps the sector with the best opportunity for widespread gains.
At first glance, these firms could seem unappealing since their price-sensitive goods create attractive margins and drive higher dividends during inflationary periods. With so many people unemployed and businesses closed, the worry now is disinflation – the reduction in the rate of inflation.
But early signals point to a manufacturing rebound. Activity in China was stronger than expected last month, while readings in the U.S. showed signs of life after falling off a cliff in April.
A good market indicator to know for sure whether these moves could be more permanent is to compare copper and gold prices. The latter becomes popular when uncertainty is high and the former when production ramps up. If copper starts to gain at the expense of gold, that’s something to note.
Against this backdrop, three stocks to watch are the global construction machinery firm Caterpillar (CAT), the medium and heavy commercial truck manufacturer PACCAR (PCAR), and the paint and coating manufacturer PPG Industries (PPG).
Their stock prices were down for the year through May, but their products have historically been successful, making them potential buying opportunities.
Markets are revealing. Despite all the negative data, what they are saying today is that money flows far more freely than most realize. That should prop up the markets in the face of extraordinary hurdles.
