Highlights

• Stocks broke their six-week winning streak, although investors continue to focus on the positives.
• Improving sentiment has triggered strong inflows into equity markets over the past month.
• At present, stock valuations appear somewhat elevated. In our view, markets are pricing in a better macro environment than we expect, which could leave stocks vulnerable to a near-term consolidation.

Investors have been focusing on a range of positives recently, including decent economic data, stronger-than-expected corporate earnings results and a sense that the global economy is stabilizing. Nevertheless, stock prices faltered last week on news that the U.S./China phase-one trade deal was looking less likely and the sense that markets have already priced in much of the good news. For the week, the S&P 500 Index fell 0.3%, snapping a six-week winning streak.¹ Health care and financials led the way, while materials, industrials and technology were the main laggards.¹

Weekly top themes

1. Economic data has been mixed, but growth could improve modestly. Last week, the flash Purchasing Managers Index and the Index of Consumer Sentiment came in better than expected.² These solid employment and consumer spending levels could very well help pull the manufacturing sector out of the doldrums.

2. The labor market is showing some cracks around the edges. While not yet alarming, initial unemployment claims have been rising. The last reported week shows a disappointing 227,000 new claims, which is the highest level since late June.³

3. Third quarter earnings were better than expected, but we remain concerned about 2020 expectations. With nearly all companies reporting, earnings are down 1% for the quarter.⁴ That’s quite a bit better than the -4.5% rate expected at the start of reporting season.⁴ At this point, forecasted 2020 earnings per-share growth is nearly 10%, which we think is unreasonably high.⁴

4. We remain cautiously optimistic over prospects for a U.S./China trade deal, but acknowledge that risks remain elevated. Recent friction over tariff levels, agricultural purchases and the protests in Hong Kong have prevented progress on the phase-one trade deal. We hold out hope that the new tariffs set to go into effect on December 15 will be delayed.

5. The impeachment proceedings have not been affecting financial markets, but political turmoil may still add to market volatility.

6. We think chances are slim of additional tax cuts being enacted in the near future. President Trump is likely to propose a new round of cuts as part of his 2020 campaign. But even if Republicans win back the House of Representatives next year (which seems unlikely), it is unclear how much appetite for additional cuts there would be in Congress.

7. The rotation into value stocks could have additional room to run. Although value has been outperforming since late August, we think value still looks relatively inexpensive. This trend could continue, especially if economic momentum picks up further.

It’s harder to make a case for near-term optimism over stock prices

Since the end of the summer, investor sentiment has improved with receding recession fears, growing optimism over a U.S./China trade deal and better-than-expected earnings. Over the last month, strong inflows into equities have pushed prices and valuations higher.

The S&P 500 is now trading at a price-to-forward-earnings ratio of close to 18, which is well above its historic average.¹ We don’t think this valuation level is egregious, given very low Treasury yields and subdued inflation, but stocks appear priced for relatively strong economic and earnings growth as well as notable improvements on trade.

In our view, economic activity and corporate earnings will likely improve modestly over the next year. And we are still relatively optimistic that some sort of trade deal between the U.S. and China will happen in the near future. But we struggle to make the case that conditions will improve to the extent implied by current stock prices.

This is particularly true given the current monetary policy backdrop. Conditions remain extremely accommodative and equity friendly, but the Federal Reserve seems unlikely to push interest rates any lower, unless it sees fresh evidence of economic weakness. And such evidence would be a bearish sign for stocks.

At this point, we think equity prices have gotten ahead of fundamentals. This doesn’t mean we are calling for a sharp pullback, let alone the end of the current bull market, but it does mean that stocks could be vulnerable to a near-term consolidation.