David Joy: Stocks’ latest rally – inching toward excessive optimism?

U.S. equities rose again last week, albeit by the slimmest of margins. Nevertheless, the 0.1% gain on the S&P 500 was the fourth straight week of higher prices, and the seventh in the last nine, dating back to Labor Day. The only stumbles occurred during the two weeks surrounding the start of the government shutdown.

During those nine weeks, the index has climbed almost 8.0%, or roughly one-third of its year-to-date gain of 24%. Notably, more than half of that 8% gain came before the Fed surprised investors by announcing no taper on Sept. 18, suggesting that the current rally is attributable to more than just quantitative easing.

Mutual fund flows don’t seem to be the answer. According to the Investment Company Institute, investors were net sellers of domestic equity mutual funds in both August and September, and even through the first two weeks of October.

Economic conditions remain uncertain, clouded by the shutdown. The data of late, such as it is, has been mixed, although overseas conditions are becoming a little better. Third quarter earnings season has been decent, if unspectacular, while inflation and interest rates remain low.

Whatever combination of factors is driving this rally, in what may be an early warning sign of excessive optimism, the trend in domestic equity fund liquidation reversed with a vengeance recently. In the week of Oct. 23, following the end of the shutdown, these funds saw inflows of $9.2 billion, more than in any single month since January. Absent something unforeseen, this renewed enthusiasm for stocks could extend for some time, especially at the expense of bond funds, which were the beneficiary of huge inflows over the past ten years, but which have been experiencing outflows for the past five months.

So far, at roughly 16.5x expected 2013 earnings and roughly 15x expected 2014 earnings, valuations are still reasonable. But, even that presumes earnings growth immediately ahead of 10% or so. The rising demand for equities could push those valuations to levels that are no longer reasonable. If the true underlying health of the U.S. economy is better than the policy-distorted data shows, and there is sustainability to the budding signs of a synchronized global upturn, then accelerating growth and rising earnings will justify those valuations. If not, eventually lower prices will bring valuations back in line.

The week ahead contains a host of what would normally be an important series of economic releases. Instead, because of the shutdown, we are once again confronted with the distortions it has created. The October employment report is scheduled for release on Friday, one week late. The household survey will presumably capture a representative sample of furloughed government workers, who will be counted as unemployed, although they are now back at work. The consensus expectation for newly created non-farm jobs is just 125,000 which would be the slowest pace since July.

But, will this report be truly representative of the current health of the labor market? Not likely, even taking into account the dent to confidence created by the shutdown.

Also scheduled for release this week is the advance estimate of third quarter GDP on Thursday. It is expected to show growth at an annualized rate of 2.0%. That would be slower than the 2.5% pace of the second quarter, but better than the 1.1% pace of the first.

Although the government shutdown was a fourth quarter event, the weeks leading up to Oct. 1 were undoubtedly impacted by the expectation of it. The Gallup daily economic confidence index reached its peak for the year on May 29 with a reading of -2. It then began a long descent that extended throughout the third quarter before bottoming at -43 on Oct. 12.

But beyond that, the third quarter was also impacted by rising interest rates, amidst widespread expectations of Fed tapering in September. Between June 30 and Sept. 17, the yield on the ten-year Treasury note rose from 2.49 to 2.85%, extending the rise that occurred in May and June, pushing mortgage rates higher and slowing housing activity and automobile sales in particular. Interest rates have since moderated somewhat, mortgages included, since the Fed has chosen to remain on the sidelines for now, which should give a boost to activity going forward. And since Oct. 12, the Gallup index has begun to recover, although its reading of -29 on Nov. 2 was the lowest at any time this year except for the weeks during the shutdown.

So the third quarter GDP report will be widely discounted as representative of conditions that do not presently exist. Unfortunately, some of those same headwinds impacted the economy at the start of the fourth quarter and will ultimately be reflected in the data.

In the meantime, home prices continue to rise, along with financial assets, further strengthening consumer balance sheets. Gasoline prices have moderated, and consumer price inflation remains subdued. Manufacturing has also generally held up throughout the shutdown. Europe, Japan, and China have all reported economic improvement recently. And the Fed once again last week refrained from tapering, and does not meet again until Dec. 17-18. Confidence is beginning to rise, and domestic equity flows have turned positive, so the rally in stocks may continue. But that may also lead to excessive optimism. We may not be there yet, but neither may we be too far from it.

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