The Surprising All-Time Highs for U.S. Stocks

Ivan Martchev  |


If I had to guess earlier this summer, I would have not guessed that most major U.S. stock indexes would have made fresh all-time highs before any concrete results in the trade negotiations with China were evident. In fact, we have seen fresh all-time highs in both the Dow Jones Industrial Average (the retail investor’s favorite index) and the S&P 500 (the fund managers’ favorite index). Small-caps and the Nasdaq Composite did not make fresh new highs last week, but they were outperforming all year and making fresh all-time highs into late August, so the advance in the market is much broader than one would have anticipated in a late-stage expansion.

What is driving this push in share prices to all-time highs? Simply put: earnings.

At the beginning of the year, 2018 EPS growth was estimated to be in the 10%-12% range, depending on if analysts used top-down or bottom-up estimates. Right now, after Q1 and Q2 EPS growth came in at 20% and 25%, respectively, 2018 EPS growth is estimated to be 20%.

Naturally, if EPS growth is accelerating by 20%, so should share price growth.

Clearly, quantitative tightening by the Fed, global trade frictions and a rout that started in emerging markets’ currencies (soon spilling into local bond markets and later into emerging markets’ stocks) had the potential to create another crisis, but the crisis is contained at the moment. As we witnessed in 1997 through mid-1998, the U.S. stock market could ignore the Asian Crisis – until it didn’t – so the current contrast between a strong U.S. stock market and weak Chinese (and other emerging) stock markets can continue for a while, but ultimately either the EM space will rally or the U.S. market will sell off.

Brazilian Real versus Brazil Foreign Exchange Reserves ChartGraphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

While there was a small recovery off of an all-time low in the JP Morgan Emerging Markets Currency index last week, the situation in the emerging markets space is very precarious. Both the Turkish lira and Argentine peso have been cut in half in 2018 and we are still very much in the contagion phase of this emerging markets crisis. Since the JP Morgan EM Currency Index is not widely available other than on a Bloomberg or FactSet database terminal, a good rule of thumb is to keep an eye on the Brazilian real, where forex reserves are ample and interest rates are high. The real made an all-time low two weeks ago. The rout in weaker EM currencies is spilling over into stronger ones and the real shows that in real time.

China Trade Talks Deteriorate

Because trade talks with the Chinese delegation slated for this week were cancelled over the weekend, just as $200 billion in new tariffs were about to go into effect, one could imagine that the U.S. stock market would have a more difficult time – as the war of words escalates and more and more tariffs go into effect.

Dow Jones Industrial Average versus Shanghai Composite and CSI 300 Index ChartGraphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Since this trade friction with China started, U.S. and Chinese stock markets have performed differently. Even though the Dow Industrials and S&P 500 lagged the small-cap and technology indexes most of the year, they did much better than the mainland Shanghai Composite and CSI 300 index (above). While in the U.S. small-caps have been outperforming large cap indexes in 2018, the small-cap indexes in China have been massively underperforming the large-cap indexes. The 1-year trailing returns as of last week for the large-cap Shanghai Composite and CSI 300 were -16.6% and -11.1%, while the 1-year trailing returns for the small-cap Shenzhen Composite and ChiNEXT Price Index were -27.3% and -24.4%.

At one point earlier in 2018, we had a situation where the large-cap indexes in China were rising, while the small-cap indexes were going down. I never trust a stock market where small-caps are notably weak. Sure enough, the wheels started to come off the wagon for large-cap Chinese stocks in earnest in March.

China Fixed Asset Investment versus China Outstanding Yuan Loa ChartGraphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The Chinese are in a precarious situation, as they managed to prolong their economic expansion for 25 years via the policy of forced lending quotas as the central government controls the major banks in the country. While such policies prolonged the economic cycle and the Chinese economy grew over 10-fold, total credit aggregates in the economy grew over 40-fold. We have a credit bubble in China, which will have nasty consequences similar to what happened in Asia 20 years ago, with the caveat that the Chinese economy is several times bigger than all of the countries involved in the Asian Crisis at that time.

Loan growth, despite a small uptick of late, and fixed asset investment growth have both been declining for a while and it very well may be a real trade war with the U.S. that pushes China over the brink. They have every incentive to make a trade deal, yet the abrasive approach of the Trump administration that produced results in the case of Mexico and the EU may be counterproductive in the case of China, since Trump’s aggressive approach runs counter to the “saving face” modus operandi of Chinese diplomacy.

By Ivan Martchev

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