This past week as an incredible week for large cap U.S. stocks, with both the blue-chip Dow Jones Industrial Average and the large-cap S&P 500 reaching new all-time highs. The Dow crossed over 28,000 for the first time, while the S&P 500 crossed over 3,100 for the first time.
The C Fund follows the S&P 500, which represents the top 500 large companies in the United States:
This rally to new all-time highs has been somewhat narrow, because small companies haven’t quite kept up. The Dow Jones U.S. Completion Total Stock Market index that the S Fund tracks has over 3,000 smaller and medium-sized companies, and it still hasn’t caught up with its 2018 all time high:
Similarly, foreign stocks continue to lag. The MSCI EAFE index that the I Fund follows is also lower than its 2018 highs:
The Inflection Point
The market is in an interesting position at the moment, because there’s a big divergence between economic fundamentals and large cap stock market performance.
On one hand, corporate profits have been relatively flat for years, and as of the current Q3 earnings reporting season which is now wrapping up, S&P 500 profits are down about 1% compared to last year.
Industrial production and construction spending are both negative year-over-year, and other economic indicators, while growing, are showing declining growth rates. As of this writing, due to this recently deteriorating data, the Atlanta Fed has a forecast of 0.3% real GDP growth for Q4 of this year, while the New York Fed has an estimate of about 0.4%.
On the other hand, the S&P 500 large cap index is doing very well. Investors may be pricing in the expectation of resumed growth acceleration in 2020, possibly due to improved trade war negotiations or other factors. In addition, interest rates remain historically low, which lowers the discount rate of equity valuations, and partially justifies high prices. The question is, how high?
As a result, we have what investors often call “alligator jaws”- a big divergence between two data points that normally correlated rather well. The result looks like an alligator holding its mouth open ready to slam shut, and the question is, will the underperforming data point (corporate income, blue line) catch up, or will the outperforming data point (stock prices, red line) fall down?
These alligator jaws have preceded both the 2001 and 2008 recessions, where corporate profits started flattening out while markets continued to push higher. However, it’s a challenging timing signal, because markets can melt up rather high before the gap closes. For example, investors that noticed the alligator jaws forming for two years prior to 1997, with historically high stock prices compared to underlying fundamentals, had to wait three more years for the divergence to reach its apex in 2000. We’ve already been in a period of alligator jaw divergence for a few years at this point, but the question remains open for when it may normalize.
Investors should be careful not to chase recent performance based on quick emotional decisions. Asset allocation should usually be based on your long-term goals and your risk tolerance. Decisions to increase or decrease your allocation to equities, for example, should be well thought-out and applied for good reasons. For many investors, the Lifecycle funds can be ideal investment vehicles because they are consistently diversified and rebalance themselves over time.
More on the Lifecycle funds here: The Pros and Cons of Lifecycle Funds