Three quick ways to test the strength of the US market

Buildings

After a lot of huffing and puffing to recapture the ground lost since January, America’s S&P 500 index is trading at fresh all-time highs and in the process setting new records for the longest bull run in US stocks in history at 3,461 days and counting.

The 428% rise since the post-Lehman bottom on 9 March 2009 is not, however, the best advance forged during a bull run. Between October 1990 and March 2000, the S&P 500 romped higher by 518%. 

To match that gain, the S&P 500 must therefore get to 3,505, some 20% higher than where we are now.

The current bull run in the US is the longest in history and offers the second-best gain

Source: Thomson Reuters Datastream

One factor in the S&P 500’s rise this year has been very strong earnings growth as the US economy has picked up steam, helped by the tax cuts pushed through by the Trump administration in late 2018.

And with interest rates slowly rising, and the Federal Reserve also withdrawing Quantitative Easing, profits growth will have to remain strong if stocks are to resist the gravitational pull of higher returns on cash, which just might one day tempt advisers and clients to take on less risk and lessen their portfolio allocation to equities.

Onward and upward

After 20% year-on-year growth in Q1 2018, analysts went into July looking for a 38% surge in Q2, buoyed by tax cuts, share buybacks, initial dollar weakness and also a strong operational performance from oil and technology firms in particular.

The good news is that corporate America has delivered in style. With just a handful of S&P 500 members yet to report, earnings look set to rise 43% year-on-year, with operating margins and earnings per share reaching fresh all-time highs.

US corporate earnings continue to march higher

Source: Standard & Poor's

Better still, profits growth looks to be accelerating and earnings forecasts are still rising.

US earnings estimates continue to rise

Source: Thomson Reuters Datastream

This helps to explain why US stocks trade at fresh all-time highs of their own, at least using the S&P 500, NASDAQ Composite and the small-cap Russell 2000 indices as benchmarks, with only the share-price weighted Dow Jones Industrials letting down the side.

But this also implies that profit growth forecasts must be met or exceeded and operating margins maintained or increased to help US stocks maintain their momentum.

It will therefore be interesting to see if any US firms flag any negative impact from tariffs, costs or the dollar. No-one is expecting a 2008-09 style margin collapse but with US stocks having done so well any disappointments could be taken badly, since arguments that the US market is still cheap largely rest on the assumption that profit margins will stay at their new highs forever (or even go up even more).

US corporate profit margins stand at all-time highs

Source: Standard & Poor's

Three against the field

Checking out some 500 sets of results every three months is a laborious job that will be beyond most investors. To cut out some of the donkey work, advisers and clients might like to keep an eye on three sector indices to help them take markets’ temperatures as the earnings numbers flood in once more.

All three tap into three key sectors of the US economy and tend to be good indicators of wider stock market sentiment. While the past is by no means guaranteed to repeat itself, the S&P 500 tends to do well when they are doing well and badly when they are doing badly.

  • Transports

The old theory is that if the economy is doing well, the transport stocks will do well, as goods are being sold and therefore new supplies must be shipped. Bulls will be delighted to see that the Dow Jones Transportation index is rumbling higher again after a slight skid in the summer.

Transport stocks are powering higher once more

Source: Thomson Reuters Datastream

  • Semiconductors

The Philadelphia Semiconductor index, or SOX, contains 30 companies that are involved in the design, manufacture and sale of silicon chips and it is therefore a very useful guide for investors on two counts.

  • These integrated circuits are everywhere, from smart phones to computers to cars to robots, so they offer a great insight into end demand across a huge range of industries and therefore the global economy.
  • Chip-makers’ and chip-equipment makers’ shares are generally seen as momentum plays, where earnings growth is highly prized and valuation less of a consideration. As such they can be a good guide to broader market appetite for risk.

Chip stocks are still cooking

Source: Thomson Reuters Datastream

The SOX is up by 11.5% this year and the S&P 500 by 8.5% so that looks good, although advisers and clients need to watch the chipmakers’ inability to set new highs. This may reflect lingering concerns over trade disputes with China in particular.

  • Banks

Both the economy and the financial markets do need healthy banks if they are to thrive, so a relatively feeble performance from the Philadelphia Banks index is a concern. Real weakness, rather than mere underperformance, could warn of economic and market troubles ahead since the sector lost momentum in early 2007, well before the peak in the S&P 500 and before the Great Financial Crisis broke.

Banks must be watched as they remain a potential weak link

Source: Thomson Reuters Datastream

Conclusion

History suggests bull markets end when interest rates are rising, valuations are stretched and earnings disappoint. The first is undeniable, the second arguable but the third, for now, is not a concern, especially with transport and chip stocks blowing hot, although any further cooling in the banks’ momentum could yet be an early warning signal.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

Top