Too Much Improvement?

November 11, 2013

Markets were mostly up last week, but the pace of the advance slowed somewhat. Both the S&P 500 and the Dow Jones Industrial Average closed the week near all-time highs, while the Russell 2000 and NASDAQ lagged a bit. Even so, all four of these major averages remain very near cycle highs.

The only real fly in the ointment for markets last week was Thursday’s GDP report which sent most major averages down more than 1 percent. It must have been a bad report, right? Wrong. While the 2.8% preliminary estimate of GDP is not exactly exciting, it was quite a bit higher than the 2% that most economists had expected. The improvement continues.

In most “normal markets,” a GDP surprise to the upside should be reason enough for rally and celebration. That is not the case in our current world of Fed interventions, legislative tit-for-tat and global monetary easing. No, in this world, too much improvement might mean that all of that central bank support for markets might eventually begin to fade or taper. If that happens, some suggest, the economy will weaken, and markets will fall.

I’ve used the training wheels metaphor in the past, and it seems relevant here as well. Markets—like a child learning to ride a bike—have been operating with “training wheels” (i.e., the Fed’s quantitative easing program) ever since the financial crisis in 2008. It’s scary to remove training wheels. You might even fall and skin your knee once or twice. Eventually, though, you’ll be able to ride a bike on your own.

The unemployment report on Friday gave further confirmation to the improvement in the economy. Friday’s report showed that over 200,000 jobs were created in October. Economists, on average, were only expecting about 120,000. This is just one more sign that the economy is improving and quantitative easing (i.e., Q.E.) may soon end.

Earnings have also been improving. With about 450 of the S&P 500 companies having reported results, we can just about call earnings season finished. About 67% have beaten analysts’ estimates, and 23% have lagged, according to Standard and Poor’s. Forward guidance from companies has been weak, but that has been the case for about two years. Management teams guide their forecasts lower, and then beat them.

Markets have done well, and the economy continues to improve. When will the training wheels come off? While we think some changes are coming in the next year, we don’t see a massive or imminent policy shift coming. Let’s just hope that our global economy is at least as adaptable as a five year old when training wheels eventually do come off.

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