Walking on Sunshine or Egg Shells?

Social media’s amplification of distorted economic signals

So far, 2018 appears to be defined by broad-based concerns that equity valuations have been stretched, economic prosperity in the US has lasted too long (9 years since exiting last recession), and the yield curve is destined to become inverted – all despite positive economic data. While we believe the widespread utilization of social media has contributed to a greater vocalization of potential economic risks and a cautious market outlook by many, fundamental data points and analysis suggest further market upside is likely, at least through 2019.

Through early July, the S&P 500 and the Russell 3000 have only increased about 3% despite positive economic trends (including the unemployment rate and manufacturing indices reaching levels not experienced in a decade). When considering results relative to the period prior to the last recession, we think it is important to point out that Twitter was only launched in mid-2006, Facebook only started supporting non-school based users in 2006, and LinkedIn only had 10M users in the Spring of 2007 (vs. 562M users today). Pundits on television and the internet are increasingly encouraged to emphasize provocative topics that amplify reactions to increase viewer ratings and clicks. A simple Google Trends poll reveals that there are more searches relating to a “market correction” or “recession” today than there were prior to the last recession, indicating at the very least that concerned investors have greater accessibility to investigate and influence the market. Given the increased accessibility of passing information and opinions through technology compared to the previous pre-recession periods, we believe emotional responses are currently contributing to a weaker market than we otherwise would be experiencing.

While it is likely that the US economy will eventually experience a reversal in economic activity, unique forces created from the quantitative easing (QE) experiments employed by the Fed through 2014 may be distorting typical economic signals. Although an inverted yield curve has historically predicted a recession within ~2 years, the Fed has recently questioned the effectiveness of using bond yields as a recessionary indicator due to the potential QE distortions and current investor apathy towards long-dated securities. While the yield curve has been flattening since its recent peak in 2013 and is approaching zero, the current economy appears to resemble the environment of the mid-1990s (yield curve bounced around under 1% for 6 years) rather than the period prior to the financial crisis (implying it may not invert anytime soon). The Fed could also resort to more aggressive balance sheet unwinding if necessary, which we believe could lead to the yield curve steepening. However, even if the economic environment is worse than we believe and the yield curve inverts in the near term, history would suggest there is still another ~2 years of market upside before recessionary forces cause investors pain. Valuations (measured by P/E) remain less than 1 standard deviation away from historical averages, further supporting our view for market upside. Therefore, we recommend investors stay committed to the market, as we think it likely has greater upside than many suspect and hear/read on various media outlets.

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