Roman Chuyan, CFA

June 10, 2016

After a seven-year bull run, stock market valuation reached its highest level since 2000. Then, corporate earnings began to decline in 2015 and U.S. economic fundamentals deteriorated this year. Under these conditions, we would normally expect a stock market correction, or worse. Yet, stocks continue to tick higher, with the S&P 500 approaching its all-time high levels in the past few days.

Why? Because central banks have turned investment fundamentals on their head. In the latest twist of “bad news is good news” logic, the weakest job growth in six years, at 38,000, minimized the market’s bet on the chance of the Fed’s rate hike this summer.

Fundamentals ultimately drive markets. US stocks were still undervalued in 2012 which led to the 2013 rally. In 2H-2014 until early in 2015, economic fundamentals strengthened and offset negative effect of high valuation. The market decoupled from fundamentals in the past 2-3 months – such short-term deviations do happen, but the market ultimately reverts to fundamentals.

What may trigger the reversal this time? Inflation has been low lately (total inflation at 1.1%, core at 2.1%) but there’s a strong possibility that it will pick up in the next few months. Commodities already rebounded strongly and are back at their mid-2015 levels (see chart). Higher inflation will force the Fed to act to keep it close to their 2% target. The Fed will find itself behind the inflation curve and will be forced to act – not from a position of strength (strong growth accompanied by inflation), but from a position of weakness.

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