The Meltup Before the Storm? Signs of a market top are emerging, but shares could move even higher before the bull finally departs. By RANDALL W. FORSYTH Oct. 6, 2017 10:35 p.m. ET Getty Images Maybe it’s the calm before the storm. So said President Donald Trump at a White House photo op on Thursday evening. “What storm, Mr. President?” shouted a reporter in the room. “You’ll find out,” the chief executive replied, leaving one wondering whether he was referring to Iran, North Korea, the Islamic State, the South China Sea, or some other site of disquiet. What the White House press corps might not have realized was that Trump could have been offering a sage assessment of the world’s stock and bond markets. Calm has descended upon them to an extent unprecedented in modern financial history. Hours before he offered his cryptic statement, theCBOEVolatility Index, aka the VIX or “fear gauge,” closed at its lowest level since December 1993. On the CNN Fear & Greed Index, fear was nowhere in evidence on Thursday. The index closed at 95 on a scale of zero to 100, a score deemed to be “extreme greed.” With all due deference to the movieWall Street’s fictional Gordon Gekko, greed is not good when it gets extreme. As with pride, another of the seven deadly sins, greed often goeth before a fall when it comes to markets. Thursday also was the sixth consecutive day on which the Standard & Poor’s 500 index ended at a record, the longest such skein since the eight straight record closes through June 17, 1997, during the dot-com days. On Friday, the streak ended—just barely—as the U.S. large-capitalization benchmark dipped 0.1%. On the week, however, the index added 1.2% for its fourth straight winning week. What’s most remarkable about the S&P 500’s ascent has been its relative lack of drama. Through Thursday, the index’s daily net change had been 0.5% or less for 17 straight sessions, Ryan Detrick, senior market strategist for LPL Financial, observed on Friday. Charlie Bilello related on his Pension Partners blog that he had been asked if it was safe “to park some money” in the S&P 500 “for a few months.” The rulerlike ascent had given the impression the index was “the new money-market fund.” “Hardly,” he replied. “The absence of risk does not mean the elimination of risk, just as the absence of rain does not mean there will never be another storm.” That, however, seems contrary to the mind-set of investors these days. “The bull market in everything” is how the current issue of the Economist sums up the state of affairs. The magazine’s subhead does ask, “Are asset prices too high?” which implies that the inevitable correction is at hand. The cover illustration also features a bull, a redoubtable contrarian indicator of trouble ahead. Not so fast, contends Jeffrey deGraaf, head of Renaissance Macro Research. Market meltups often are the most manic in their final, climactic stages. Which, by implication, means that portfolio managers who try to avoid the risk that the markets are getting overheated face another sort of risk—to their careers. There’s pretty compelling evidence of things getting stretched, deGraaf explains in a phone chat. Readings on the widely watched purchasing managers’ index from the Institute for Supply Management are moving toward extremes, which is the only time they are important. The PMI topped 60 in September, putting it in the top 10% of its range; the middle 80% doesn’t matter for the stock market, his work shows. While the ISM data show the economy is cooking, credit remains easy, by deGraaf’s lights. To be sure, the Federal Reserve has raised its federal-funds rate target three times in quarter-point increments since late 2016. Another similar hike has a 78.5% probability, according to Bloomberg’s analysis of the fed-funds futures market. The central bank, moreover, has signaled that it will soon begin shrinking its $4.5 trillion balance sheet, withdrawing liquidity from the financial system. That may be, but, as deGraaf points out, on a global basis central banks’ balance sheets are still growing by 8%, year over year, even with the Fed not adding to its assets. Market-based credit indicators also suggest ease. Notably, the risk premium between investment-grade and high-yield corporate bonds is “within a whisker” of its three-year low. That shows marginal corporate borrowers aren’t having to pay up, a sure barometer of accommodative conditions. Another indicator deGraaf watches is the slope of the short end of the Treasury yield curve. Specifically, the spread between the fed-funds rate (1.125%, the midpoint of the 1% to 1.25% target range) and the two-year Treasury note’s yield, which deGraaf suggests would represent an equilibrium level of the fed-funds rate. The two-year yield ended the week at 1.5%, which suggests further Fed hikes ahead. All of which adds up to a bubbly manufacturing sector, pointing to the later phase of an economic cycle that will eventually be terminated by less-easy credit. During the past 50 years, when the PMI is in the top decile, the S&P 500 loses about 4% in the subsequent six months, deGraaf’s charts show. But easy credit also could keep the bull market going for a while. Asked if this is when the central banks start taking away the proverbial punch bowl, deGraaf replies that maybe this is when somebody makes the first call to the cops about the noise. But this rowdy party still has time to run. Switching metaphors, he says it’s time to grab the tiger by the tail, since experience shows that the last portion of these moves can get pretty dramatic. But he’s keeping an eye on signs that the credit cycle could be giving a clue about when to let go. One suspicious sign: Shares of business-development corporations—nonbank lenders, mainly to midsize companies—have been trailing in recent months. Scanning further out on the horizon, Japanese credit-default-swap spreads have widened, while the Topix has been advancing. So far, however, these have been outlier meteorological readings in the calm before the proverbial storm. Or as “Blue Skies,” a song from the Roaring ’20s, put it: “Never saw the sun shining so bright, never saw things going so right.” The euphoria of that era—or the dot-com craze of the 1990s—is conspicuously absent these days, but that doesn’t mean similar bubbles aren’t building. AFTER THE INCONCLUSIVE,hurricane-distortedSeptember employment report was released on Friday, the stock market’s attention turned to the flood of third-quarter earnings reports about to begin. As for the jobs data, payrolls shrank by 33,000 last month, including 40,000 in the private sector, owing to Harvey and Irma. Average hourly earnings jumped by 0.5%. But, as Philippa Dunne and Doug Henwood at the Liscio Report observe, it’s likely the storms cut the ranks of the lowest-paid workers (leisure and hospitality payrolls were down 111,000), so “it would be premature to see this as a serious wage acceleration.” The hurricanes probably will play havoc with some third-quarter profits, as well. And bad weather provides a handy excuse to put bad news into the quarter just ended. If anything, corporations have been playing their typical game of guiding expectations lower to an even greater extent than usual, according to BCA Research. Using Thomson Reuters/IBES data, third-quarter forecasts for the S&P 500 have been lowered by 900 basis points (nine percentage points), in part because of hurricane effects. That brings the year-over-year gain to 6%, a relatively low hurdle to clear. In comparison, the forecast reductions in earnings growth for the first and second quarters were 600 and 500 basis points, respectively. On average, companies have beaten these forecasts by 470 basis points, so recent history suggests they will clear the lowered bars again. Much of the aggregate gains will be accounted for by just two sectors, technology and energy, adds BCA. If health care, industrials, and financials are added, the percentage contribution to the gains jumps to 98%. “Such a high concentration is a risk,” the advisory service contends. Given the distortions that may affect third-quarter results, the key will be managements’ projections for future quarters. Those forecasts may also be more clouded than usual. How much did the hurricanes pull forward future demand (as evidenced in the surge in auto buying in September, to replace water-damaged cars) or delay sales? The outlook for policy also is a complication, especially for tax reform. Central to the Trump proposal is a cut in the corporate tax rate to 20% from 35%. According to a Bank of America Merrill Lynch report using analyses from the Tax Policy Center and the Committee for a Responsible Federal Budget, the proposed plan would add more than $2 trillion to the federal budget deficit over the next decade. And that includes the elimination of all individual deductions, except for mortgage interest and charitable donations. Given the opposition to aspects of the plan, notably the elimination of the state and local tax deduction, the BofA ML economists are skeptical that a major tax bill will pass this year or next. “The latest proposal has not resolved any of the tough questions around the deficit or the myriad details that go into a complete bill,” they write. Maybe there will be trimmed tax cuts, but they’d be unlikely to change the trend growth of the economy. And the economists conclude: The positive supply-side incentives are likely to be offset by the crowding-out effect of a bigger budget deficit. Email:editors@barrons.com Email:randall.forsyth@barrons.com http://www.barrons.com/articles/the-meltup-before-the-storm-1507343724