Non-farm payroll and the S&P 500: which narrative?

by George Hatjoullis

S&P 500

The S&P 500 made a marginal new high on April 11, corrected, and then made another marginal new high on May 1 and is now waiting to see the NFP data before deciding what to do next. The chart is consistent with a price correction lower, potentially as far as 1555, before continuing on this steady grind higher. Looked at in isolation the chart (courtesy of IG Index) is unremarkable and consistent with a steady bull run.

However, on the last two occasions that the S&P 500 index achieved these levels or thereabouts, it was the beginning of two nasty bear markets. There is a great deal of fear because of these prior events. Moreover, other asset classes that have correlated with the equity market over the recent years have begun to show clear signs of reversing. The S&P 500 is deemed by many to be defying gravity and due a fall.

The common factor is GDP growth or so everyone claims. The S&P must come lower because growth is slowing and this will impact earnings. This would seem to imply a bear market is likely with at least a 20% fall. This would take us down to around 1300. Ironically, when pressed the ‘bears’ do not see quite such a big fall and are all looking for a correction in order to buy equities. The market narrative for the S&P does not quite hang together.

Market prices are of course about narratives. They are loosely connected to reality but for long periods the connection can be non-existent. The narratives set up waves of collective action  and these sustain trends. To be successful in financial markets investors need to grasp which narrative is in play and act accordingly. However, this is easier said than done as, living in the real world, investors are often sidetracked by facts and other noise.

The other important element to identify is how investors, in aggregate, are disposed. Now it would not be outlandish to speculate that investors, in aggregate, have a much higher weight in cash and fixed income than they could have and much lower weight in equities. If this is true then the narrative that must emerge is one that justifies an asset allocation shift to equities. This is secretly what everyone is looking to do.

But how can this occur? Central banks have been pumping money out as fast as they can for several years and the Bank of Japan is about to up the pace. Growth outside of the eurozone has picked up but not to the heady levels seen before. Commodity prices are falling back and the Gold-emperor is beginning to look a little ragged. Growth is apparently slowing again.

Let us try to construct a narrative form this assortment of fact-assertions. Central bank money has been printed fast but has not led to much money supply growth because broken banks have not been lending. The banks are slowly mending and this means credit will grow as the banks, cautiously, seek more volume. The central banks will not be withdrawing their money any time soon.

Commodities are of course an input into production. Over the past few years they have become an asset class and attracted a lot of speculative cash. With banks failing, equities suspect and bonds paying very little, the stock of investable cash looked wider and wider for a home. However, things are looking up outside of the eurozone and commodity prices are adjusting down to user demand and away from the exalted level of investment demand. The fall in commodity prices is a good thing (except for the commodity producers). It does not necessarily reflect slower growth but rather less demand as an asset class.

In this narrative growth does not slow much and continues at a steady, positive pace. It is fuelled by lower input costs (notably energy) and the growing availability and lower cost of bank credit. It may even get a little boost from a slower pace of fiscal contraction as synchronised austerity is seen as a destructive and self-defeating force.

What light will the NFP shed? It will tell us which narrative is in play.