Newton's Law of Inertia

Why does the stock market continue to rise? 

It seems like the market has been rallying on news of tax reform since Trump’s election win in November, 2016. Sure, tax reform is one reason for the rally, but we’ve known about that for months.  Corporate earnings have been strong, but not abnormally so.  Economic growth has been good, but not dramatically above average.  Lately it seems that the stock market simply goes up for no reason at all. 

Isaac Newton’s first law of motion may give us the answer.  Newton’s law of inertia states (paraphrased) that “an object put into motion will remain in motion unless acted upon by an outside force.”  Simply put, the stock market is going up because it has no reason not to.  It will remain in the uptrend until acted upon by an outside force.  The law of inertia was always my personal favorite of Newton’s!

What may cause it to end?

What ‘outside forces’ could halt the motion?  The obvious suspects like war and terrorism are always possible.  Bad corporate earnings could cause a reversal, but that’s unlikely in light of the new tax reform.  International concerns like we saw from Greece in 2012 or China in 2016 could spook investors.  Higher interest rates could become problematic.  Either way, at some point, an outside force will stop the trajectory of the market.  Until that time, however, let’s continue on the assumption that the market will remain in motion. 

When might it end?

The economy generally follows a pattern of expansion (early cycle), peak (mid cycle), contraction (late cycle), and trough (recession).  Equity performance tends to be best from the trough to the peak.  With that said, it does appear that we may be transitioning from the peak (mid cycle) to the late stages of the business cycle.  The business cycle is generally more predictable than the stock market, but that’s not super helpful because it tends to be a lagging indicator.  In other words, the stock market tends to head south before the actual economy does.  I believe we are seeing the early stages of a rotation into “late-cycle” dynamics. 

Generally, in the later innings of the business cycle we begin to see sectors like Utilities and Real Estate underperform the general stock market as interest rates increase.  On the other hand, we see the outperformance of sectors like Energy and Materials.  The Energy sector is often a classic late-cycle indicator.  Fidelity’s paper The Business Cycle Approach to Equity Sector Investing researched performance of each sector throughout various business cycles and stated, “Looking across all three analytical measures, the Energy sector has seen the most convincing patterns of outperformance in the late cycle, with high average and median relative performance.”  As the economy matures, the Energy and Materials sectors often see the biggest gains from the heightened demand and benefit from increased inflationary pressures.

According to Fidelity’s research, once the market enters the later phase of the business cycle, which generally lasts a year and half, stock market performance slows.  However, the performance is still positive, averaging roughly 5% on an annualized basis.

In the last thirteen weeks the best performing sector in the market is…. Drumroll…. Energy (+16.32%) as of 1/23/18, measured by Morningstar research.  The worst performing sector over the same time is…. You guessed it….Utilities (-7.54% courtesy of Morningstar), followed by Real Estate (-2.78%).  It appears that a changing of the guard is taking place, and it’s pretty easy to make the argument that we are entering the later stages of the business cycle.