Stock ETFs Surge As Economy Surprises

The market rallied powerfully in the past week as recession fears ebbed and oil bounced back. But is the worst behind us, or is there more downside to come? That's the question everyone is pondering.

Double Bottom?

Since bottoming out on Feb. 11 around 1,810, the S&P 500 quickly jumped 120 points in the next few sessions. Some investors see the February bottom as a successful retest of the 1,812 low from Jan. 20.

S&P 500

Since the February intraday low, the SPDR S&P 500 ETF (SPY | A-98) gained 5.8%; the iShares Core S&P Mid-Cap ETF (IJH | A-83) added 5.9%; and the iShares Russell 2000 ETF (IWM | A-91) rallied 7%.

While technical factors and short covering were surely at play during the recent market rebound, the fundamental backdrop seems to have improved as well.

Economic Data Solid
The bears who claimed the U.S. was headed for an imminent recession, or was already in a recession, have been proven wrong by the latest economic data.

Labor market indicators remain exceptionally strong. January's job gain of more than 150,000 marked the 71st-straight monthly increase, the longest streak on record. Meanwhile, the unemployment rate ticked down to 4.9%, a post-recovery low.

Initial jobless claims, a weekly measure of layoffs, fell to 262,000 this week, the lowest level since November. Jobless claims have been below 300,000 for 50-straight weeks, the longest such stretch since the early 1970s, according to Reuters.

Initial Jobless Claims

Other data outside of jobs also improved. Retail sales ticked up a better-than-expected 0.2% month-over-month in January thanks to a pickup in wages, and some feel lower gas prices are fueling spending as well. Excluding autos and gas, sales were up 0.4%, an improvement from December's 0.1%.

At the same time, industrial production in January surged 0.9% on the back of a 0.5% increase in manufacturing output, the largest since July.

While it's much too early to call a bottom in the depressed manufacturing sector, the latest numbers suggest it may not be as much of a drag on the economy going forward as previously thought, with a halt to the dollar's two-year uptrend helping exporters.

Incorporating these latest economic figures, the Atlanta Fed's GDPNow model forecasts first-quarter growth for the U.S. economy at 2.6%―a far cry from recessionary territory.

Emerging Markets & Credit Still An Issue

That said, while the U.S. economy doesn't look like it's hurtling toward a recession right now, that could change if some of the stressed areas of the global financial system and global economy bring it down.

Emerging markets—including China and commodity-producing countries like Russia, Brazil and Venezuela—are a wild card. All these economies are facing challenges in the current environment, but there has yet to be a shock that raises systemic risk across the global economy. That could change.

Domestically, credit spreads have widened significantly due in large part to the downturn in the oil industry. Energy-heavy junk bonds are in the tank, with spreads over Treasurys at about 800 basis points—the highest level since the eurozone sovereign debt crisis in 2011, according to a Barclays index.

Corporate High Yield Spread

Even investment-grade corporate bond spreads have been on the rise, reaching 200 basis points over Treasurys, the most since mid-2012.

As the Federal Reserve explained in the minutes to its January policy meeting, widening credit spreads―in addition to a strong dollar and volatile stock markets―could weigh on economic growth and are "roughly equivalent" to further rate hikes by the central bank.

Just as with the downturn in emerging markets, wider credit spreads have yet to noticeably impact U.S. economic growth, but that could change.

Oil-Driven Earnings Drag

The credit markets aren't the only area where oil has done a number. Corporate earnings took a big hit last year due to the drop in energy sector profits.

The final numbers are still coming in, but it looks like aggregate earnings for companies in the S&P 500 will have declined for three-straight quarters through the end of 2015, the first time that's happened since the financial crisis.

For 2015 as a whole, S&P 500 earnings were fractionally negative. Yet essentially all of that decline stems from the 60% plunge in energy sector earnings. Excluding energy, profits for S&P 500 firms were up by more than 6% for the calendar year, according to FactSet.

A big part of why the stock market has been flat to down for the past 12 to 18 months is because earnings have stalled―due to energy. However, as energy's drag is reduced, aggregate earnings will likely begin to climb again later this year.

Headlines Too Negative

There are plenty of things investors can point to in order to raise concerns about the stock market. But that's almost always the case.

Emerging markets, credit markets and oil are worthy of keeping an eye on, but the issues affecting those areas have yet to derail the U.S. economic expansion. In fact, the U.S. economy may be in the process of accelerating, as faster wage growth and savings from lower oil prices buoy consumption.

While it may be premature to give the "all clear" sign for the economy or the stock market, the underlying fundamentals look much more balanced―if not bullish―than the negative day-to-day headlines suggest.

Contact Sumit Roy at [email protected].