Why sentiment is key to stock market's direction

Investors' optimism is being tested.

The rally in U.S. stocks that began a day after Christmas has (so far) survived the following: An escalating trade war with China, slowing growth in the global economy, an uncertain future for Europe and political unrest in Hong Kong.

The latest land mine to navigate appeared this week when the 10-year U.S. Treasury yield fell below the two-year yield. While other parts of the yield curve have previously inverted at various times in the last 12 months, the 10-year vs. two-year inversion is most widely considered a strong warning of a looming economic recession.

To be clear, an inversion does not imply a recession is imminent. It is, however, another weight on the shoulders of investors trying to maintain their confidence. Whether or not the stock market rewards that confidence with gains in the months to come is based primarily on two factors: Federal Reserve policy and investor sentiment.

"Don't fight the Fed" has been a rallying cry among investors for more than a decade.

Ever since its first round of quantitative easing began in November 2008 under then-Chairman Ben Bernanke, the Fed has helped foster a financially friendly environment in which stocks have thrived. Regardless of how strong or weak the economy may have appeared, the argument could be made that favorable policy from America's central bank would ultimately drive equity prices higher.

The significance of Fed policy on the stock market has been especially obvious recently. After slow-but-steady interest rate increases in 2018 fanned concerns of choking off economic growth, equities sold off 20% in the fourth quarter. The Fed then calmed investor sentiment and spurred the current rally by pausing its rate increases in January and preaching patience regarding future hikes. Long story short: Too many Fed hikes led to a 20% correction. A pause and (eventual) rate cut by the Fed contributed to a 25% rally.

Market sentiment, it seems, has been tied almost exclusively to Fed policy. But what happens when investors stop focusing on the policy and instead consider the reasons why those fiscal decisions are deemed necessary?

The answer can be found by looking at Europe. In many ways, Europe and the U.S. are navigating a similar economic climate. Unlike in America, however, years of aggressive central-bank stimulus in Europe and the resulting negative interest rates have not led to investor optimism or strong equity returns. It's true that uncertainty surrounding Brexit and the evolving future of the eurozone add an extra layer of anxiety for Europeans. Generally, however, it's the sentiment, not the symptoms, that is drastically different.

None of this is meant to raise any particular alarm about the state of the U.S. stock market. Trading around 16 times forward earnings estimates after an ugly week on Wall Street, valuations for the S&P 500 remain reasonably priced and cheaper than their five-year average.

Experience has taught us that people tend to underestimate the resilience of the U.S. economy, which despite slowing growth is in better condition than its global counterparts. Our economy is more diverse, energy-independent, and less export-driven than the rest of the world.

In 2018, exports made up only 8% of America's gross domestic product (GDP). That's a considerably lower portion than other major economies like Japan (15%), the U.K. (17%), China (19%) and the eurozone (20%). In many emerging market countries, exports make up 30% or more of those economies. While much of the world may be held hostage by global trade uncertainty, the U.S. economy is less affected, relatively speaking.

At some point, earnings and economic data will become more important drivers of the market's direction than news conferences held by Jerome Powell. It's certainly possible the data will be positive enough to keep this rally going.

Long-term, as we've seen in Europe, monetary policy will not be enough.