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MV Weekly Market Flash: Japan and the Fifty Percent Curse

March 3, 2017

By Masood Vojdani & Katrina Lamb, CFA

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The heady cocktail of animal spirits and hope that is the so-called reflation-infrastructure trade has many fans, but perhaps none more so than the monetary policymaking committee of the Bank of Japan. One of the first casualties of last year’s big November rally was the yen, which plummeted in value against the US dollar. That plunge was just fine, thank you very much, in the mindset of Marunouchi mandarins. A weak yen would make Japanese exports more competitive, while the continuation of easy money and asset purchases at home would finally create the conditions necessary for reaching that long-elusive 2 percent inflation target.

Lo and behold, the latest price data show that Japan’s core inflation rate rose 0.1 percent year-on-year in January, the first positive reading in two years. Only 1.9 percent more to go! Expectations of stimulus-led growth, continued weakness in the yen and a return to brisker demand both at home and in key export markets have led Morgan Stanley’s global research team to name Japan as the stock market with the most attractive prospects for 2017.

Patience Has Its Limits

Beleaguered long-term investors in Japan’s stock market would be more than happy to see Morgan Stanley’s prognostications come true – but they have heard this siren song before. The Nikkei 225 stock index reached a record high of just under 40,000 on the last trading day of 1989. As the chart below shows, things have been pretty bleak since those halcyon bubble days when the three square miles of Tokyo’s Imperial Palace were valued by some measures as more expensive than the entire state of California.

If the Morgan spivs are right about Japanese shares, and keep being right, it will represent a decisive break from a struggle of more than two decades for the Nikkei to sustain a level greater than 50 percent of that all-time high value. Prior to 2015, the Nikkei had failed to even touch that 20,000 halfway point at any time since March 2000 (which, as you will recall, was when the US NASDAQ breached 5,000 just before the bursting of the tech bubble). 2015 represented the high water mark of investor expectations for “Abenomics” – the three-pronged economic recovery program of Prime Minister Shinzo Abe – to deliver on its promises of sustained growth. Those expectations stalled out as the macro data releases kept pointing to more of the same – tepid or negative growth and the failure of needed structural reforms to take root. Japan’s problems, as anyone who has studied the long-term performance of the one-time Wunderkind of the world economy will tell you, are deep and very hard to dislodge.

No Really, It’s Different This Time

Abe is not the first prime minister to apply stimulus in an effort to shake the economy out of its lethargy. Massive public works programs have been a hallmark of the past quarter century. Over this time, yields on the 10-year benchmark Japanese Government Bond (JGB) have never risen above 2 percent (including during periods when yields on US and European sovereigns were at 6 percent or higher). The 10-year yield’s trajectory is shown (green trend line) on the chart above. No amount of stimulus, it would seem, was enough to convince Japanese households to go out and spend more in anticipation of rising prices and wages.

So what is it about the current environment that could induce Japanese share prices to break the 50 percent curse for once and all? We would imagine the answer to be: not much. While it is true that both the US and Europe look set to continue a modest uptrend in growth and demand (with or without the reflation jolt catalyzing all those animal spirits), Japanese companies are not necessarily positioned to benefit – certainly not in the way they did in the very different economy of the 1970s-80s when “Japan as Number One” was required reading for MBAs and corporate executive suites. While they have arguably become more shareholder-friendly in recent years, as evidenced by higher levels of share buybacks and the like, corporate business practices remain largely traditional and hidebound. Just a decade ago, these companies blew a once-in-a-lifetime chance to ride the wave of the great growth opportunity that was China – in their own back yard.

There is no magic formula for growth. In a country with an old and declining population (and extremely strict limits on immigration), a supernova-like burst of productivity is the only plausible route to real, organic improvement. Until then, that barrier of 20,000 in the Nikkei may continue to be a tough nut to crack.

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MV Weekly Market Flash: Political Risk and the Cloak of Invisibility

February 17, 2017

By Masood Vojdani & Katrina Lamb, CFA

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Over the past couple weeks we have been snooping around some of the contrarian corners of the world, to see what those folks not completely enamored of the “Trump trade” have been up to (Eurozone, Brexit, what have you). While we were away, all manner of things has gone down in Washington, often in a most colorful (or concerning, take your pick) fashion. But virtually all the chief planks of that Trump trade – the infrastructure, the corporate tax reform – remain stuck in the sketchbooks and doodlings of Paul Ryan and his band of policymakers, waiting to see the light of day. By this point in his first term, Barack Obama had already passed a $1 trillion stimulus bill, among other legislative accomplishments. Is there a point at which the band of inverse-Murphy’s Law acolytes begin to question their faith that if something can go right, it will? To put it another way, does political risk still matter for asset valuation?

“Vol Val” Alive and Well

If there is a political risk factor stalking the market, it appears to have paid a call on J.K. Rowling and come away with a Hogwarts-style cloak of invisibility. For evidence, we turn to our favorite snapshot of trepidation and animal spirits – those undulating valleys of low volatility occasionally punctuated by brief soaring peaks of fear that make up the CBOE VIX “fear gauge,” shown in relation to the price performance of the S&P 500.

Since the election last November, market volatility as measured by the VIX has subsided to its lowest level since the incredibly somnambulant dog days of summer in 2014. In fact, as the chart shows, the lowest vol readings have actually occurred on and after Inauguration Day (so much for that “sell the Inauguration” meme making the rounds among CNBC chatterboxes a few weeks back). Meanwhile, of course, the S&P 500 has set record high after record high. How many? Sixteen and counting, to date, since November 9, or about one new record for every four days of trading on average.

That by itself is not unheard of though: the index set a new record 25 times (measured over the same time period) following Bill Clinton’s reelection in 1996. But 1996 was a different age, one with arguably less of the “this is unprecedented” type of political headlines to which we have fast become accustomed in the past two months. To a reader of the daily doings of Washington, it would seem that political risk should be clear and present. One of this week’s stories that caught our attention was the good times being had by London bookmakers setting betting markets for the odds of Trump failing to complete his first term (the odds apparently now sit around 2:1). So what gives with this week’s string of record highs and submerged volatility?

The Ryan Run-up

The “Trump bump”, of course, was never about the personality of the 45th president, or anything else that he brings to the table other than a way to facilitate the longstanding economic policy dreams of the Ayn Randian right, represented more fulsomely by House Speaker Paul Ryan than by Donald Trump. Looking at the rally from this standpoint perhaps explains at least in part the absence of visible political risk. So what, goes this line of thinking, if Trump were either to be impeached or somehow removed under the provisions of the 25th Amendment? Vice President Pence ascends to the Oval Office, the Twitter tornadoes subside and America gets on with the business of tax cuts and deregulation in a more orderly fashion (though not much infrastructure spending, as that was never really a Ryan thing). Move along, nothing to see here.

While we understand the logic behind that thinking, we think it is misguided, not least of all because – London oddsmakers notwithstanding – we think that either impeachment or a 25th Amendment removal from office are far out on the tail of any putative distribution of outcomes. We would ascribe a higher likelihood to a different outcome; namely, that political uncertainty will continue to permeate every sphere of activity from foreign policy to global trade to domestic unrest in a bitterly divided, partisan nation. So far we are muddling through – headlines aside, many American institutions are showing their resilience in the face of challenge. That’s good news. But not good enough, in our view, to keep political risk behind its Invisibility Cloak for much longer. We’re not prophesying any kind of imminent market cataclysm, but we do expect to see our old friend volatility make an appearance one of these days in the not too distant future.

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MV Weekly Market Flash: The Valuation Ceiling’s Moment of Truth

January 6, 2017

By Masood Vojdani & Katrina Lamb, CFA

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It’s a new calendar year, but markets continue to party like it’s late-2016. Remember Murphy’s Law? “If something can go wrong, it will” goes the old nostrum. U.S. equity markets, in the pale early dawn of 2017, exhibit what we could call the inverse of Murphy’s Law. “If something can go right, it will!” goes the happy talk.

Happy Talk Meets Sales & Profits

We’re about to get an indicative taste of how far these rose-tinted glasses will take us through the next twelve months. Earnings season is upon us. Analysts expect that earnings per share for last year’s fourth quarter will have grown by 2.81 percent from a year earlier, according to FactSet, a market research company. Stock prices grew by a bit more than that – 3.2 percent – over the same period, so valuation measures like price to earnings (P/E) and price to sales (P/S) edged up further still. In fact, the price to sales ratio is higher than it has ever been since the end of 2000, and within striking distance of the nosebleed all-time high reached at the peak of that bubble in March 2000. The chart below illustrates this trend. 


Price to sales is a useful metric because it shines the spotlight on how much revenue a company generates – from sales of its goods and services – relative to the price of the company’s stock. We inhabit a world where global demand has been persistently below-trend for most of the time since the 2007-08 recession. Weaker demand from world consumer markets, along with the added headwind of a strong dollar, has impeded U.S. companies’ ability to grow their sales from year to year, and that in turn helps explain why stock prices have run so far ahead of revenue growth.

Knock Three Times on the Ceiling

While price to sales is important, investors generally tend to place more emphasis on the bottom line – earnings – than on the revenue metric. Some investors focus on past results, such as last twelve months, or full-cycle measurements like Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio. Others believe that forward-looking measures are more useful and pay closer attention to analysts’ consensus estimates for the next twelve months. By any of these measures the market is expensive. The Shiller CAPE ratio, for example, currently stands at 28.3 times. That’s higher than it has been any but two times in the last 137 years (yes, one hundred and thirty seven, that is not a typo). The CAPE ratio was higher in September 1929, before the Great Crash, and again in March 2000 before that year’s market implosion.

While CAPE is a useful reality check on the market, neither it nor any other metric is necessarily a useful timing tool. There is no reason to believe that the so-called “Trump trade,” based largely on Red Bull-fused animal spirits, will end on a specific date (all the silly chatter of the “sell the inauguration trade” aside). What particularly interests us as earnings season gets underway is whether – and this would be contrary to the trend of the last several years – the earnings expectations voiced by that consensus outlook actually squares with reality. Consider the chart below. 


There’s a lot on this chart, so let’s unpack it piece by piece. Let’s start with the horizontal lines depicting two “valuation ceilings” which, over the past two years, have served as resistance levels against upward breakouts. The first such ceiling is defined by the S&P 500’s high water mark reached in May 2015. The index challenged that high several times over the next 14 months but consistently failed to breach it. Then Brexit happened. The post-Brexit relief rally in July 2016 powered the index to a succession of new highs before topping out in August. It then again traded in mostly sideways pattern through early fall up to Election Day. Of course, we know what happened next.

Hope Springs Eternal

Now we come to the second key part of the above chart, and the one to which we are most closely paying attention as we study the forward earnings landscape. The thick green and red dotted lines show, respectively, the last twelve months (LTM) and next twelve months (NTM) earnings per share for the S&P 500. In other words, this chart is simply breaking the P/E ratio into its component parts of price and earnings, using both the LTM and NTM figures.

So how do we interpret these LTM and NTM lines? Take any given day – just for fun, let’s say December 10, 2015. On that day, the NTM earnings per share figure was $125.79. If we could travel back in time to 12/10/15 and talk to those “consensus experts,” they would tell us that they expected S&P 500 EPS to be $125.79 one year hence, on December 10, 2016. But now look at the green line, showing the last twelve months EPS. What were the actual S&P 500 earnings in December ’16, twelve months after that $125.79 prediction? $108.86 is the right answer, quite a bit lower than the consensus brain trust had expected!

Why is this Kabuki theater of mind games between company C-suites, securities analysts and investors important? Look at the NTM EPS trend line, which has gone up steadily for the last year even as real earnings have failed to kick into growth mode. Right now, those gimlet-eyed experts are figuring on double-digit earnings growth for 2017. Double digit earnings growth would offer at least some justification for those decade-plus high valuation levels we described above. Is there a chance that reality will fall short of that rosy outlook? That is the question that should be on the mind of any investor at all concerned about the fundamentals of value and price.

Global demand patterns have yet to show any kind of a significant pick-up from recent years, though the overall economic picture continues to improve at least moderately. And the headwinds from a strong U.S. dollar do not appear to be set to abate any time soon. As we said above – and have said numerous times elsewhere – none of this means that the market is poised for a near-term reversal. Animal spirits can blithely chug along as long as there is more cash sitting on the sidelines ready to jump back in, or a sense that there is still a “Greater Fool” out there, yet, to come in and buy.

But pay attention to valuation, and specifically to whether double-digit earnings truly are just around the corner or yet another case of hope flailing against reality.

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MV Weekly Market Flash: Dr. Pangloss’s Market

December 30, 2016

By Masood Vojdani & Katrina Lamb, CFA

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“It is demonstrable that things cannot be otherwise than as they are; for as all things have been created for some end, they must necessarily be created for the best end.” Thus spake Dr. Pangloss in Voltaire’s satirical short story Candide. Stripping away the eighteenth century rhetorical flourishes, Pangloss’s philosophy can be read thus: “All things always happen for the best.” Satirizing that attitude was the French Enlightenment wit, Voltaire’s way of poking fun at the smug certainties of the popular mindset of his day.

Mr. Market and the Gradually Filling Glass

Voltaire seems an appropriate touchstone for this, our final commentary of the year 2016, as we have spent much of the past six weeks or so gently poking fun at the popular mindset of our day, at least as it pertains to sentiment in risk asset markets. Let’s step back, take a brief trip down memory lane (as one is wont to do at this time of year) and look at the larger picture.

2016 started off with Mr. Market viewing the glass as half empty. The Fed’s rate hike in December 2015, followed by some mildly disturbing news from China as the opening bell rung stocks into the New Year on January 2, served up our first technical correction (pullback of 10 percent or more) since 2011. The “Fed put” reliably arrived to contain the damage, and interest rates marked time. Stocks rebounded and settled into a corridor, with the S&P 500 mostly fluctuating between its May 2015 high of 2130 and an arbitrary magic-number floor of 2000.

Britain Leaves, Elephants Heave

Then along came Brexit, and the glass went from being half empty to half full. Stocks surged, crashing through the valuation ceiling to set a series of new highs in July before settling into another lackluster sideways trading pattern in August. In September, investors were on watch for some important policy events, but Mr. Market sailed through these with an air of insouciance.

Finally, in November, Republican candidate Donald Trump scraped together some 100,000-odd votes in the key battleground states of Pennsylvania, Michigan and Wisconsin to eke out a victory in the Electoral College that surprised just about everybody, including the Trump campaign team. Now the glass went from being half full to being full to the brim and sloshing over the sides onto the coffee table.

It is not entirely true to say that a new paradigm was born overnight. Financial stocks, the big winners of the last two months of the year, had been outperforming the market before the election as steadily improving wage data indicated a likely upswell of pressure on prices. But the election did catalyze two dominant themes: the “reflation-infrastructure” trade, based on expectations of a flood of new public works projects (and a corresponding spike in the deficit, interest rates and the dollar); and a sharply lower corporate tax rate that would flow straight to the bottom line and goose up corporate earnings per share.

Simply the Best, Better Than All the Rest

Enter Dr. Pangloss and the best of all possible worlds. Where the market is priced today (including market risk levels at multi-year lows alongside record high stock prices) seems to reflect a broad sentiment among investors that, of all the variables good and bad swirling around in the global economy and its policymaking centers of influence, only the good ones will actually happen. Infrastructure spending that translates to actual GDP growth? Check. Corporate tax reform that not only cuts the statutory rate but widens the base by getting rid of all the loophole goodies (through which most companies pay far less than the statutory rate today)? Yes, certainly! Debilitating trade war with China? No way! Geopolitical shock waves as long-standing alliances are called into question and traditional adversaries brazenly throw down the gauntlet to challenge them? Uh-uh, not gonna happen. All things were created for some end, and that must necessarily be the best end, said Pangloss.

To be perfectly clear, we, too, hope that 2017 will serve up more in the way of positive than negative developments. But our analysis is never based on hope. It is based on connecting the dots between disparate pieces of empirical evidence to arrive at a view on where assets appear priced relative to the value drivers and risk factors affecting them. As 2016 closes out we find ourselves still faced with large open spaces between as-yet unconnected dots. We will be coming back to work next week with our pencils sharpened, ready to crunch the numbers as they come in.

Meanwhile, we wish all our clients and friends the happiest of New Years, and a healthy and personally fulfilling start to 2017.

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MV Weekly Market Flash: Magic Numbers and Animal Spirits

December 23, 2016

By Masood Vojdani & Katrina Lamb, CFA

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So here we are again, nearing one of those seminal milestones in stock market lore. The Dow Jones Industrial Average, comprised of thirty (mostly household name-y) large-cap stocks, is an index whose main claim to fame is that its life span as a barometer of market sentiment extends all the way back to 1896. The Dow is poised to break through 20,000, a number whose main claim to fame is that it contains four zeroes. “Dow 20,000” screamed the entire front cover of Barron’s magazine last week. At the round earth’s imagined corners, blow your trumpets angels!

For portfolio analysts toiling away in the data-dense world of relative value movements, 250-day rolling returns and the like, these periodic “magic number moments” are scarcely worth a second look. That is particularly true when the index in question is the Dow, a much less useful or significant gauge than, say, the S&P 500 or the Russell 3000. Rationally speaking, there is nothing whatsoever of importance in these periodic episodes.

But rationality only counts for so much. In the vulgate of the wider population of investors and kibitzers, “the Dow” and “the market” are virtually interchangeable, and a nice round number like 20,000 has all the cultural significance of a special calendar date like January 1 or July 4. As with much else in the market, perception often becomes reality. Indexes do exhibit somewhat distinct trading patterns around these magic number moments, however silly it may seem. Thus, attention shall be paid.

Uncage the Elephant

The present magic number moment happens to coincide with a period of animal spirits stampeding up and down Wall Street. The Dow is up nine percent since the post-election rally kicked off on November 9.  While the index has not actually broken through the threshold as we write this, it is entirely plausible that it will be on the other side by the time we publish. Given the momentum that continues to feed off itself, counterfactuals be damned, it is more likely than not that the melt-up will carry stocks through to year-end. What then? Inquiring minds will want to know.

We have no crystal ball, of course, but we can supply a bit of historical perspective. As it turns out, the last time the Dow reached a four-zero magic moment, we were also in the middle of a market melt-up. Consider the chart below. 

This chart tracks the performance of the Dow – with the tech-heavy NASDAQ shown for comparison – during the last gasp of the late-1990s tech bubble and the ensuing bear market. As the chart shows, the Dow (green line and left-hand y axis) broke through the magic number of 10,000 in late March of 1999. Dow 10,000! These round numbers often act as very tough resistance levels, but 1999’s animal spirits pushed through the barrier with relative ease and, for good measure, surged an additional 1,000 points before settling into a brief holding pattern.

Forks in the Road

One interesting feature of this end-game stage of the late-90s melt-up is the pronounced divergence between the Dow and the NASDAQ on several occasions. This observation may have some relevance in thinking about today’s environment. The last gasp of the tech bubble, when investors more or less indiscriminately bought anything that sounded tech-y and Internet-y regardless of valuation or other counterfactuals, started in late summer 1999 and topped out in March 2000. The NASDAQ, as a proxy for the tech rally, enjoyed about seven months of near-unidirectional upward momentum during this melt-up.

The Dow, conversely, fell more than 11 percent from August to October 1999, and experienced another, even more pronounced correction of minus 16 percent from January 17 to March 7, 2000. The trough for this Dow pullback, then, roughly coincided with the NASDAQ’s March 10 bubble peak of 5,048. And, in fact, the Dow proceeded to bounce up by 15 percent from March 14 to April 11, during which time the wheels came off the dot-coms and NASDAQ experienced the first of what would be a series of bone-jarring descents over the next twelve months.

Mass Movements Then…

Why did the Dow diverge so far away from the NASDAQ (and, to a somewhat lesser extent, from the S&P 500) over that last leg of the 1999-2000 melt-up, and what light may that shed on market movements in today’s environment?

The driving narrative of that late-era ‘90s rally was technology. Investors were less concerned about what individual stocks they owned, and more concerned about getting in on the general action. The ability to obtain broad exposure to the tech and Internet sector – either through one of the then-small number of nascent ETFs, a passive index fund or similar pooled vehicle structure – was more important than the relative merits of any given stock.

By contrast to the tech-dominated NASDAQ, the Dow had a relative scarcity of tech names; only IBM, in fact, at the beginning of 1999, with Intel and Microsoft somewhat latterly tossed into the mix in November of that year. The Dow’s pullbacks in late 1999 and early 2000 thus had almost nothing in common with prevailing attitudes about the tech sector, and plausibly much more to do with valuation-wary investors looking for ways to pare back equity holdings without risking their clients’ ire by dumping those beloved shares of Cisco and

…Mass Movements Now

This year’s post-November 8 environment is likewise largely driven by a couple top-down themes. This time, the blessings of the narrative have fallen disproportionately on a couple sectors, in particular financials, but so far the broad indexes continue to move fairly closely in lockstep.

The mass movement vehicle of choice today is the exchange traded fund. ETFs offer exposure to just about any equity or fixed income asset class, including all the major broad indexes. Complex (and not so complex) algorithms employ ETFs for quick and efficient exposure to thematic narratives, such as the reflation-infrastructure trade that has been dominant since November.

But not all indexes attract the same level of interest from the short-term money. Consider that the average daily trading volume of SPY, the SPDR S&P 500 ETF, is about 94 million shares. For XLF, SPDR’s financial sector offering, average daily volume is about 80 million shares, and for QQQ, the PowerShares NASDAQ 100 vehicle, it is a still-respectable 24 million shares.

How Now, Dow?

By contrast, the average daily volume for DIA, the BlackRock iShares ETF for the Dow Jones Industrial Average, is just around 3 million shares – less than five percent of the volume for SPY. This statistic underscores one of our opening observations in this paper: as much as the average investor equates “the Dow” with “the market,” professional investors have little use for this quaint artifact of U.S. stock market history. Since the Dow is really not a ready proxy for either a specific asset class or a wider market gauge, it doesn’t offer much of a compelling reason for use in those algorithm-driven strategies that dominate short-term trading volume.

Which, in turn, may make it worth keeping an eye on the Dow once that magic number moment of 20,000 has receded into the rear view mirror. If those thirty stocks diverge away from their broad index cousins – S&P, Russell, NASDAQ et al – they may again be the canary in the coal mine warning that the fundamentals are out of line with the still-giddy prevailing market narrative. Of course, there is no assurance that this scenario will play out, and we would advise against hanging one’s hat on this outcome. Good investing is about paying attention to lots of moving parts while maintaining the discipline not to rely unduly on one or two. But we will be keeping track of the Dow’s fortunes in the coming weeks, even after the Dow 20,000! hoopla has come and gone.

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