Posts published in October 2014
QE is dead. Long live QE.
As the week opened, the single thing on which nearly all market pundits agreed was that the Fed would announce the end to its bond-buying program, known as QE3, at the conclusion of its Open Market Committee meeting on Wednesday. Sure enough, the Fed did just that. But QE was far from done for the week. As we on the Atlantic Seaboard slept on Thursday night, another stimulus story was playing out far across the Pacific. Bank of Japan Governor Haruhiko Kuroda, in an announcement that caught analysts by surprise, raised the annual target monetary base in his country by ¥80 trillion ($720 billion), about 33% higher than the previous target increase.
Not to be left out, the Eurozone today is contemplating the latest set of sub-1% inflation data in advance of next week’s European Central Bank meeting. Expectations continue to grow that a more full-throttle stimulus program will be needed to deal with the Continent’s ongoing economic woes. In short, QE in its various forms and manifestations is going to be with the world for some time to come, even as the Fed (for now) hangs up its cleats.
A Tale of Two Economies
It seems simplistic to divide the world into two economies. China is nothing like Europe which is nothing like Australia or Japan. But increasingly it does seem like there is US and ROW: the United States and the Rest of the World. Here at home things are more or less fine, thank you very much. On the heels of the Fed’s QE-ending announcement came word that U.S. GDP grew by 3.5% in the 3rd quarter, above the 3.0% consensus estimate. We are set to see out 2014 with unemployment below 6%, growth above the forecast long term average, and sub-2% inflation that gives the Fed plenty of maneuvering room in how and when to deal with interest rates next year. In this context it is not hard to ascribe the stock market’s recent pullback to a technically-driven flash in the pan.
By contrast, GDP growth has been contracting in Japan this year. Europe is on the edge of deflation. China still posts growth numbers Europeans could only dream about, but it, too, is below-trend. Australia’s commodity-intensive economy is marking time. Brazil is struggling to hit 3% growth targets. And so what we are seeing is policy divergence. The U.S. is carefully moving away from stimulus, while other markets face the need to keep the monetary taps flowing. The Bank of Japan’s latest surprise announcement is unlikely to be the last QE salvo.
Arigato (Thank You), Kuroda-san
There is more to the Japanese announcement than the new monetary base target. The Government Pension Investment Fund of Japan is the world’s largest institutional investor, with over $1.2 trillion in assets under management. A Reuters report this morning indicates that GPIF plans to reallocate its target allocation weight for equities from 12% to 25%, amounting to potentially $150 billion of new demand for Japanese and global shares. The Nikkei stock index jumped 4.8% overnight, and world markets are giddy as we close out October.
Markets generally like stimulus, at least in the short term. A favorable outlook for the holiday season here at home along with stimulus abroad could facilitate a nice tailwind as we see out the year. But there are a great number of X-factors at play that we believe are likely to make for very interesting times in 2015.
For a brief few intraday trading moments last week the S&P 500 fell below the level of 1848 (year of revolutions!) where it started 2014. The ensuing v-shaped rally has pushed the index fairly comfortably back into positive territory. But the price-equity (PE) ratio remains a bit below where it opened the year; the twelve trailing months (TTM) PE ratio as of October 23 is 16.3 as compared to 16.5 at the beginning of January. The chart below shows how the PE ratio has trended over the course of this year.
What the PE Ratio Tells Us
The PE ratio is a valuation metric. Think of it as a yardstick for how much investors are willing to pay for a claim on a company’s earnings. For example, a PE ratio of 10x at ABC Company means that investors are willing to shell out $10 for each dollar of ABC Company’s net earnings per share (EPS). If the PE goes from 10x to 12x it signifies that investor perceptions of ABC company have improved; they are now willing to pay $2 more for that same dollar of earnings. A fall in the PE – say from 10x to 8x – would mean the opposite. Value investors, in particular, analyze companies with low PE multiples (relative to the market or their industry peer group) to see if there is a bargain to be had; to see whether there is value in the company that the market, for whatever reason, is not recognizing.
The Multiple and Its Message
Bringing the discussion back to the above chart, it would seem that investors’ attitude towards stocks in general isn’t far today from where it was in January. There were a couple rallies that pushed the PE higher and a couple pullbacks that brought it back down, but over the course of the year the multiple has repeatedly reverted towards the mean (average) level of 16.5x. In our opinion there is a good reason for this, and potentially a message about where stocks may be heading as we start planning our allocation strategy for 2015.
The consensus growth estimate for S&P 500 earnings in 2014 is around 6%; in other words, earnings per share on average should be around 6% higher at the end of the year than they were at the beginning for the companies that make up the index. As it happens, 6% is not too far from the index’s price appreciation this year. We would not be surprised to see this relationship still largely intact as the year closes: a positive year for stocks in which the PE multiple neither expands nor compresses, with mid-upper single digit gains for both share prices and earnings.
Still Not Cheap
The recent pullback has done little to change the fact that stocks are still expensive, on average, relative to long term valuation levels. In the chart below we see the same PE ratio as in the first chart, but the time period goes back ten years to October 2004.
For the last ten years the average TTM PE ratio was 14.6x, considerably below the current level of 16.3x. Remember that the higher the PE, the more expensive the market. In fact, prices are currently higher than at any time since 2005 (we should note, though, that they are still far below the stratospheric levels achieved in the final frenzied years of the late ‘90s bull market). This prompts us to recall the title of the 2014 Annual Outlook we published back in January: “How Much More?” In other words, how much more multiple expansion could we expect to see given how high the multiple already is?
For the past three years the Fed has been the driving force behind an across-the-board rally in U.S. and, mostly, global equities. With QE3 coming to an end (probably) and rates heading slightly higher next year (probably), stocks will be left more to their own devices. We think it reasonable to assume a base case of positive growth in share prices more or less in line with earnings; in other words, a continuation of the 2014 trend. We also see a good case to make for a return to focus on quality and selectivity – companies with solid cash flows and robust business models – rather than an indiscriminate buy-everywhere approach. We may be wrong. Late-stage bull markets can lure cash in from the sidelines and expand PE levels ever higher, as in 1998-99. Conversely, any number of things from Europe’s economy to a China slowdown to worsening geopolitics could spark more broad sell-offs. When we establish a base case we do so with several alternative scenarios. Our thinking may change – we are data-driven and not ideological. But right now, growth without much multiple expansion seems plausible.
There were not too many headline macroeconomic numbers out this week, a week in which a large dose of volatility returned to global equity and commodity markets. One data point that did stand out was a 14 year record low number of claims for unemployment benefits. The seasonally adjusted number of jobless claims stood at 264,000, the lowest since April 2000. This, along with another report of growth in the manufacturing sector, added more data to a long string of upbeat numbers for the U.S. economy. Yet concerns abound that growth is too slow, too uneven and too dependent on monetary stimulus to sustain itself. This week’s pullback - 7.4% in the S&P 500 following double-digit falls in riskier assets – has brought the growth debate back to the center of discussion.
When Doves Cry
The market volatility has, predictably, elicited dovish cooing from some corners of the Fed (though not from Chairwoman Yellen herself). Talk is on the table of extending the current round of bond purchases past the planned sell-by date of October 29, and even potentially a new easing program if conditions warrant. We would be surprised to see either of those outcomes from the next Fed meeting, and still expect the first rate cut to take place sometime in 2015. But the Fed has a dilemma. On the one hand, it is aware of the risks that come with too much easy money, including the risk that there may not be much more that monetary stimulus can do to boost wages or get inflation closer to its 2% target level. On the other hand, the Fed is clearly sensitive to how markets react to its policy decisions. If the 7.4% hiccup in the S&P 500 were to spill into larger losses (even if for no clear reasons, as can happen from time to time) then the likelihood of some kind of QE4(ever?) would increase.
Weaning the Patient
The first bout of QE in 2009 was necessary to restore liquidity to financial markets that had been devastated by the 2008 crash. The second and third rounds, in 2010 and 2012, were arguably less urgently necessary but, we believe, were the right thing to do in support of economic growth and in the absence of effective policymaking anywhere else in the government. And there is a good case to make that growth even in the U.S. has not quite reached escape velocity. But the longer the patient stays on morphine, the harder it becomes to wean the patient off the drug. The economy should be able to handle continued growth without more Fed bond buying and with overnight rates 0.25-0.5% higher than where they are today. Unless falling asset prices are a clearer manifestation of a real, imminent crisis than we see today, they should not be the prime motivating factor in further monetary easing.
Where We Go From Here
Investors will be reading the smoke signals from the October 28-29 FOMC meeting with extra scrutiny. In the meantime we may see some continuing volatility in the markets. A testing of the recent lows is not out of the question. But wherever the growth debate eventually takes us, we see few compelling reasons in the here and now to change the fundamental picture we have seen for a while, with steady U.S. growth at the center and mostly manageable problems where they do exist. That picture could change. If it doesn’t, though, we would expect further price damage to be limited.
Volatility is back in risk asset markets, at least for the time being. There is no one single factor to explain the wild intraday gyrations in major stock indexes, all of which are experiencing a pullback of varying magnitudes from their high water marks. Europe’s economic woes, growing fears about the spread of Ebola and the usual geopolitical flash points all figure into the mix. But one market that is now solidly in bear county is crude oil. Brent crude, a key benchmark oil futures contract, has fallen from a late June peak of $115 to just over $90 as of yesterday’s close. That’s a fall of more than 20% and, as the chart below shows, its lowest level in more than three years.
Shale Fever: The Supply Equation
Oil prices, like any commodity, are driven by supply and demand. Arguably the biggest development on the supply side is the dramatic increase in U.S. domestic oil production, fueled by the boom in shale oil extraction. Domestic production is estimated to be around 8.9 million barrels a day (mm/bbd), an output level very close to that of longstanding production king Saudi Arabia. Imports now account for just 14% of our total oil consumption, down from about 60% in 2005. As U.S. demand for imported oil has slowed, foreign producers have had to find other markets. OPEC countries, Russia and Latin American producers are furiously competing with each other for market share. That means cutting prices; the OPEC cartel’s storied ability to micromanage and dictate world crude prices is a long distant memory.
Sluggish in Shanghai: The Demand Equation
Unfortunately for the oil producers, their attempts to increase share in non-U.S. consumer markets come at a time when demand is sluggish. GDP growth is flat or negative in Europe and Japan, and slow relative to historical norms in China, the most important market for most major commodities. Analysts estimate that 1Q 2015 global demand for OPEC oil reflects about a 2.5 mm/bbd surplus from the cartel’s current production levels. Last week Saudi Arabia lowered its official prices to key Asian customers. Fears of continuing price wars are weighing heavily on the prices of oil producer stocks, which are strongly underperforming the broader equity market.
This Too Will Pass
As dire as conditions look at present, they cannot last forever. The profitability of oil production is directly linked to the price at which it can be sold. Consider the U.S. shale oil boom. Extracting oil from shale formations requires nontraditional techniques, such as horizontal drilling, which are costlier than drilling in conventional wells. If oil prices fall much further, fewer producers will keep drilling. That will reduce supply, which in turn will impel prices higher. And OPEC, despite its reduced leverage today on world markets compared to the salad days of the 1970s, is still able to coordinate and reduce output if price levels get too extreme. We’re not likely to see a return to $50/bbl oil. But prices may have a hard time breaking out too much above $100 for sustained periods of time.
Oh, and how is this all affecting prices at the pump? By less than you might think: average gas prices in the U.S. have fallen about 11% since their June peaks, and much of that is seasonal. Refining and distribution economics are entirely different from exploration and production, giving us less relief at the pump than we would want.
Every now and then we go back to the annual market outlook we published back in January, to see where our views have changed and where they are more or less the same. With regard to the economic landscape it appears that our views have changed very little indeed: the story largely remains the same. The recent string of headline macro indicators have been notable for their consistency, leading up to today’s release of yet another upside surprise in job creation. The unemployment rate is below 6% for the first time since before the 2008-09 recession. GDP and consumer confidence readings are robust, and inflation remains tame. Corporate earnings and the S&P 500 are up by about the same amount for the year to date, so valuation levels aren’t much different from where they were when the year began.
Trick or Treat
With such a humdrum top-level picture it would seem easy to make a good case for ambling into the end of the year with few surprises. But we’re in October now, folks, and we all know that this month can be full of nasty scares. There was some jitteriness earlier this week, with the S&P 500 pulling back about 3% from its record high set on September 18. A closer look, though, shows this to be part and parcel of this year’s pattern: intermittent, relatively shallow and brief reversals in an otherwise upwardly moving market with subdued volatility and modest share trading volume. The chart below shows the pullback history for the year so far:
Pullbacks of this magnitude offer little scope for defensive measures. By the time you build the defenses the market is already going back the other way. As the chart above shows, the support level of choice for the S&P 500 this year has been the 100 day moving average. Not that there is anything special about that or any other moving average – but if enough quantitative models are programmed to react to it, then perception creates its own reality. Nor is there any single compelling reason to argue as to why the pullbacks happen at the particular times they do. On any given day there are any number of X-factors in the mix – geopolitical flash points, health scares, currency markets turmoil – that could bubble up to the surface and cause mayhem. But there is no orderly pattern to how and when they impact asset prices. In this realm, chaos theory rules.
What We’re Watching
We are closely paying attention to some trends that could set up some bumps in the road. There is a continuation of flows out of riskier asset classes and a failure to hold technical support levels. Emerging markets equities are at or near 52-week lows. U.S. small caps are trading below their 200-day moving averages, and technical weakness is seeping into the mid cap sector as well. And while U.S. growth is leading the global economy, the picture is less rosy in Europe, Japan and elsewhere.
As long as the fundamental story in the U.S. stays more or less the same – and we don’t see too many data points out there to make a strong case otherwise – we think a little more upside is a likelier outcome than a major pullback. We continue to favor dollar-denominated assets and believe that a potential 25 basis points rate hike by the Fed next year is already baked into the cake (probably more so after today’s job numbers). Of course a larger correction could happen any time and we need to be vigilant. But even with a technical correction of 10% or so, we would see a buying opportunity as a more likely outcome than a slide towards secular bear territory.