Posts published in March 2016
After the three year bear market of 2000 to 2002, stock indexes around the world enjoyed a sustained bull cycle with broad participation across all major regions from the US to Europe, from Latin America to developed and emerging Asia. Most major markets set all-time highs in October 2007. Then came winter, and then another spring.
We broadly think of the period from the 2009 market bottom to the present as another single, uninterrupted bull market. Indeed, as measured by the standard of the S&P 500 or any other major US stock index, that moniker fits. But – unlike 2000-02 and most prior bull markets – the same cannot be said for the rest of the world. For example the MSCI Europe, All Country Asia and Emerging Markets indexes, as shown in the chart below, have all failed to recapture their October 2007 high water marks. For much of the non-US world, the post-2009 period can be divided into two periods: a recovery from the 3/09 trough into the summer of 2011; and then a listless sideways performance from then to the present. In fact, all three of these non-US indexes remain today below their post-recovery 2011 high points.
As anybody with a diversified portfolio knows, the S&P 500 has been a devilishly unforgiving benchmark for most of the last four years, the bane of many an asset allocator and active stock picker alike. Is there anything about the unusual contours of this time period that suggests what might lie in store? Is it time to anticipate mean reversion and load up on non-US assets, or is it better to hunker down for ever more years of Pax Americana? We consider three alternative scenarios below.
#1: Central Banks Rule , World Catches Up
This scenario starts with the largely uncontroversial observation that central banks have been the headline story in risk asset markets since 2009 and especially since the Fed announced its second quantitative easing program – QE2 – in 2010, following up with QE3 in fall 2012. QE2 in particular is a textbook case study in how central banks move markets; one can picture then-Fed chair Ben Bernanke simulating an all-net jump shot with a smug “that’s how it’s done.” That year started off poorly for US stocks, with lots of volatility and a handful of pullbacks of 5 percent or more throughout the spring and summer. In August the Fed hinted that it was considering a second QE program, after QE1 ran out in June. That was all markets needed hear to stage a robust second-half rally (the formal QE2 announcement only came in November). QE2 firmly established the playbook for the Bernanke put: more liquidity from the Fed whenever markets run into trouble. Thus there was no great amount of surprise when QE3 played out in almost exactly the same way, in fall 2012, guiding markets over the so-called “fiscal cliff” and safely into the solid double-digit returns of the next two years.
Other central bankers came later to the stimulus party, but almost all eventually showed up at the punch bowl. The “world catches up” scenario posits that non-US markets will benefit from being in the springtime of their policy stimulus programs while the US settles into autumn. Even with a more dovish Fed stance on the cadence of rate hikes this year, policy divergence is still very much a reality. The key question is whether central bank stimulus today packs the same punch as it did in 2010 and 2012. If not, we may be looking at a second scenario.
#2: Central Banks Wane, World Swoons
It would be fair to say that market reaction to monetary stimulus policies this year has been all over the place, and perhaps nowhere more so than in Japan. When the Bank of Japan moved into negative interest rate territory last month there was a very brief moment when everything went according to plan: stocks up, domestic currency down. That reversed quickly, though. In the week following the BoJ announcement the Nikkei 225 plunged and the yen soared. The currency has set successive twelve month highs against the dollar since the policy decision was announced. Over in Europe, ECB showman Mario Draghi had somewhat better luck with the markets when he announced that the ECB would essentially pay banks to make loans through a loosening of terms for the existing long term refinancing operations (LTRO) policy.
But the ECB’s move raises the expectations bar. If cheap LTRO winds up not making much of a dent in real economic activity in Europe it will reinforce a growing belief among investors that central bank stimulus amounts to not much more than a temporary reprieve for risk asset markets. The Fed is in the crosshairs on this point as well. Much editorial chatter has been expended this week on the apparent divisions among FOMC members about the appropriate pace of rate decisions this year. If the market’s collective consciousness wraps itself around the idea that central bank puts have slipped out of the money, it will then be forced – heaven forbid – to take stock of growth and earnings prospects in the real economy. That could lead Mr. Market straight to the fainting couch. Or, alternatively, things could start looking up for growth and profits, producing a third possible scenario.
#3: Valuation Matters Again
The US economy is doing okay – not great, but okay. China has not (yet) lived down to fears of a hard landing in its economic transition. Europe is staying out of recession while some Eurozone economies such as Spain are doing quite alright, thank you very much. Brazil remains a basket case, but its neighbor Argentina is coming back into the mix after a long winter. India continues to grow nicely. Commodities markets are recovering. It is not out of the question that the world economy could emerge as a more pleasant place for companies to ply their trade. If this happens, we would expect a closer focus on valuation levels that in turn could favor bargain-hunting in those world markets that have underperformed the S&P 500 in recent years. This would be especially true if a strong dollar continues to be the major revenue and profits headwind for US companies (though we should note that the dollar has lost some of its force as of late, particularly against the yen and the Aussie dollar).
Of course, it is just as plausible that none of these scenarios will come to pass. Associating cause with effect is never easy in financial markets, and this year has been particularly problematic for the professional soothsayers of our industry. The fact is, though, that in a global economy it is unlikely that the asset performance of one country will dominate the landscape forever, even if that country is the largest and most influential. Sooner or later, those geographically diversified portfolios will likely have their day. Some advance preparation may not be a bad idea.
The punch bowl was not even half empty after Mario Draghi served up another round of stimulus last week, but Janet Yellen & Co. filled it right back to the brim on Wednesday and the party rolled on. The surprisingly dovish statement after this week’s FOMC meeting acknowledged what credit markets had already priced in: the cadence of rate hikes is going to be much gentler than December’s “dot plots” suggested. The brisk central bank tailwinds of late, along with a general absence of anything truly bad having happened for some time, have pushed the S&P 500 through some key resistance points. The index now finds itself…right back in the corridor where it has been for much of the past 15 months. The question for investors now is what it will take to push stocks through the corridor’s ceiling. We believe a sustained second leg of this rally will be considerably more difficult than the first.
Relief Rallies of a Feather
The two conspicuous banishments from the corridor share some characteristic patterns of intermittent bull market corrections: an initial steep drop followed by a sequence of tentative rallies and selling waves, and finally a double-digit relief rally to reclaim the lost ground. The chart above shows that the market finally kicked into gear in October 2015, rallying 13 percent back to the middle of the trading corridor. Similarly, shares recently have pushed up nearly 12 percent from their February 11 low point. The recovery has been fairly broad, as noted in some of our recent commentaries. Market breadth indicators like the advance-decline and 52 week high/low ratios are reasonably healthy. Higher risk areas like small caps and emerging markets are going gangbusters; to cite one example, Brazil’s Bovespa index is up 35 percent since its late January lows. That’s a bit surprising given that the economy is mired in a deep recession and the country’s political system is falling apart. Animal spirits and all that.
Given those animal spirits (and the auto-refilling central bank punch bowl), it is not hard to imagine that there is a bit more near-term upside for U.S. large caps. The S&P 500 is about 4.4 percent away from the all-time high it reached 301 days ago. Can it get there? Anything is possible, of course, but we imagine the headwinds are going to start getting stiffer if shares manage to get back to the middle of that corridor. That is when investors will have to start asking themselves whether this bull market still has room for another burst of the valuation multiple expansion we saw in 2013 and 2014.
The Valuation Ceiling
In 2013 stock prices soared, while earnings moved ahead at a more leisurely pace. Earnings per share on the S&P 500 advanced 5.6 percent that year, while share prices topped 30 percent for their giddiest year since 1996. Prices kept going up in 2014 and the first half of 2015, while earnings gradually tapered off and eventually turned negative. The chart below shows the 10 year trend for the next twelve months (NTM) price to earnings (P/E) and price to sales (P/S) ratios for the S&P 500.
Both the P/E and the P/S ratios remain considerably above their 10 year averages. Even at the low point of the recent correction the P/E ratio was only briefly below its pre-crisis 2007 high, while the P/S ratio didn’t even come close to approaching its 2007 levels. Now let us consider the outlook for the rest of this year. The most recent consensus outlook for Q1 2016 earnings per share according to FactSet is -7.9 percent, while the EPS outlook for the full year is 3.2 percent. Sales are expected to be slightly negative in Q1 and to grow by about 1.5 percent for the year. Now, it is plausible that sales could enjoy a light tailwind if the dollar continues to weaken in response to a more dovish Fed. And some recent price and wage data suggest at least the possibility of a brisker than expected pickup in consumer activity in the U.S. (though this data was largely downplayed by the Fed this week).
Even so, though, we see little to suggest that the cadence of EPS and sales growth will be strong enough to lift prices too far off their current levels without pushing the valuation metrics closer to bubble territory. For that to happen, we think we would need to see some random confluence of events acting as a catalyst for a melt-up. That’s not out of the question – melt-ups have served as the codas for previous multi-year bull markets. But predicting the timing of such a melt-up is a fool’s errand. Meanwhile, that valuation ceiling looks fairly imposing.
In a fundamental sense, not a whole lot has changed for the global economy since the beginning of the year. Economic growth remains below trend just about everywhere, hindered by the well-known headwinds of weak demand, stagnant wage growth and supply-demand imbalances among others. US companies continue to experience earnings headwinds from a strong dollar. X-factors abound, from capital outflows in China to the refugee crisis in Europe and the unusually volatile political climate in the US.
When we surveyed this landscape back in early January we could see a plausible case to make for a continuation of the kind of quality rally that had characterized a good bit of the second half of 2015. Sales growth a challenge? Opt for the companies with a demonstrated model for growing the top line by double digits despite the headwinds. Productivity not what it used to be? Focus on those enterprises able to sustain strong operating profit margins.
Nice idea in theory. In practice, not so much. We are indeed experiencing a rally in global equities now, after the rocky start to the year. But a quality rally it is not. Perhaps our January outlook will be vindicated before the end of the year, but for now the market appears reactive to anything other than fundamental quality measures.
A glance at some key performance metrics for S&P 500 constituents bears testament to the seeming disregard for quality. The top ten percent of companies in the index, ranked by total stock price return for the year to date, showed average revenue growth for the last twelve months of minus 4.2 percent. By contrast sales growth for the bottom ten percent – i.e. the companies with the lowest total stock price return for the year to date – was a positive 2.3 percent for the last twelve months. Same goes for EBIT (earnings before interest & taxes): this year’s outperformers grew by negative 4.8 percent compared to a positive 3.0 percent for the dogs of 2016.
But markets are forward looking, right? Maybe investors are more interested in next twelve months’ growth prospects than in last twelve months. Then again, maybe not. The consensus estimate for next twelve months EPS (earnings per share) growth for that top decile cohort is 4.7 percent. For the bottom decile the consensus outlook is more than twice that, at 10.7 percent. And that bottom contingent is also less leveraged, with a debt-to-total capital burden of 47 percent versus 53 percent for the top decile.
Super Mario’s Bright New Shiny Objects
If investors are not paying any attention to fundamentals, it’s a pretty good bet that what they are focused on rhymes with “ventral tanks”. By all accounts the central bank in question this week is Mario Draghi’s European Central Bank. The ECB made headlines on Thursday when it announced a raft of new stimulus measures, including some genuine novelties. The market expected the deposit rate cut to minus 0.4 percent. Rather less expected, though, was an easing of the terms by which the ECB provides liquidity to banks through long-term refinancing operations (LTRFOs). Essentially, Draghi & Co. will pay banks to make loans through rates as low as minus 0.4 percent on LTRFO facilities. Other goodies in the ECB swag bag included an expansion of monthly QE purchases from €70 billion to €80 billon, and a broadening of QE-eligible instruments to include corporate debt. Draghi seemed to be at pains to emphasize his goal to see this round of stimulus actually work its way into the real economy through a higher level of credit creation.
Market reaction was predictably all over the place. The euro plunged within microseconds of the ECB announcement on Thursday morning, then turned around and rallied hard, finishing up more than two percent against the dollar. Likewise for equity markets, which condensed a “best of times/worst of times” sentiment into a single day of trading. After sleeping on it, Mr. Market seemed to like what he saw, and European bourses chugged ahead with gains of mostly two percent or more on Friday trading.
There and Back Again
That kind of intraday volatility is characteristic of an environment entirely at the mercy of central bank announcements and other macro events. It is what keeps our own sentiment in check and wary of reading too much into any directional trends. There are plenty more central bank moments on tap this year, starting with the Fed next week. How will Janet Yellen and her colleagues explain their thinking about the appropriate trajectory for rate policy here at home? The policy divergence theme – with the Fed going one way and the rest of the world going another – is back on center stage. We don’t expect the Fed to move next week, though it is worth noting that the February inflation numbers will be released just as discussions are getting underway on the second day of the event. If the recent string of upbeat numbers continues, there will be some tough decisions ahead for the FOMC.
Unfortunately, the takeaway from all this is that expectations for markets to wean themselves off central bank dependence were premature. We’ve reverted back there after an oh-so-brief flirtation last year with free cash flows and return on invested capital and the like. If this rally continues, though, at some point someone is likely to look up and notice that, gasp, valuations are really stretched. The results may not be pretty. In the end, fundamentals do matter.
Animal spirits are running high in the month of March to date. A whole dealer’s choice of assets ranging from global stocks to crude oil to the South African rand and Turkish new lira are all climbing out of the depths of despair in which they had been mired for most of the first two months of the year. For the time being, anyway, it appears to be a moment for the long-suffering to shine. While emerging markets and energy & production stocks have their day in the sun, the so-called “Nifty Nine” and other darlings of 2015 languish. The MSCI Emerging Markets index is up 5.4 percent since the month began, and more than thirteen percent above the six and a half year low point reached back on January 21. Bargain hunters quite naturally sniff a deal: is it one worth taking?
The Rally in Context
Thirteen percent is nothing to sneeze at, but it remains a long way even from relatively recent high water marks. The chart below illustrates the price performance of the MSCI Emerging Markets index over the past ten years. The dotted horizontal lines represent, respectively, the pre-recession all-time high (2007), post-recession high (2011) and last two years’ high (2014).
Investors viewing emerging markets from a tactical standpoint would probably look with most interest at that last two years’ number: even after the recent rally, the index is still more than 28 percent away from the L2Y high point reached in September of 2014. That’s a lot of ground, which arguably means that tactical investors could take comfort in not having missed the boat. Double-digit annual gains would not necessarily be out of the question with the right combination of EM-friendly tailwinds.
Not Much New Under the Sun
Chief among those tailwinds would likely be a continued run-up in energy and industrial metals prices, a strengthening of local currencies against the US dollar, and a general absence of bad-news surprises principally from China, but also from other suffering EM locales including Brazil and Russia. A glance at the headlines in the month to date, though, suggests that not much has really changed in the fundamental landscape of the global economy. The recent rally in crude prices, arguably (if unusually) the principal catalyst in equity strength, is based less on a real improvement in the global supply-demand balance than on atmospherics about what oil ministers will say to each other when they (supposedly) meet later this month. China’s recent headline numbers have been less than impressive, including capital outflows, weak industrial production and sagging imports and exports. Brazil’s recession is turning deeper than expected, while the ongoing Petrobras political scandal has now ensnared the country’s former president, Luiz Inácio Lula da Silva. Perhaps the brightest recent news tidbit from emerging markets comes from the unlikely source of Argentina. That longstanding pariah appears ready to return to the capital markets after the new government of Mauricio Macri settled a longstanding debt dispute with major creditors earlier this week.
In our commentary last week we suggested not getting too comfortable even while enjoying the fruits of the recent global equities rally. We would extend that cautionary note even more emphatically to emerging markets. While the above chart shows enticing new ground to break on the upside, there is plenty of potential downside as well. In a market environment driven largely by whichever lurking X-factors pop into or out of existence like so much antimatter, the next big move could be either way.