Posts published in September 2016
Way back in the middle of July, we wrote about what investors might expect come September. With the year’s ninth month drawing to a close, we pulled up that piece to see how our midsummer musings actually panned out. It concluded with the idea that, while surprises may percolate up for a temporary disruption, the TINA syndrome rules – There Is No Alternative when it comes to equities, and particularly large cap, domestic U.S. equities.
There could be worse ways to sum up this past month. Central bankers spoke (and spoke, and spoke), OPEC doyennes hung out and chatted on the sidelines of an energy conference in Algiers, and derivatives traders frowned at their book of business with Deutsche Bank. Markets overall were a bit more volatile than in August, which is to say that they actually registered a pulse. But the S&P 500 opened the month at a level of 2170. With four-plus hours of trading left before month-end, the index is – guess where? 2170! Alles ruhig -- All quiet on the large cap front.
…and the Red Queen’s On Her Head
The above chart is an old favorite we like to update and trot out when our point is to show how little has changed over the past couple years. For most of this two year period U.S. large cap stocks, here represented by the S&P 500, traded in a fairly well-defined corridor between price levels of 2,000 and 2,130. That corridor was punctuated twice on the downside by the pullbacks of August 2015 and January 2016. The ceiling was finally breached this July in a frenetic post-Brexit rally. Since then, the old ceiling has become the new floor in an even narrower (as yet) corridor. Briefly put: those events that – from the standpoint of an observer in July – could have catalyzed a major market move wound up not having much impact at all. The expectations bar keeps rising for the capacity of anything to truly shake up this market. This week’s talking points – Deutsche Bank, oil and the U.S. election – are no exceptions.
Deutsche Doesn’t Rhyme with Lehman (or AIG)
While diversified equity portfolios are generally doing fine, pity the poor sort with a bag full of Deutsche Bank stock. That name has plunged 62 – yes, 62 – percent from its 52-week high set last October. The large German concern has long been seen to have a comparatively thin capital cushion and a rather complex book of business making a straightforward asset-liability analysis difficult. Negative sentiment about the bank gained steam with a U.S. Justice Department announcement that it intended to seek $14 billion in penalties for the bank’s role in mis-selling mortgage backed securities. A terse statement by Angela Merkel’s government to the effect that Germany has no intention to supply any capital injections to Deutsche or any other troubled domestic bank ahead of next year’s federal elections ramped up the bears and led to a spate of Lehman/AIG circa 2008 analogies. The analogies are poor, starting with the notion that the Justice Department would go all-out to claw that $14 billion in full regardless of any potential market fallout. On the German side, the idea of hundreds of millions of euros in domestic deposits left to hang in the wind in an election year is somewhat farcical. We do have larger concerns about the health of the Eurozone banking system. But we don’t see much likely collateral damage from Deutsche’s current woes.
One Night in Algiers
“We’re ba-a-a-ck!” was the underlying message of various OPEC nabobs from the sidelines of an energy conference in Algeria’s capital city this week, with Iran’s oil minister lauding an “exceptional decision” made by the cartel. While crude oil prices did jump up mid-single digits as a result of the happy talk, there is little to suggest that a production freeze of 240,000 – 700,000 barrels per day (the putative range under consideration) will by itself sort out the supply-demand imbalances that are still working themselves out in world markets. As always when the contentious agendas of OPEC members collide – particularly those of Saudi Arabia and Iran – the details will be sufficiently devilish to cast doubt on the efficacy of any outcome. As far as equity markets were concerned, in any event, the Algerian goings-on merited little more than a casual side-glance.
Blue, Red, Back to Bed
We were pleased to see a Barron’s article this morning titled “Does the Market Care Who Wins in November?” Readers of our weekly commentary will not be surprised to learn that the article answers this question with an emphatic “No.” Even better, for empiricists such as ourselves, was that the article went on to cite an actual academic study, conducted by the American College of Financial Services, that supplies data in support of this argument. What the study says, in essence, is that in a multi-variate world, a single event like a political election will be lost in a multitude of other variables, mostly monetary factors, that will more actively influence the market’s direction.
Take it from us, you’ll never hear a CNBC news anchor intone the phrase “multi-variate world.” We would strongly suggest committing that phrase to memory, though, and calling it to mind every time you run into someone with a “strategy” for how to invest ahead of the election.
The tumult and the shouting dies, the Captains and the Kings depart. Rudyard Kipling’s 1897 “Recessional” comes to mind as we contemplate the remarkably quiet aftermath to September’s much-hyped marquee policy events. Yes, there was a frisson of excitement in equity markets after the Fed lived up to its reputation as the definitive cautious, controversy-avoiding institution of our time. And the yen went hither and yon in the immediate aftermath of the latest blast of new policies from the Bank of Japan.
But as the brief tumult subsides, the S&P 500 is back in its July-August corridor while the VIX has crawled into yet another low-teens slumber. The yen, meanwhile, has blithely brushed aside any notion of bite in the BoJ’s bark and is resuming its winning ways to the consternation of the nation’s policymakers. September is not yet over. With just one week left, though, this oftentimes fearsome month appears poised to go quietly into the night. So is it smooth sailing from now to New Year’s Eve? Is the overhang of policy risk off the table?
Dissent and Stern Words
We start with the Fed, where the policy debate was a simple will-they-or-won’t-they (we thought the matter was settled some time ago for reasons articulated in previous weeks’ commentaries, but still). Chair Yellen pronounced herself happy with the economy and the karmic “balance” of near-term economic risks, and put out a placeholder for December. A pair of hawks (Kansas City’s George and Cleveland’s Mester) were joined by habitual dove Rosengren of Boston in arguing for moving now.
That higher than usual dissent, along with a reasonable likelihood that headline economic numbers won’t deliver much in the way of surprises in the coming months, does raise the likelihood of a December move. In the absence of some global shock manifesting itself between now and the December FOMC meeting, in fact, a 25 basis point move would be our default assumption for the outcome of that meeting.
Unlike last December, though, when a quarter-point move led the way into a sharp risk-off environment in January, we think the Fed could get away with a move without roiling markets. The difference between this year and last? Those silly, yet telling, dot-plots showing where FOMC members see rates one, two and more years down the road. Last year, the consensus view was a Fed funds rate of 3.4 percent by the end of 2018. Reality took a bite out of that, though, down to what is now a 1.9 percent end-2018 view. In fact, apart from two outliers (anyone out there from KC or Cleveland? anyone?), nobody sees rates going above 3 percent for as far ahead as the eye can see. A benign, historically low cost of capital world appears to be our collective future.
The Drunk Archer
If there is a fly in the balm, though, the identity of that fly may well be the other party heard from in Policy Week. The Bank of Japan gave no clear indication going into deliberations as to what it intended to do. On the other side, it left no clear consensus as to what its flurry of policy measures actually meant: was it stimulative, or neutral, or maybe even restrictive in its practical implications? At least one clear winner emerged: Japanese financial institutions. By not further lowering already-negative interest rates, and adding a twist to the current QQE program likely to favor a steepening of the yield curve, the BoJ is sending a little love to its beleaguered member banks. The Topix Bank index jumped about seven percent in the aftermath of the announcement.
The problem with anything the Bank of Japan says, though, is that it has a credibility problem. That problem was very much on display with the other main platform of the Wednesday policy announcement, namely the stated intention to overshoot the longstanding two percent inflation target. The Bank hopes that by explicitly targeting an inflation rate higher than two percent (how high? not clear) it will finally be able to deliver on that monetary policy “arrow” in the original Abenomics blueprint: pull the economy out of its chronic flirtation with deflation.
The problem is that inflation in Japan has been nowhere near two percent for a very, very long time. The idea that a new mindset of inflationary expectations could suddenly take hold to reverse this longstanding trend is extremely hard to take seriously. To use the “arrow” metaphor of Abenomics, it’s as if a stone-cold drunk archer, wildly shooting at and missing a bulls-eye target, decides that the best way to hit the target is to move it even further away! It will take more than words to convince markets of any real change to Japan’s price environment – as evidenced by the yen’s prompt return to strength in the second half of this week.
Hence that “fly in the balm” comment we made a couple paragraphs above. The main risk we see in asset markets today is the credibility risk of the central banks that collectively have been holding things more or less together since the Great Recession. Lose that credibility and you lose a lot. Japan’s economy has been stagnant for 26 years, and policymakers there are still throwing pasta at the wall to see what sticks. In the absence of either normal levels of organic economic growth or intelligent economic policymaking by national governments, a loss of confidence in the ability of central banks to deliver effective monetary policy is not something we can afford to indulge. This is not a risk we see as likely to actualize in the very near-term, but it is a key concern looking ahead to next year and beyond.
We’re halfway through September and markets have gone a bit wobbly, as some random character in a Bridget Jones sequel might say. Nothing yet to require the smelling salts, but the VIX volatility index has perked up into the high teens while the S&P 500 is back to flirting with that May 2015 ceiling of 2130 it had finally broken through back in July. If you were a reader of our weekly commentary back in the first half of this year, you would recall our frequent use of the phrase “valuation ceiling” in this context. This was how we described the stiff resistance headwinds US large cap stocks faced in managing a sustained price rally given the lackluster pace of earnings growth.
Fast forward to the present. While 2130 is now more of a loose support level than a hard price ceiling, not much has changed on the sales or earnings front. Indeed, share valuations remain very close to decade-long highs. The chart below shows the ten year price to earnings and price to sales ratios (based on next twelve months estimates). We consider why these valuation levels might – and might not – matter to near-term price performance.
The Expectations Game
According to FactSet consensus projections, average Q3 earnings for S&P 500 companies are estimated to come in at -2.2 percent, which is quite a bit lower than the 0.3 percent increase projected by the same consensus group back in June. At face value that is not good news for already expensive stock prices. There are a couple caveats, however.
First, earnings season is essentially an elaborate Kabuki dance between the sell-side securities firm analysts who make up that “consensus” and the corporate management teams who talk the analysts through their financial results each quarter. The formula is every bit as stylized and predictable as the 1,000th retelling of the Tale of Genji on an actual Kabuki stage. Companies “guide light” on sales and earnings over the course of the previous quarter, and analysts steadily lower their projections in response. Then, lo and behold, the results come in and the companies manage to jump over that lowered expectations bar. These “upside surprises,” in Wall Street earnings-speak, usually account for more than 70 percent of the total variance between expected and actual earnings per share results.
Averages and Outliers
So the fact that earnings are projected to drop another 2.2 percent doesn’t mean much as the Q3 season gets under way. We fully expect that figure to trend up and potentially turn positive as more results come in (thus far only one company has reported). More importantly, though, is that the average skews negative almost entirely due to the residual heavy losses being experienced by the energy sector. Earnings in this sector are projected to decline by 68 percent, for reasons already widely known and largely priced in. Energy stocks may look wildly expensive, given how far the denominator of the P/E equation has plunged over the last twelve months, but investors by now have largely discounted the misery of last year’s oil price drop and assume more stability ahead, if not necessarily robust growth.
Energy stocks at this point make up about 6.5 percent of the S&P 500’s total market capitalization. By contrast, the four leading sectors by this metric – technology, health care, financials and consumer discretionary – account for more than 65 percent of the index’s total market cap. Q3 earnings growth for these for sectors is expected to be in the low-mid single digits. The Q4 outlook (for what it’s worth, given that Q4 earnings Kabuki hasn’t even started yet) has these four leading sectors growing a bit more than eight percent.
Valuation Matters, But Not for Timing
Does any of this matter? Yes, valuation does matter, because in the long run a company’s stock price is no more and no less than a function of the company’s future ability to generate cash flows with its assets in place. In the short run, though, the valuation ceiling may be as hard as a rock or as porous as a sponge. Today’s NTM P/E of 16.8 times is expensive, but nowhere near the nosebleed mid-20s levels it reached at the height of the technology bubble in early 2000. In fact, as we have noted in previous commentaries, the late stages of a bull market often come with a giddy disregard for valuations as late money and animal spirits chase performance with a “greater fool” mentality. That has not yet happened in this bull run. After the twists and turns of September and October, though, we’ll see whether Santa Claus is ready to come out and play.
Central banks in developed and (most) key emerging markets operate independently from their national governments. This independence is what endows monetary policymakers with the ability to act in times of economic strain while elected officials, hemmed in by unyielding partisan constraints, bicker haplessly on the sidelines. Increasingly, though, a taskmaster of an entirely different stripe has dominated the deliberations of monetary mandarins. Global asset markets were the unseen, but very much felt, presence in the room when the Fed convened this year to debate policy actions in January (China-sparked stock market correction), March (post-correction nerves) and June (Brexit). Asset sensitivity has been no less on the table for deliberations in Frankfurt, London and Tokyo.
The perceived reluctance of the Fed and other central banks to “provoke” risk asset markets into tantrums has drawn criticism from observers who see the bankers’ dependence on asset price movements as unhealthy and likely to end badly. Perhaps the most telling evidence of this phenomenon is in the chronic gap between the short to intermediate term interest rate projections of central bankers themselves and the market’s own take, from spot rates at the short end of the curve to Fed funds futures projections around upcoming FOMC outcomes. This week offered some evidence that the bankers may be trying to strike back. We’ll know more in the coming weeks about how much of this is posturing and how much is actual policy.
Super Mario Stands Pat
In the same week when the electronic form of Super Mario took the leap onto Apple’s new iPhone 7, real-life ECB chairman Mario Draghi chose, not only not to move, but not to say anything about not moving. The former was not a surprise; not many observers expected the ECB to announce an expansion of its current €80 billion per month bond purchasing program. But there was a general sense that Mr. “Whatever It Takes” might give a verbal nod in one or both of two ways: to extend the term of the current program from March to September of next year, and/or to indicate a widening of the eligible asset pool for ECB purchases. That second issue may be in any event unavoidable, given supply constraints on the amount of available debt under current eligibility rules.
Nothing in any way explicit, though, came from Draghi. Slumbering Eurozone bonds were suddenly jolted out of their summer reverie; the 10-year Bund yield is actually positive for the first time in many weeks. Flummoxed investors now wonder if the ECB’s silence portends something more profound; namely, an incipient declaration by central bankers that fiscal policymakers need to join the team, and meanwhile short-term asset prices be damned.
On Deck: Janet and Masahiro
Are bond yields overreacting to the ECB’s absence of verbal cues? It certainly would not be the first time. A less dramatic reading of Thursday’s meeting would simply be that Draghi’s stimulative inclinations haven’t changed at all, but that he still has work to do in bringing a likely reluctant Bundesbank on board with any expansion to the current framework, either for an extension or for a widening of the eligible asset pool. We imagine it likely that yields may fluctuate back and forth over the next ten days or so, driven more by tea leaves-reading than anything else. Both the Fed and the Bank of Japan meet in the first half of the week after next. We have made it clear in recent commentary that we see a vanishingly small chance that the Fed would actually raise rates in September, given the general absence of a need to do so and the charged political environment into which such a move would be made.
A string of recent musings by Fed officials, though, and most recently that of the normally dovish Eric Rosengren of the Boston Fed, has kept the Fed’s September meeting very much in the center of market chatter. Coming as it did on the heels of Draghi’s silence yesterday, asset markets are repricing expectations. In particular, Rosengren offered shades of Alan Greenspan circa 1996 with a reference to the dangers of “ebullient” asset markets in a climate of perpetually low rates. We should note, though, that while Rosengren got most of the headlines his was not the only view in circulation today; fellow FOMC voting member Dan Tarullo offered a more cautious observation, based on the same available empirical data informing our own recent opinions, that there is still enough slack in overall growth and price targets to not necessitate immediate action.
If the Fed does move on 9/21 – and we still do not think it will – we would see that as genuine evidence that a concerted declaration of independence is at hand. Our view would be bolstered further still if the currently very hard to read Masahiro Kuroda and his colleagues at the Bank of Japan signal at their meeting an intent to back off further forays into negative interest rate territory.
Fight or Flight?
More interesting still, though, would be the central bankers’ reaction to what could be a very nasty aftermath in those asset markets spurned by the bankers’ attempt at liberation from their clutches. How steely would the resolve of Janet, Mario and Masahiro be in the face of a violent spasm in equity and other asset markets? After all, it’s not like elected politicians and their fiscal policy executors are waiting in the wings, ready to swoop in with their own pragmatic solutions to our economic problems. Nor is there much evidence of the kind of robust organic economic growth that could get asset prices back on track after an initial swoon. Are central bankers really ready to cut the cord and see how markets survive in a world of diminished stimulus? All verbal (and non-verbal) Kabuki aside, we don’t imagine they will be inclined to tempt fate.
For anyone who likes to keep a record of these things, the S&P 500 broke out of its last corridor fever back on July 8, when it finally topped the previous record close set on May 21, 2015. The large cap benchmark index went on to set five more consecutive records and, for good measure, added three more before July drew to a close. In August the pace slackened, with three fairly unconvincing new record highs languidly popping up amidst yet another overall sideways drift. Bonds likewise showed little inclination to exert any directional effort, as the yield on the 10-year Treasury note meandered between 1.5 and 1.6 percent for most of the month. The lazy, hazy days of both assets are shown in the chart below.
August has now ceded the calendar to September, that notoriously tricky and sometimes perilous month. It’s time to once again take stock of what may be at play as the baton passes from the third to the fourth quarter.
A Policy-Less Equinox
The autumn equinox will approximately coincide with the Fed’s next policy meeting, and there will be more action in the celestial realm than the terrestrial. Yes, we have been saying for many weeks now that we expect no rate action in September on account of X, Y and Z reasons, but today’s jobs release should be the final word on this matter. It’s not that the jobs report was bad – the payroll number was below expectations as was the average wage growth figure, but the quality of job gains has improved over an intermediate-term basis. It’s simply that there is no reason of any urgency for the Fed to move on rates while nothing – not jobs, not inflation, not GDP, certainly not productivity – suggests even a hint of dangerous economic overheating. Short of an unimaginable surprise coming out of the next CPI release on September 16, that calculus won’t change. So go out and enjoy the official transition from summer to fall without worrying about anything that’s going on in Washington DC’s Eccles Building.
Earnings and Valuations: Will They Matter?
With nothing much in the way of policy events, then, attention should reasonably turn back to earnings and the fact that stock prices remain very expensive by the usual valuation metrics. Consensus earnings for 3Q 2016 have slipped again, with the FactSet analyst consensus outlook once again calling for a decline in average S&P 500 earnings per share by more than two percent. If realized, that would put calendar year 2016 under the water and notch six straight quarters of earnings declines. Headwinds including the strong dollar and weak foreign demand have not gone away. The next twelve months P/E ratio, meanwhile, remains near a 12 year high.
Those are the facts and they are hard to dispute; the question is whether they will matter much or whether benign sentiment will prevail for what may be perhaps a last giddy rally before investors come around to contemplating a 2017 landscape filled with potential landmines. We’ll have more to say about next year as we get closer to our annual outlook in January; at least from our vantage point today, that may be shaping up to be a sobering conversation.
Surprise, No Surprise
A giddy late-2016 rally would in our opinion be a more likely outcome if we do indeed get through that twisty period from about mid-September through early October. That, in turn, depends largely on the absence of any out-of-the-blue surprises that force a radical revaluation of asset price models. The good news, perhaps, is how immune markets seem to be to surprises these days. Brexit is the poster-child for this sanguinity in the face of surprise; the outcome was unexpected, the potential real-life consequences far-reaching, and yet the market response was crammed into just two days of negative reaction followed by a relentlessly upbeat relief rally.
Think ahead to the weeks leading up to the US presidential election. Is there any possible outcome that could exert a real shock effect on the market – meaning one which lasts more than a week and which pulls risk asset prices into sustained double-digit declines? If there is, we don’t see it. The market already assumes that the US political system is broken, that November’s outcome will not fix the dysfunction regardless of who moves into the White House and occupies a majority on Capitol Hill, and that the Fed will retain its independent role as the sole architect of actual economic policy. If nothing changes that equation, we believe, nothing will truly surprise the stock market.
So here we go. We imagine the fall will contain more rollicking times than did summer, but we don’t see the case for too many far-reaching tactical moves. 2017, though, may be another story entirely.