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President & CEO
Masood Vojdani began his career in the financial services industry in 1981. From the outset, he was driven by the vision of a firm that was different from the industry status quo. At the heart... Full Bio
As we wind our way through the random twists and turns of the first quarter, a couple things seem to be taking on a higher degree of likelihood and importance than others: (a) the Fed is back in the game as the dice-roller’s best friend, and (b) corporate earnings are starting to look decidedly unfriendly for fiscal quarters ahead. And we got to thinking…have we seen this movie before? Why, yes we have! It’s called the Corridor Trade, and it was a feature of stock market performance for quite a long time in the middle of this decade. Consider the chart below, which shows the performance path of the S&P 500 throughout calendar years 2015 and 2016.
What the chart above shows is that from about February 2015 to July 2016, the S&P 500 mostly traded in a corridor range bounded roughly by a fairly narrow 100 points of difference: about 2130 on the upside, and 2030 or so on the downside. There were two major pullbacks of relatively brief duration during this period, both related to various concerns about growth and financial stability in China, but otherwise the corridor was the dominant trading pattern for this year and a half. Prices finally broke out on the upside, paradoxically enough, a few days after the UK’s Brexit vote in late June 2016. An overnight panic on the night of the Brexit vote promptly turned into a decisive relief rally because the world hadn’t actually ended, or something. A second relief rally followed the US 2016 elections when collective “wisdom” gelled around the whimsical “infrastructure-reflation” trade that in the end produced neither.
So what was this corridor all about? There are two parts: a valuation ceiling and a Fed floor.
Corridor Part 1: Valuation Ceiling
In 2015 concerns grew among investors about stretched asset valuations. Earnings and sales multiples on S&P 500 companies were at much higher levels than they had been during the peak years of the previous economic growth cycle in the mid-2000s. The chart below shows the price to earnings (P/E) and price to sales (P/S) ratios for the S&P 500 during this period.
Those valuation ratios were as high as they were during this time mostly because sales and earnings growth had not been keeping up with the fast pace of stock price growth in 2013 and 2014. While still not close to the stratospheric levels of the late-1990s, the stretched valuations were a cause of concern. In essence, the price of a stock is fundamentally nothing more and nothing less than a net present value summation of future potential free cash flows. Prices may rise in the short term for myriad other reasons, causing P/E and P/S ratios to trade above what the fundamentals might suggest, but at some point gravity reasserts itself. That was the valuation ceiling.
Corridor Part 2: The Fed Floor
The floor part of the corridor is just a different expression for our old friend, the “Fed put” begat by Alan Greenspan and bequeathed to Ben Bernanke, Janet Yellen and now Jerome Powell. Notice, in that earlier price chart, how prices recovered after both troughs of the double-dip China pullback to trade again just above that corridor floor level. The same thing seems to be happening now, with the extended relief rally that bounced off the Christmas Eve sell-off. The floor is a sign of confidence among market participants that the Fed won’t let them suffer unduly (which confidence seems quite deserved after Chair Powell’s capitulation at the end of last month). It is not clear yet where the floor might establish itself. Or the ceiling, for that matter. Might the S&P 500 reclaim its September 20 record close before hitting a valuation ceiling? Maybe, and then again maybe not.
What we do know is that bottom line earnings per share are expected to show negative growth for the first quarter (we won’t find out whether this is the case or not until companies start reporting first quarter earnings in April). Sales growth still looks a bit better, in mid-single digits, but we are already seeing corporate management teams guiding expectations lower on the assumption that global growth, particularly in Europe and China, will continue to slow. Meanwhile price growth for the S&P 500 is already in double digits for the year to date. That would appear to be a set-up for the valuation ceiling to kick in sooner rather than later.
Could stock prices soar another ten percent or even more? Sure they could. The stock market is no stranger to irrationality. A giddy melt-up is also not unknown as a last coda before a more far-reaching turning of the trend. But both elements are pretty solidly in place for a valuation ceiling and a Fed floor. A 2015-style Corridor Trade will not come as any surprise should one materialize in the near future.
Every time the topic of “technical analysis” comes up in our weekly commentary, we need to begin with the customary disclaimer. There is nothing magical about the tools of the technical trade. 200 day moving averages, round numbers, head-and-shoulders formations – these are all silly things with no inherent meaning. BUT, they do affect short term trading patterns. Why? Because the 70-odd percent of daily market volume driven by algorithm-based trader-bots turns these whimsical flights of fancy into meaningful pivots around which markets go up and down. As per Arthur Miller’s “Death of a Salesman” – attention must be paid! We are paying attention this week because a trend is coming into view with potentially bearish overtones. Which may mean something or nothing at all, but it’s worth a look.
When Support Becomes Resistance
The long term moving average is a staple of technical analysis, with 200 days being a particularly popular representative of the species. In bullish times the 200 day average acts as a support level, while in a bear market it becomes a ceiling of resistance. We will illustrate this phenomenon with the chart below, showing a comparison of the last twelve months price performance on the S&P 500 as compared to the period from January to December in 2000 (the first year in the 2000-03 bear market).
That reddish line coursing across each chart is the 200 day moving average. In both time periods (2000 and today) you can see the specific instances when the index bounces off the moving average and resumes an upward trend (for example, May and July 2000, and April and May 2018). You can also see where the moving average becomes a resistance ceiling (October-November 2000 and November-December 2018).
This past week, the 200 day moving average seemed to work with surgical precision. On the back of an impressive six week rally starting just after Christmas, the S&P 500 closed Wednesday just 0.15 percent below the moving average. It then promptly fell back in Thursday and early Friday morning trading. Again – this may or may not mean anything significant. Perhaps it even rallies back up after we go to print with this piece – who knows? But the technical pattern of the market since last October is thus far looking less like a bullish resumption and more like settling into a more negative cadence. Short term traders will be inclined to read it as such and then the Copenhagen theory of markets comes back into focus: the observation affects the outcome. Negative feeds on more negative.
What Say the Fundamentals?
As much as technical indicators impact short-term market movements, though, it takes more than that to produce a full-on chronic bear. Fundamentals matter. Here, the current contextual environment allows one to take a glass half full or half empty approach. The half full contingent will point to the more or less unchanging stream of good headline macro data here in the US: a robust jobs market with inflation right around the Fed’s two percent target, and still-healthy levels of consumer and business sentiment if not quite as optimistic as a year ago. Based on the data at hand, the likelihood of a near-term recession in the US is quite low. That’s good news.
But wait, says the half empty crowd. Look at where the consensus is going for Q1 2019 corporate earnings. Back in September last year the consensus forecast for first quarter earnings growth was 6.5 percent according to FactSet. That same forecast today, a bit more than seven weeks away from the end of Q1, is negative 1.9 percent. Even if the usual “estimates Kabuki” games are at play, that is a big delta. The lowered estimates come from corporations lowering their guidance for expected earnings.
What is notable is that the consensus outlook on sales has not come down as much as earnings. This means is that companies are not yet too concerned about structural demand – sales are expected to grow around 5 percent in Q1, which is a healthy number. But it implies that profit margins are going to be squeezed by a combination of factors such as higher wages, higher interest rates and other factors giving less profit bang for each incremental buck of sales. That feeds back into one of the main “glass half empty” talking points of recent months, namely peak profit margins.
Tilting at Headlines
While the fundamentals are confusing and the short term technical indicators giving cause for concern, the market has reverted to grasping at daily headlines for directional guidance. For most of this year there has been enough meat on the positive headlines – the Fed put being back in play (as we wrote about last week), nothing particularly negative on the trade war front, no other sudden surprises – to keep the direction positive.
But a headline-driven market is inherently skittish. There’s not much more room in the Fed punch bowl for positive surprises – even if the Fed were to start actively signaling towards a near-term rate cut it would leave the market wondering just how bad the underlying situation is. Europe’s problems are coming back into focus – spreads between Italian and German debt, for instance, are resuming a notable widening trend. British government leaders seem to be trying their hardest to convince the rest of the world that they are the most inept bunch of chummy toffs ever to claim the mantle of governance anywhere (these days, a decidedly low bar). Where the market winds up at the end of this year is anybody’s guess – but we expect to see plenty more ups and downs along the way, with downside risks that are not going away.
There is something almost symmetrical about it all. On December 19 last year the Federal Reserve delivered a hawkish monetary policy statement that sent the stock market into a tailspin. Two days later the US government shut down. Fast forward to January 25 of this year. The US government reopened amid generally upbeat sentiment in asset markets. Several days later, the Fed surprised traders with a decidedly dovish policy statement hinting at a pause, not only in further interest rate hikes but in winding down the central bank’s balance sheet of bonds purchased during the quantitative easing (QE) era of 2008-14. Stocks surged in the aftermath of that announcement and closed out a January for the record books. Hallelujah, exclaims Mr. Market. The Fed put is back and better than ever!
What Exactly Changed?
The January Federal Reserve Open Market Committee (FOMC) statement was not just a tweak or two away from the December communiqué – no, this was closer to a full-blown U-turn. As much as investors thrilled to the news that the Fed was solidly back in their corner to privatize gains and socialize losses, there was quite a bit of head-scratching over what exactly was so momentously different in the world over this 30 day interval. The FOMC press release seemed to say little about changes in economic growth prospects, with a strong labor market and moderate inflation paving the way for a sustained run of this growth cycle. True, it chose the world “solid” to characterize growth, which may be a slight demotion from “strong” as the adjective of choice in December. And yes, muted inflation affords some leeway to adjust policy if actual data were to come to light. But real (inflation-adjusted) rates are nowhere near recent historical norms, as illustrated in the chart below.
“Muted inflation” is the Fed’s term to describe the current level – but is it really “muted?” The chart above shows the Consumer Price Index (the blue dotted line) to be squarely within a normal range consistent with growth market cycles in the late 1990s and the mid-2000s. Yet in both of those cycles real rates were much higher, as is clear from the gap between nominal 2-year and 10-year yields (green and crimson respectively) and the CPI. Is the Fed worried that real rates at those levels today would be harmful? If so, there must be some element of fragility to the current economy that wasn’t there before.
Oh, Right. That.
Or, maybe that’s not it at all, as the FOMC press release sort of gives away in the next sentence. “In light of global economic and financial developments…” Aha, there it is, the language of the 2016 Yellen put reborn as the 2019 Powell put. What, pray tell, could those “financial developments” possibly be? A stock market pullback, blame for which was almost entirely laid at the feet of those two FOMC press releases last September and December? Once again, monetary policy appears to be based principally on ensuring that market forces not be given free enough latitude to inflict actual damage on investment returns.
And maybe that’s fine – perhaps the pace of growth will continue to be slow enough to allow the Fed to ease off the monetary brakes without any collateral damage. If that turns out not to be the case, though, then we foresee some communication challenges ahead. The data continue to suggest the growth cycle has a way to go before petering out. Today’s jobs report was once again robust, with year-on-year wage growth solidifying a trend in the area of 3.2 percent year-on-year. Unfortunately we won’t know about Q4 2018 GDP for some time, as the Bureau of Economic Analysis was impacted by the government shutdown and does not yet have a date for when its analysis will be ready for release.
March is probably safe – the likelihood of a rate hike then is now close to zero. But if Powell has to go back to the market sometime later in the year and ask investors to get their heads around another rate hike – a U-turn from the U-turn, in effect – that would likely be problematic. This Fed still has a learning curve to master when it comes to clarity of communication.
It wasn’t all that long ago that Davos Week was a big deal. Confident, important communiqués about the state of the world delivered by important, impeccably tailored men (and a few women here and there). The rest of the world’s inhabitants might live out their quotidian habits in a perpetual fog, but the great and good who assembled in the little Swiss Alpine town every January were there to tell us that it was all going to be okay, that the wonders of the global wealth machine would soon be trickling their way. Now the fog has enshrouded them as well. While their status as influencers was getting sucked down into the lowest-common-denominator Twitterverse, their ability to explain the great trends of the day was upended by the improbable turn those trends were taking away from the comfortable Washington Consensus globalism of years past. “The mood here is subdued, cautious and apprehensive” reports Washington Post columnist (and Davos Man in good standing) Fareed Zakaria from the snowy slopes this year. Apprehensive, not confident, which is an apt way to sum up the present mindset of the world.
Never Underestimate the Power of Kick the Can
Yet, for all the fretting and fussing among the stewards of the world’s wealth pile, some of the key risks that have been plaguing investors in recent weeks seem to be turning rather benign. Consider as Exhibit A the state of the British pound, shown versus the US dollar in the chart below.
The pound has rallied strongly since plummeting in early December last year. If you go back and track the history of Brexit negotiations since that time, you find that the actual news about a Brexit resolution is almost all dismal. The deal PM Theresa May brought back from Brussels was panned as soon as it reached Westminster; that same deal formally went down to one of the most ignominious defeats in UK parliamentary history last week.
All the while – the pound sterling has rallied! Why? Because the Brexit deal’s unpopularity means that there are only two ways this whole sorry affair plays out between now and March, when the Article 50 deadline comes into effect. One is that the UK crashes hard out of the EU, which would be a disaster for the country. The other – and far and away the most likely, is to kick the can down the road. Extend the Article 50 deadline, probably to the end of the year, and see what kind of fudge can be worked out between now and then. Maybe (most likely, as we have been saying for some time now) a second referendum that scotches Brexit for once and all. Maybe something else. Maybe someone has to make a bold decision at some point. But not yet, not yet, as that fellow said in “Gladiator.” Thus the strong pound.
March Without the Madness
The month of March has in fact been looming large over Davos think-fests and cocktail parties this week. In addition to Article 50, there is that self-imposed deadline by Washington’s trade warriors to reach some kind of deal with China on the terms of cooperation going forward – absent which, according to Trump’s protectionist acolytes, there would be hell to pay in the form of new tariffs. Yet as the days go on, the evidence mounts that this administration’s tough talk on any number of fronts is all hat and no cowboy. This administration has plenty of other troubles with which to contend, and by now they know that actually following through with tough trade rhetoric will spark another pullback in the stock market. We don’t think it’s being Pollyanna to say that this trade showdown at high noon will likely not come to pass.
Finally, the other risk event that could befall markets after the Ides of March would be the Fed meeting that month with the potential for another interest rate hike. While that is a possibility, the Fed’s actions in recent weeks have been very cautious and non-confrontational with edgy markets. Recent inflation numbers have come in a bit below expectations. We’ll see what happens with Q4 GDP next week, but indications are that it will settle back somewhere in the 2-plus percent real growth range. In other words, the Fed will have plenty of flexibility if it decides to join in with the kick the can fun and hold off until next time. Even on the question of the Fed’s balance sheet there have been some recent indications that it may not wind down as quickly or deeply as previously thought.
“Never make tough decisions today that you can punt down the field for later” – this instinct is alive and well in the world of global policymaking. As long as that remains the case, Davos Man, you should take a deep breath and go back to enjoying your cocktails and canapés.
What do global capital markets and the Warrumbungle National Park in New South Wales, Australia have in common? Topology, for one. In the chart below we have juxtaposed an image of one of the best-known features of Warrumbungle, known affectionately as the Breadknife, with yesterday’s price trend graph for the S&P 500. The similarity, we think you will appreciate, is remarkable.
The Topology of the Twitterverse
What exactly was it, shortly after 2:30 pm on Thursday, that sent the broad-based US stock index into its best imitation of an eastern Australian rock formation? Something on Twitter, of course, because that is where most news headlines land a few microseconds before they make it into the pixelated pages of mainstream news outlets. The little item in question was a report from Steve Mnuchin’s Treasury Department suggesting that sanctions on China should be lifted in order to encourage a settling of the trade dispute between the US and China. The chronology goes thus: a snippet of the Treasury report made its way onto Twitter, where it was gobbled up by a vast gaggle of tradebots that feed solely off the effluvia and attendant waste products of social media. Stock prices jumped by some three quarters of a percent from where they had hitherto been ambling along.
Almost immediately afterwards came a countervailing comment from Robert Lighthizer, the US Trade Representative, throwing cold water on the idea that sanctions should be lifted. The White House, for what it’s worth, chimed in to quash the idea that lifting sanctions was a possibility in the immediate future (it’s worth noting that the only other meaningful piece of trade-related news earlier in the day was a report that the US, in trying to pressure the EU to buy more agricultural products to offset declining exports to China, was thinking of slapping some new tariffs on automobile imports). The Breadknife crested and shaped the contours of its downward slope back close to where it had begun. Trading ended on a reasonably optimistic note because, apparently, the winning theme was “if someone’s even talking about sanctions at all it must mean the atmospherics are a bit better than they were.” Or something to that effect. Win!
Life In Volatile Times
To be clear: there was technically no news – nothing of any substantial meaning – that transpired between 2:30 pm and the banging of the antique gavel on the floor of the New York Stock Exchange at 4 pm with whatever invitees of the day slow-clapping the close of another trading session. Nothing to merit that Breadknife of 75 basis points up and down. So it goes in a jittery market where rumors, counter-rumors and the sudden catalyzing of vague sentiments one way or the other drive share volumes on any given day. For most of the year thus far (all two weeks and change of it) the prevailing sentiment has been mostly of the glass half full variety. Last month was quite the opposite, where every little X-factor that bubbled to the surface on any given day was a raven foretelling the imminent arrival of the Four Horsemen of the Apocalypse. Expect more of these back-and-forth reels as the year goes on.
Early next week we will be releasing our 2019 Annual Outlook, the main theme of which is that the principal characteristic of risk assets this year is likely to be volatility. Volatility goes up and volatility goes down – just like the Breadknife in Warrumbungle National Park. When markets gyrate excessively in response to the continuous stream of drivel that courses through the Twitterverse, what matters most is staying disciplined and focused on the things that do matter.