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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
How do you tell whether someone is a novice investor or a seasoned observer of the ways of the capital markets? Simply pose a question like the following: “Growth data show a marked slowdown in economic activity in key economic regions like China and the European Union. Good or bad for global equities?”
“Bad!” says the novice. “Low growth means a poor outlook for companies’ sales and earnings, and that should be bad for the stock price, right?”
To which the seasoned pro chortles a bit and ruefully shakes his head. “Let me tell you how the world really works, kiddo. That low growth number? That’s good news! It means the central banks are going to prime the pump again and flood the world with cheap money. Interest rates will go down, stocks will go up. Easy as ABC!”
Down Is Up
The logic of “bad news is good news” has been a constant feature of the current economic growth cycle since it began in 2009 (and, barring any surprises, will become the longest on record come July of this year). The key economic variable of this period has not been any of the usual macro headline numbers: real GDP growth, inflation or unemployment. It has been the historically unprecedented low level of interest rates.
Short term rates in the US were next to zero for much of this cycle, with persistent negative rates (a phenomenon which itself flies in the face of conventional economic theory) in Europe and Japan. Central banks argued that their unconventional policies were necessary to restore confidence in risk assets and stimulate credit creation for the benefit of consumer spending and business investment. The evidence would seem to support the bankers’ view, as growth started to creep back towards historical trend rates while labor markets firmed up in most areas. The Fed has drawn its share of criticism for the easy money policies of quantitative easing (QE) from 2009 to 2015 -- but the Bernanke-Yellen-Powell triumvirate will forever be associated with the phrase “longest economic recovery on record” when that July milestone is reached.
Draghi Speaks, Markets Balk
But to return to that conversation between our novice investor and seasoned stock pro: Does “bad news is good news” always work? Is there a point at which the magical elixir of monetary stimulus fails to counter the negative effects of a slowing economy? That is a question of particular interest this week. On Thursday, the European Central Bank (ECB) backed away from its attempt to wean markets off easy money when it reopened the Targeted Longer-Term Refinancing Operations, a stimulus program to provide cheap loans to banks, for the first time in three years. ECB chief Mario Draghi made it clear that the catalyst for this return to stimulus was the steadily worsening outlook for EU economic growth.
This time, though, markets failed to follow the “bad is good” script and reacted more the way our novice investor would think makes sense: selling off in the face of a likely persistence of economic weakness. Italy is already in recession, Germany is only barely in growth territory, and demand in the major export markets for leading EU businesses is weakening, most notably in China. That economy, the world’s second largest, has its own share of problems. A record drop in Chinese exports -- far worse than consensus expectations -- sent Chinese shares plunging overnight Thursday. Other Asian export powerhouses including South Korea and Japan are also experiencing persistent weakness in outbound activity.
Pivot to Fundamentals
In our annual outlook published back in January we noted that weakness in Europe and China was prominent among the X-factors that could throw a wrench into markets in 2019. For much of the time since then it has not seemed to be much of a factor. World equity markets bounced off their miserable December performance in a relief rally driven by the “bad is good” logic of a dovish pivot by central banks, underscored formally by the Fed in late January.
But the market’s underwhelming response to the ECB on Thursday, amid a vortex of troubled headline data points that now includes a tepid US February jobs report, suggests that real economic activity may be starting to matter again. In just a few weeks we will start to see corporate sales & earnings numbers for the first quarter, which consensus expectations suggest could be negative for the first time since 2016. Shortly after that will come Q1 real GDP growth, which analysts are figuring could be in the range of one percent. All this could suggest more of that volatility we predicted would be a primary characteristic of 2019 risk asset markets.
Our novice investor of that earlier conversation may not be schooled in the ways of markets, but she made one salient point. Low growth should mean a poor outlook for company sales and earnings. Those sales and earnings, in the long run, are all that really matters, because a share price is fundamentally nothing more and nothing less than a net present value expression of all that company’s future cash flows. Perhaps the time is at hand when this long-term truth will actually have an impact on the market’s near-term directional trends.
Happy meteorological spring! Not that the calendar’s third month is bringing much in the way of springlike conditions to many parts of the US, including our own Chesapeake Drainage Basin Region. There’s not a whole lot of warmth in the world of value investing either – and there has not been for a very long time. Why exactly has one of the most time-tested old chestnuts of investing – the value effect – gone so completely pear shaped? We ponder this question in today’s missive.
Another Rotation Forestalled
For awhile it seemed that the tide had turned for the beleaguered legions who continue to swear by the Graham & Dodd value formula. Last fall’s comeuppance in equity markets dealt particularly harshly with the high-flying tech stocks and other growth sectors that had led performance for much of the recent phase of the bull market. But a snapshot of the last three months reveals how fleeting that value rotation was. As shown in the chart below, all four S&P 500 industry sectors trailing the overall index on a three month trailing basis are traditional value sectors: consumer staples, health care, financials and energy.
The dichotomy is not perfect: the utilities sector, generally considered a dividend/value play, continues to outperform the overall index. And the top-performing sector over this period is industrials (the purple trend line on the chart), which is cyclical but typically not an overweight component of growth stock indexes. Otherwise, though, the traditional growth cohorts of technology, communications services and consumer discretionary have been at the leading edge of the extended relief rally we have witnessed since late December last year (along with materials, which is a sort of growth-y cyclical sector).
The Long View Looks Even Worse
Now, the traditional value investor’s response to any short-term snapshot like the one we provided above goes thus: “sure, there are those irrational periods where starry-eyed investors flock to pricey growth stocks. But in the long run, value always wins. That’s why there is such a thing as a value effect enshrined in the scriptures of modern portfolio theory.”
Er, not so much. Consider the chart below, which shows the relative performance of the S&P 500 Growth Index versus the S&P 500 Value Index over the last quarter century going back to 1994. A quarter century that encompasses bubbles, crashes, growth cycles and bear cycles – a veritable kitchen sink of equity market conditions. A quarter century in which growth – the blue trend line – outperformed value (the green line) by nearly double.
You can call a quarter century a lot of things, but you can’t really call it “short term.” To say that “value outperforms growth in the long run” is simply to ignore the glaring evidence supplied by the data that there is actually no such thing as a value effect any more. It is dead, requiescat in pace. But why?
Nothing Stays the Same Forever
There probably will not be a settled conclusion about the demise of the value effect for some time to come. For one thing, there will continue to be value stock fund managers whose livelihood depends in some part on there being a value effect, just like there will always be fossil fuels company executives whose compensation structure benefits from a belief that there is no such thing as climate change. We might posit an idea or two about what has caused the long term malaise in value, though.
If you think about our economy in the sweeping scale of the last quarter century there are two trends we would argue rise to the level of tectonic shifts. The first is the downfall of the financial services industry as the lead engine of economic growth. From the early 1980s through the middle of the 2000s, the share of total S&P 500 corporate profits claimed by the financial sector more than doubled, from around 20 percent to 44 percent just before the crash of 2008. Financial services, in a variety of consumer and commercial guises, powered the economy out of the doldrums of the 1970s and into the halcyon days of the Great Moderation.
The second trend, which started roughly in the mid-1990s but really gained traction in the 2010s, was the encroaching by the technology sector into just about every other facet of commerce – and of life itself, if one wants to extend the argument to the rise of social media and the like. Not a single industry sector exists wherein competitive advantage does not derive in some meaningful part from technology. In this environment those who sit closest to the servers – i.e. the megacap tech firms who own the platforms and the attendant network effects – reap the lion’s share of the rewards.
Now, it just so happens that financial services companies typically have the characteristics of value stocks (low price to book ratios and similar metrics) while enterprises in the technology sector are more likely to sport the sales & earnings growth traits that screen into growth stock indexes. At the same time, the economic growth cycle of 2009 to the present has been dominated by one gaping anomaly when compared to any other growth cycle – near-zero interest rates for a large percentage of the time. Low rates have been particularly harmful to financial firms that make money based on profiting from the spread between their financial assets and their financial liabilities. They have been a boon for companies looking to leverage their growth prospects through cheap external financing.
This is by no means a complete and comprehensive explanation for the vanishing of the value effect. And from a portfolio management standpoint there should always be a rationale to include value as an asset class for diversification purposes. But the traditional interpretation of the “value effect” as being a sure-fire winning proposition in the long run is not a valid proposition. Financial markets are complex, and complex systems produce emergent properties that only become apparent after they emerge. Change happens. No doubt there will be a few emergent surprises for us in the weeks and months ahead.
Just a couple years ago, the notion of “secular stagnation” was a favorite topic of conversation in the tea salons of the chattering classes. Secular stagnation is the idea that structural forces are at play pushing the growth rate of the global economy ever farther away from what we call “historical norms” (which really means “average rates of growth since the end of the Second World War”). Former Treasury Secretary Lawrence Summers was a leading proponent of the secular stagnation theory, pointing to widespread evidence of reduced levels of business investment and subdued consumer demand. Secular stagnation offers a different explanation of economic performance than the usual ups and downs of the business cycle. It suggests that the very idea of “historical norms” is meaningless: the world, and the world’s economy, has changed in profound ways since the 1950s and the 1960s, and there is no point in benchmarking current trends off those prevailing sixty and seventy years ago.
Hit the Mute Button
Secular stagnation lost quite a bit of mojo in the immediate aftermath of the 2016 election and the brief infatuation with the “reflation-infrastructure” phenomenon that was supposed to happen when the incoming administration turned on the full force of corporate tax cuts and deregulation. Although the tax windfall did arguably give a momentary sugar high to GDP growth rates, it didn’t have much of a sustained effect on business spending levels. And it had absolutely no effect on inflation. The chart below shows the long term inflation trend (core inflation, excluding food and energy) along with the corresponding ten year Treasury yield. The data go back to 1990.
There are a couple noteworthy things about this chart. The first is that inflation really has been a non-factor in the US economy since the mid-1990s. Core inflation has not risen above three percent since 1996. Through up cycles and down cycles, inflation has been – to use the word that is now embedding itself into the working vocabulary of the Federal Reserve – muted. And of course, in the recovery that began in 2009 core inflation has never even come close to the three percent level it last flirted with at the height of the manic real estate boom of 2006.
The second thing to observe in the above chart is the subduing of long term interest rates. We have talked about this in recent weeks, but here we focus on the 10-year yield as a barometer of inflationary expectations. One plausible reason for the persistence of the low benchmark yield – even after the Fed stopped buying intermediate term bonds as part of its QE programs – is that bond markets bought into the structural nature of muted inflation long before the Fed did. When the FOMC’s January 30 communiqué seemed to make official the Fed’s view of lower-for-longer inflation, one can picture the bond market replying thus: Thanks for telling me what I already know.
Alvin Hansen Gets His Day
And with that, a long-dead economist may finally have his life’s work recognized in formal monetary policy. Alvin Hansen was the originator of the term “secular stagnation,” way back in 1938. That was a grim year. Six years after the peak of the Great Depression, monetary authorities gingerly attempted to tighten policy and prevent the recovering economy from overheating. Things went south quickly, and policymakers realized that the economy was still too fragile to withstand traditional medicine.
Hansen’s secular stagnation theory seemed on the money at the time. Fortunately for the country, if not for Hansen’s own posterity, the theory quickly went out the window when the economy reflated onto a war footing as the Second World War broke out. Now that’s an infrastructure-reflation event! And dormant the theory lay until resurrected by Dr. Summers et al in the mid-2010s. We may still be one or two FOMC meetings away from calling it the dominant interpretation of today’s economy. But barring some genuinely massive exogenous shock to reflate the economy, the pattern of core inflation suggests that “lower for longer” is indeed what the world is going to have to get used to.
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.