Posts tagged Current Market Trends
This past Wednesday, apparently, was one of those red-letter special days in US stock market history. The current bull market, which began in 2009, became the longest on record, based on the daily closing price of the S&P 500. So said the chattering heads, not just on CNBC but on your friendly local news channel. Hooray! Or should we worry, perhaps, that the good times are coming to an end?
The right answer to that question and all others about the bull market’s record longevity is to ignore it, because technically it didn’t happen. Nope, this is not the longest bull market on record, not by a long shot. Now, some may quibble when we present the facts, arguing that we are splitting hairs. Well, sorry, but ours is supposed to be a precise business where performance measurements are concerned. And facts, surprisingly enough in this day and age, are still facts.
So, to be precise, the bull market that reached its peak on March 24, 2000 (the one we supposedly beat on Wednesday) did not in fact begin on October 11, 1990. That was a span of 3,452 days. The basis for “longest bull market ever” claims made this week is that 3,453 days elapsed from March 9, 2009 (the low point of the last bear market) to August 22, 2018. However! Based on the technical definition of bulls and bears, the bull that peaked in March 2000 actually began, not in 1990, but on December 4, 1987. That’s a total span of 4,494 days, or 1,041 days (about 2.8 years if you prefer) longer than our current bull market.
So why did the media spend so much energy this week talking about the “longest bull market?” Because (a) it’s more fun to talk about things grand and historical than about the daily grind of random market movements, and (b) on October 11, 1990 the S&P 500 closed down 19.9 percent from the previous record high set in July of that year, and, well, 19.9 percent is close enough to 20 percent, which is the commonly accepted technical threshold of a bear market.
Let the quibbling begin! 19.9 percent is close to 20 percent, certainly. But it never passed that threshold. More importantly, the stock market pullback of 1990 (which started with the recession of that year but had recovered before the recession was over) never spent a single day – not a single day! – in actual bear market territory. You can’t say that a bull market began the day after a bear market ended when that bear market never even began.
So, again sticking to the definition of a 20 percent pullback from the prior high, the last bear market before the dot-com crash of 2000 occurred after Black Monday in 1987. On December 4 of that year the S&P 500 had retreated 33.5 percent from the prior record high reached in August. That wasn’t a super-long bear, lasting less than a couple months from the breaching of 20 percent, but it was certainly impactful.
The Music of the Market
Here’s the more important reason why we’re not just splitting hairs over the 19.9 versus 20 percent, though. If you look at the way markets trend over a long enough period of time you notice a certain pattern – a tune, if you will, the music of the market. Every bull market experiences periodic pullbacks. These happen for a variety of reasons, some of which may seem frivolous and some of which may seem more serious at the time. Traders in the market are highly attuned to how far these pullbacks draw down from the previous bull market high. A 5 percent pullback is deemed significant. The 10 percent threshold has its own special name – correction. And the 20 percent level, as we noted above, is the event horizon for a bear market.
What tends to happen during the more severe bull market corrections is that they get ever so close to the 20 percent threshold without actually going over it. This happened in October 1990, as we showed above. It also happened in August 1998 with a 19.3 percent pullback (this coincided with the Russian debt default and subsequent meltdown of hedge fund LTCM). More recently, it happened in 2011 with a 19.4 percent pullback in the S&P 500 while the Eurozone crisis and US debt ceiling debacle played out simultaneously.
It’s not accidental that these pullbacks flirt with bear markets but refrain from going all the way. It’s how short term trading programs, which make up the lion’s share of day to day liquidity, are set up to work. A correction or bear market threshold is considered to be a technical support level. If prices approach, but don’t breach the support level it means that the net consensus of the market supports the status quo; in other words, that conditions continue to justify a bull market. These pullback-recovery movements happen frequently. Real bear markets are much rarer, and more durable when they do happen.
The chart below provides a good illustration of this “music” – it shows the price trend of the S&P 500 from 1987 to the present (lognormal scale to provide consistency in magnitude of returns over time).
This chart is instructive for another reason. To paraphrase Tolstoy, every pullback has its own dysfunctional story. What causes a pullback to become a full-on bear market? It’s not always a recession – witness 1990, when we had an economic downturn but only a limited market pullback. It’s not always a financial crisis – we had one of those in 1998 and again in 2011 but in both cases economic growth stayed positive. In 1987 financial markets came close to shutting down, but again the economy was still resilient and the drawdown, while intense, turned out to be brief. By contrast, in 2000-02 and again in 2007-09 we got a double-dose of financial crisis and recession in roughly the same time frame (the grey bands in the above chart signify recession periods). Both the magnitude and the duration of these drawdowns, of course, were more severe.
In any event, with all apologies to financial market pundits everywhere, there was nothing particularly historical about this week. Perhaps our good fortune will last another 1,039 (and counting) days and we will have a real, actual “longest bull” to celebrate. Or maybe not. Expect more pullbacks along the way in either case. Remember that most pullbacks do not end up in a real bear market, and also remember that while we humans have a need to read meaning into calendar events, markets themselves do not.
The languid dog days of August are truly upon us. Risk asset markets would seem to be feeling the soul-draining humidity as much as runners and cyclists slogging through day after day of relentlessly damp blankets of heat while training for fall goal races. The S&P 500 hovers just below its January record high, while volatility has resumed last year’s deep slumber. The 10-year Treasury yield casts a sleepy glance every now and then at the 3 percent level, yawns and goes supine again somewhere around 2.95 percent.
Random headlines make a splash on these days where nothing much from macroeconomic or corporate earnings data releases manage to perk up investor attention. This week’s little diversion came – as seemingly all diversions in 2018 must come – from Twitter and specifically from the account of Elon Musk, founder of Tesla, as he mused about the likelihood of taking his $60 billion enterprise private. Now, once upon a time a major strategic undertaking like taking a public company private would have simmered under the radar in boardrooms and hushed discussions with bankers, lawyers and advisors before proceeding in an orderly fashion into the public domain. But such are the times in which we live.
Mind The (Listing) Gap
While Musk’s method of communication may have been unusual (and quite possibly illegal), the decision itself – to take a public company private – is anything but an anomaly. Our interest piqued, we went hunting for some data on the subject and came across a 2017 Credit Suisse paper entitled “The Incredible Shrinking Universe of U.S. Stocks” with some eye-opening facts and figures. The universe of publicly traded equities – i.e. shares of common stock traded on an accredited stock exchange, compliant with SEC disclosure and transparency regulations, and available for purchase by any institutional or retail investor – has radically diminished over the past several decades.
Here’s a good illustration of what this means in practical terms. How many stocks do you think make up the Wilshire 5000 Total Market Index? Ah – you were about to say “5,000, of course!” but then realized it must be a trick question if we’re asking it. Indeed, this bellwether index launched in 1970 to represent the “total US stock market” does not consist of 5,000 companies. It consists of 3,486 companies as of June 30, 2018. Why? Because that is roughly how many publicly traded companies exist in the United States. In 1976 there were about 4,800 companies with publicly traded stock, and in 1998 that number soared to more than 7,500. The Wilshire 5000 reached its peak holdings with 7,562 names on July 31 of that year.
Where Did They All Go?
Why are there so many fewer listed companies now, and how much does it actually matter from the standpoint of an investor seeking to capture as wide a swath of global wealth as possible through portfolio diversification? The answer to the first question is relatively straightforward. The second – not so much.
The main reason why there are fewer companies on stock exchanges in 2018 than there were in 1998 or 1978 is twofold. First, mergers & acquisitions (M&A) activity has gone gangbusters over this period, and has been the main driver for delisting (a company, when acquired, naturally retires its stock ticker at the signing ceremony). Second, initial public offering (IPO) activity has fallen. If M&A is the main way that a company falls off the stock exchange, then IPOs are the main source for new supply. According to the Credit Suisse report we noted above, the average number of IPOs every year from 1976 to 2000 was 282. From 2000 to the present the average annual number was a mere 114.
Long story short – M&A fever has raged while the IPO market has slumbered. This in itself is unusual. Historically, strong equity markets tended to encourage both M&A and IPOs. That makes sense – companies feeling flush look to bulk up by taking out competitors or to buy their way into new industries, while start-up founders want to cash in with the high valuations available in bull markets. But that positive correlation no longer holds. From 1976 to 2000 the correlation between M&A and IPO activity was 0.87 (1.0 being perfect positive correlation). From 2007 to 2016, the correlation is actually negative: minus 0.08. Those start-up founders apparently have other, more enticing options for cashing in.
The Changing Market For Private Capital
And indeed, those alternatives exist. Probably the most noteworthy, in terms of explaining the diminished attractiveness of IPOs, is the growth of late-stage venture capital / private equity. Venture capital used to be concentrated in the early years of a start-up company’s history, with the VCs motivated to get their investments through successive funding rounds and out the door into the public markets via IPO as fast as possible. Now there is a whole distinct asset class of late-stage private investors. This includes most of the major mutual fund families, like Fidelity and BlackRock, that operate dedicated late stage private equity funds. This asset class provides a level of liquidity that previously could be found only in public markets. For example, late stage private deals allow start-up founders and their employees to cash out some of their stock and options – again, reducing the natural pressure to go public.
The Implications for Asset Allocation
So the story about how we wound up with so many fewer public companies is relatively easy to understand. But that second question we posed a few paragraphs ago remains outstanding. Is the long term investor with a diversified portfolio missing out on a major asset class exposure by not being invested in private equity?
This is a question we take seriously: after all, our primary job is to construct portfolios with a prudent level of diversification aligned with each client’s specific investment objectives and risk considerations. The data thus far are somewhat inconclusive, with attendant benefits and costs.
For example, while there may be fewer publicly traded companies out there, the total market capitalization of the US stock market is more than 1.35 times the value of US real gross domestic product (GDP). By comparison, total market cap in 1976 was just 0.47 times GDP, and in the late 1990s, when the number of listed firms peaked, it was 1.05 times. The collective profits of all listed firms today is close to 9 percent of GDP versus 7 percent in 1976. And share volume – hence liquidity – is at record levels today.
For investors there are other potential downsides to owning private equity, including reduced transparency and less consistent, available data for performance benchmarking. On the other hand, it is not possible to simply dismiss the reality of a new structure to the US capital market and the existence of distinct new asset classes large enough to demand consideration, if not inclusion, for long term diversified portfolios. We will have more to say about this in the coming weeks and months.
Sentiment travels quickly in the hyperkinetic world of the global capital markets. Just a week ago, the talk of the town was all about the Great Rotation. After weeks, months…nay, years! of underperformance, value stocks looked poised to unseat the great megatrend in growth stocks.
Remember one week ago? Facebook tanked as investors found reasons aplenty not to like the company’s earnings report, which suggested that stupendous revenue growth in the mid-40s would turn into not-quite-as-stupendous revenue growth in the mid-20s, and fat profit margins in the mid-40s would become somewhat less obese (though still hefty) profit margins in the low 30s. Facebook’s woes came on the heels of an earlier subdued outlook by Netflix and was followed by more downbeat headlines from Twitter (apparently being the official platform for the communication of US government policy doesn’t add much in the way of monetary value…). Suddenly FAANG nation (and its fellow travelers like Twitter) was in trouble! Rotation to value in three…two…one…
Blessed Be The Fruit
And then there was Apple, and the $1 trillion market capitalization that swiftly dispatched away all that talk of a Great Rotation from growth to value. As the chart below shows, growth (in green) has recovered quite nicely, thank you, in the space of the past three days.
The only thing financial pundits love more than talking about a market rotation is talking about big round numbers, and they don’t get bigger or rounder than $1 trillion. Value rotation, we hardly knew ye!
The Unsolved Mystery of Value Investing
Now, the fact that we have to bide our time for awhile longer before value stocks come back into favor does not do anything to solve the big mystery of what, in the name of all that is good and wholesome, ever happened to value stocks in the first place. After all, the “value effect” is supposed to be one of the fixtures of long term investing. The value effect holds that investing in stocks whose market price is lower than their fundamental value pays off. Over time, you are more likely to perform well by buying and holding out-of-favor names that are mispriced by the market than you are by getting into a hot growth name that everyone else is chasing.
The logic behind the value effect seems impeccably tight. But the numbers tell a different story. Over the last thirty years, the value segment of the Russell 3000 stock index, a broad measure of US stocks, actually underperformed the broader index. Not by much – the Russell 3000 Value returned an average annual 10.38 percent compared to 10.53 percent for the Russell 3000. But still – that’s a 30 year span of time, nearly one third of a century. And the numbers don’t improve. The value index underperformed growth over most time periods since then, with the gap between them increasing. Over the last five years a growth investor outperformed her value counterpart by more than 5 percent on an annual average basis.
The Software That Ate the World
The value conundrum is occupying quite a bit of our research brainpower here at MV Financial and we plan to come out with a more in-depth research piece on the topic some time in the coming weeks. One way of looking at the mystery is supplied by Marc Andreessen, the Silicon Valley venture capitalist and founder of Netscape (hi, kids! That was a browser we used back in the days when we used to dial into our AOL accounts. See “hissing modems”…). Back in 2011 Andreessen penned an article called “Why Software Is Eating the World.” The premise was that software platforms were encroaching into the central business value propositions of practically every industry sector, with the lion’s share of rewards falling to those companies most adept and developing and deploying technology solutions for their markets.
At the time Andreessen’s article was dismissed by many as so much Valley technobabble, but it has stood the test of time. Just look at what happens on any given day when, say, Amazon threatens to enter the retail pharmaceutical business or buys Whole Foods. Competitive industry dynamics these days do appear to be about little else than the deft execution of hard-to-imitate software platforms.
If Andreessen’s thesis is behind the growth stock megatrend, then investors will not be too happy when the FAANG sharks and their extended court of growth stock pilot fish do run out of upside. The result may be less an orderly reversion to mean while value stocks run for a while, and more a winding down of this historically long bull market. We are not suggesting that this is imminent, but it does bear watching. Meanwhile, detective work on the Case of the Missing Value Effect will continue apace.
Something interesting happened earlier this week – well, interesting for those who like to read meaning into round numbers. The number in question is 2, as in 2.0 percent, as in the yield on the 3-month US Treasury bill reached on July 18, the first time this widely used proxy for “cash” breached 2 percent since before the 2008 recession. The practical impact of this round-number event, though, is that it extends a trend underway since April; namely, that the yield on cash is now greater than the dividend yield on large cap stocks. The chart below shows the spread between the S&P 500 dividend yield and the 3-month T-bill over the past 5 years. After a yawning chasm for much of the post-recovery period when interest rates were held close to zero, the Fed’s monetary tightening program begun in late 2015 has now closed and reversed the dividend-cash spread.
Meet the New Spread, Same As the Old Spread
There is nothing unusual about cash returns exceeding the dividend yield; it is usually a feature of a recovery cycle. For example, over the course of the growth cycle from 2003-07 the yield on the 3-month Treasury bill was 3.0 percent, compared to a dividend yield on the S&P 500 of 1.7 percent. As we have often noted in these commentaries, though, this most recent growth cycle has been profoundly different. When short term rates started trending up at the end of 2015 the recovery was already five years old. It’s unheard of for interest rates to stay so far below dividend yields until nine years into the recovery.
But, of course, this was no accident. Rates were kept low in order to stimulate risk appetite after the 2008 financial crisis. Essentially, the Fed induced investors to move into riskier assets by making it as economically unattractive as possible to invest in risk-free securities. The European Central Bank of course went even further – they made investors actually pay – via negative interest rates – for the “privilege” of holding Eurozone credit obligations.
Welcome to the Jungle
Now that investors can actually get something in the way of a return on their cash allocations, however modest, market pundits are raising the chatter volume on whether this signals a potential cyclical drift out of equities into safer investments (similar to the very much related concerns about the yield curve we addressed last week). Another way to put the concern is this: can equities and other assets with higher risk properties still be attractive without the explicit inducement by monetary authorities? We’re back in the market jungle and ready to test the survival skills of common shares in the wild, goes this train of thought.
As with any other observation made without the assistance of a fully functioning crystal ball, the answer to that question is “it depends.” What it depends on, primarily, is the other component of value in a share of common stock beyond dividends: capital appreciation. In the chart above, the capital appreciation variable is the dotted crimson line representing the price appreciation in the S&P 500 over this five year period. While getting close to 2 percent each year from dividends, investors enjoyed substantial capital gains as well.
What the spread reversal between cash and dividends does more than anything else is to put paid to the “TINA” mantra – There Is No Alternative (to investing in stocks and other risk assets). The calculus is different now. An investor with modest risk appetite will need to be convinced that the dotted red line in that chart above has more room to move upwards. The dividend component of total return is no longer free money – there is now an alternative to that with a slightly better yield and less risk. The rest will have to come from capital appreciation.
Now, we have argued in recent commentaries that the growth cycle appears durable, given the continuity in macro growth trends and corporate sales & earnings. The numbers still would appear supportive of further capital appreciation. But we also expect that the change in the TINA equation will have an effect on capital flows at the margins. Whatever money is still on the sidelines may be less inclined to come into the market. At the very least, investors on the sidelines skeptical of how much longer the bull has to run will have a better reason to stay put in cash. If enough of them do so it can become a self-fulfilling trend.
The transition from summer to fall is always an interesting time in markets, as a consensus starts to form around what the driving trends of the fourth quarter will be. There’s enough at play right now to make the stakes particularly high this year.
If you have paid any attention to the daily dose of financial media chatter over the past month or so (and we are of the firm opinion that there are many, many more productive ways to spend one’s time) you have no doubt come into contact with the phrase “flat yield curve.” If the phrase piqued your interest and you listened on, you would have learned that flat yield curves sometimes become inverted yield curves and that these are consistently accurate signals of imminent recession, going back at least to the beginning of the 1980s.
This topic is of particular interest today because the yield curve happens to be relatively flat. As we write this the spread (difference) between the 10-year Treasury yield and the 2-year Treasury yield – a common proxy for the yield curve – is just 0.25 percent. That is much tighter than usual. In fact the last time the yield curve was this flat was in August 2007 – and any financial pundit worth his or her salt will not hesitate to remind you what happened after that. The chart below diagrams the longer-term relationship between 10-year and 2-year Treasury yields going back to 1995.
Before the Fall
In the above chart we focus attention on two previous market cycle turns where a flat or inverted curve was followed by a recession and bear market environment: 2000-02, and 2007-09. It is true that in both these instances a recession followed the flattening of the curve (the red-shaded columns indicate the duration of the equity market drawdown). But it’s also important to pay attention to what happened before things turned south.
Both of these bear market environments were preceded by an extended period of growth during which the yield curve was also relatively flat. These “growth plus flat curve” periods are indicated by the green-shaded columns in the chart. As you can see the late 1990s – from about mid-late 1997 through the 2000 stock market peak – were characterized by very little daylight between the 2- and 10-year yields. The same is true from late 2005 through summer of 2007 (the S&P 500 peaked in October 2007 before starting its long day’s journey into night).
You Can Go Your Own Way
In both of those prior cases, in other words, a flattening yield curve wasn’t a signal of very much at all, and investors who took the cue to jump ship as soon as the spread went horizontal missed out on a considerable amount of equity market growth. In fact, the dynamic of “flat curve plus growth,” far from being unusual, is not unexpected. It has to do with what the respective movements of short term and long term yields tend to tell us about what’s going on in the world.
Short term rates are a much more accurate gauge of monetary policy than yields with more distant maturities. If bond investors anticipate an upcoming round of monetary tightening by the Fed, they will tend to move out of short-term fixed rate securities, sending yields on those securities higher. When does monetary policy normally turn tighter? When growth is heating up, of course – so it should be no surprise that short term rates will start trending up well before the growth cycle actually peaks.
Longer term yields, on the other hand, are much less predictable and tend to go their own way based on a variety of factors. For example, in that 2005-07 period when short term rates were trending up, the 10-year yield stayed relatively flat. Why? Because this period coincided with the height of China’s “supercycle” during which Beijing routinely bought gobs of Treasury bonds with its export earnings, building a massive war chest of dollar-denominated foreign exchange reserves.
To Every Cycle Its Own Story
At the same time, many other central banks were building up their FX reserves so as to not repeat the problems they experienced in the various currency crises of the late 1990s. Yes – the late 1990s, when economies from southeast Asia to the former Soviet Union to Latin America ran into liquidity difficulties and injected a massive amount of volatility into world markets. Global investors responded to the volatility by seeking out safe haven assets like – surprise! – longer-dated US Treasury bonds. Which partly explains why the yield curve was so flat from ’97 through the 2000 market peak.
So yes – at some point it is likelier than not that we will see another flat-to-inverted yield curve lead into another recession. Meanwhile, the dynamics driving longer-term bond issues today are not the same as the ones at play in the mid 2000s or the late 1990s. Maybe spreads will widen if a stronger than expected inflationary trend takes root. Maybe the 10-year yield will fall further if US assets are perceived to be the safest port in a global trade war storm. The important point for today, in our opinion, is that there is a resounding absence of data suggesting that this next recession is right around the corner. We believe there is a better chance than not for some more green shading on that chart between now and the next sustained downturn.