Posts tagged Current Market Trends
Every profession has its core mantra. The mandarins of medicine solemnly invoke the Hippocratic oath (first of all, do no harm). “Equality under the law” say the Doctors of Jurisprudence. In the practice of investment management, generations of money men and women since the 1930s have been trained thus: “in the long run, value outperforms growth.” The value effect has gone through some iterations since Benjamin Graham and David Dodd bestowed their masterpiece “Security Analysis” on the investment world in 1934, but it has largely stood the test of time. It’s not a difficult premise to grasp: buying stocks whose price is relatively cheap when compared to certain fundamental valuation measures – like book value, cash flow or net earnings – is on average a better long term investment approach than favoring the more expensive stocks that get red-hot and then flame out just as quickly.
Anomaly, or New Normal?
So far in 2017, value investors are taking cold comfort in the time-tested wisdom of their philosophy. The Russell 3000 Value index, a broad-market measure of value stocks, is up 2.50 percent for the year to date. Its counterpart, the Russell 3000 Growth index, is up a whopping 13.68 percent. That is the kind of performance gap that will make the most lackadaisical of investors do a double-take when their quarterly statements show up in the mail. And their value fund managers are reliving the nightmare that was the late 1990s, when ticky-tack dot-coms regularly crushed “old economy” stocks and made instant (if very short-lived) experts out of amateur punters the nation over.
Now, we all know that it is inadvisable to draw larger conclusions from a relatively small time window. But the value effect’s failure to stick the landing extends much further than the current market environment. The chart below shows the relative performance of these same two Russell value and growth indexes over the past fifteen years.
These fifteen years encompass multiple market cycles, from the depths of the dot-com crash to the commodity boom cycle of the mid-2000s, then the 2008 market crash and subsequent recovery (which itself contains at least three sub-cycles). As the chart shows, investors who stuck with a growth discipline performed substantially better than their value counterparts over the course of this period.
The Fleetingness of Factors
Is the value effect dead? Or is it “just resting,” like the Norwegian blue parrot in the Monty Python sketch? When we look at the long-term durability of factors, we tend to follow the methodology of prior generations in using a 30 year window of analysis. When Eugene Fama and Kenneth French (then at the University of Chicago) produced their groundbreaking analysis in 1992 of the value effect and the small cap effect (“The Cross Section of Expected Stock Returns”, published in the Journal of Finance), 30 years was the duration of their time series. Fama and French concluded that both value (defined as low market-to-book value) and small market capitalization were long-term outperformers relative to the broad market.
Looking back 30 years from today, value still retains a small edge over growth, while small cap appears to have lost the performance edge that Fama and French reported. The chart below shows the performance of the Russell 3000 Value and Growth, along with the Russell 2000 Small Cap index, over this 30 year period from 1987 to the present.
Value stocks (the blue dot just up and to the left of the broad market benchmark) returned 9.99 percent per annum on average over this 30 year period, which amounts to 0.21 percent more than the broad market. Now, 21 basis points per annum is nothing to sneeze at, particularly as it came with slightly less volatility. But, as the earlier 15 year performance chart showed, growth stocks have outperformed consistently over virtually the entirety of the period from 2009 to the present. The 1992 insights of Fama and French do appear to have diluted somewhat over time.
It’s too early to pronounce the value effect as dead. But factors – even the most durable ones – are never a guaranteed win. Today’s investors on the receiving end of pitches by “smart beta” managers – those sexy factor-based approaches that are currently all the rage – should always remember what is in our opinion the only investment mantra worth its salt: “there is no such thing as a free lunch.”
Another week, another record for stocks. Sadly for those of us inclined to jump at “buy the dip” opportunities, the window now appears to bangs shut almost before we even know it’s open. It took a mere five trading days to fully atone for last Wednesday’s mini-squall, with two new all-time highs following in quick succession. C’mon stockpickers, haven’t you ever heard the phrase “sell in May?” Throw us bargain hunters a bone or two!
Bond Bears, Beleaguered
Whatever is in the water in equity-world still has not made it over to the more subdued climes of fixed income. While the S&P 500 is just shy of eight percent in price appreciation this year, the yield on 10 year Treasury securities ambles along in the neighborhood of 2.25 percent, well below where it started the year and further still below the 52 week high of 2.6 percent. The chart below illustrates the alternative mentalities driving stock and bond trends this year.
The dourness is showing up in other credit markets as well. Average rates for 30 year mortgages finished this week at their lowest level for the year. Long-dated Eurodollar futures contracts, which reflect what traders think Libor levels will be up to 10 years in the future, indicate that we should expect a world of low inflation and low real interest rates well into our senescent years. The “10-2 spread” – the difference between intermediate and short term yields that we discussed in some detail a couple weeks back – is narrower than at any time since last November’s election. Reflation trade, we hardly knew ye!
On one level, the bond market’s lackadaisical drift is not all that surprising. It dovetails with the relentless monotony of an overall macroeconomic narrative that – at least according to the usual “hard” data points of labor, prices and output – has barely changed over the past twelve months. Low growth and restrained inflation are entirely consistent with sub-3 percent 10 year yields (unsurprisingly, the forecasting mandarins at banks such as JP Morgan and Goldman Sachs have lowered their 2017 expectations accordingly). The shiny veneer of the reflation trade has been wiped clean to reveal the same old undercoat of modest growth, with no evidence of a productivity-driven catalyst to bring the growth trend closer to the norms of decades past. Yes, the world’s major economies are aligned to a remarkable extent in their growth trajectories – GDP growth rates are trending in near-lockstep in the US, Europe and Japan. That alignment alone, though, does not suggest some emergent property to drive the trend higher.
And then there was the other dog that didn’t bark this week to send yields soaring. The minutes from the FOMC’s last meeting earlier this month made their way into public hands on Wednesday, offering a peek into the Fed’s thinking about starting to wind down its $4.5 trillion balance sheet in the coming months (the vast majority of which is in the form of Treasuries and mortgage backed securities). This winding down, many have noted, will involve some fancy footwork on the Fed’s part to avoid the kind of tantrums that sent bond markets into a tizzy back in 2013.
As it happened, though, the minutes gave little indication of anything other than that the Fed feels comfortable getting the process underway sometime in 2017. There’s also a question about how much “winding down” will actually happen. A recent study by the New York Fed suggests that a “normalized” balance sheet of $2.8 trillion should be achieved by 2021. Now, in 2010, before the second and third quantitative easing programs kicked in, the Fed had about $2.1 trillion on its balance sheet. So “winding down” would not mean going back to anything close to earlier “normal” balance sheet levels. Higher for longer. Tantrum fears may once again be somewhat overblown.
Red Bull and Tech Stocks
So what’s still driving equities? “No reason to sell” is about as good an answer as any, and that sentiment was clear in the market’s quick snap-back from last week. Tech stocks continue to lead the way while the former reflation trade darlings – financials, industrials and materials – lag. We appear to have reached the point where politics and global events are utterly irrelevant to market movements (the VIX’s retreat from last Wednesday’s spike was even brisker than the stock market recovery). Q2 earnings are expected to be decent, no recessions as far as the eye can see…what’s not to love? As Jo Dee Messina would say – “it’s a beautiful day, not a cloud in sight so I guess I’m doin’ alright.” For now, at least.
Anyone who has lived for some time in a city like Los Angeles or Tokyo knows what an inconsequential tremor is. You feel that shaking motion, perhaps hear some objects rattling on your desk. You momentarily catch your breath, and then it’s all over, usually within the span of less than ten seconds. Those inconsequential tremors happen frequently in any city with proximity to a major tectonic fault line. Only rarely – very, very rarely – do they develop into a serious earthquake capable of creating lasting damage.
Pullbacks by the Numbers
As with seismic tremors, so with financial markets. Our natural inclination is to not even categorize Wednesday’s 1.8 percent pullback in the S&P 500 as a tremor. Since it did briefly puncture the preternaturally serene calm prevailing in markets as of late, though – and come as it did amidst a new level of political volatility in Washington – we think this is a good time to dust off that pullback study – long unused – and remind our clients that tremors generally do not an earthquake make.
Our standard measure for a “pullback event” as it pertains to US large cap stocks is a retreat of five percent or more from a high water mark, followed by a subsequent recovery of five percent or more. There is no higher truth associated with the five percent threshold, but we think it is a useful benchmark. A five percent decline has impact – the TV talking heads take notice and investors feel those ephemeral goosebumps – but it falls short of a technical correction (10 percent off the high) or a bear market (20 percent retreat).
By this standard, there have been 190 pullback events on the S&P 500 since the end of the Second World War, or about 2.7 every year, on average, for the 71 years between then and now. And how many times did the pullbacks metastasize into full-fledged bear markets? Well, there was a very brief bear – about seven months in duration – from the end of 1961 to midsummer 1962. There was the dismal stretch from the record high of November 1968 to August 1982, which is how long it took for the S&P 500 to forever rise above that (nominal) ’68 high and bid it goodbye. And there were the two bear markets that bookended the first decade of the 21st century.
And that’s pretty much it for bear markets (Black Monday 1987, yeah, but that was basically a flash crash, not a bear proper). Mostly, those pullback events are just inconsequential tremors with no particular sustaining narrative. Revolutions, it is often noted by political historians, don’t happen far more often than they do happen.
Much Ado About Nothing
No two bear markets are alike, but the forces that propel them tend to arise organically from the thousands of disparate nodes of activity in the economy, and not from singular events in Washington DC. Whatever outcomes happen as a result of the current political and legal woes of the Trump administration – even the more far-fetched notions of some form of removal from office or a doubling-down of the crazy by the current residents of 1600 Pennsylvania – are highly unlikely to exert a meaningful impact on the economy at large. The slow-growth recovery continues at home and abroad. Quarterly earnings seem able to sustain at least mid-high single digit growth rates over a full fiscal year. These trends preceded Trump, and these trends seem likely to keep on keeping on.
We have no trouble imagining a near-term scenario that registers another five percent-plus pullback event in keeping with our definition above. We haven’t had one since February 2016, and that’s a long dry spell (remember that 2.7 events per year statistic we cited above). In the absence of any data implying a potential meaningful shift in the overall economic narrative, though, we are likely to consider any such event as yet another inconsequential tremor.
Another Friday, another “hard” piece of data that comes in shy of expectations. The Bureau of Economic Analysis released the first estimate of Q1 2017 real GDP growth, and the 0.7 percent quarter-on-quarter growth rate was a bit below economists’ consensus estimate of one percent. As a standalone data point this does not tell us very much. There will be two further revisions that could increase (or reduce) this first estimate. Q1 is notoriously subject to seasonal factors; for example, a warmer than average winter resulted in lower utility consumption by households, which in turn had a slowing effect on personal consumption expenditures. The first quarter of 2016 also produced sub-one percent growth, but that perked up to more robust levels as the year played out. As always, one data point doth not a trend make.
That being said, today’s release will do little to shed light on the mysterious “hard versus soft” debate that has been a staple on the menu of financial gabfests this year. The GDP number comes on the heels of two other underwhelming “hard” macro releases of recent Fridays past: headline inflation below the Fed’s two percent target, and March payroll gains falling short of 100,000. By contrast, a number of “soft” numbers reflecting sentiment among consumers and small business owners have being going gangbusters; by some estimates consumer confidence is higher than it has been any time since the tech bubble peak in 2000. The upbeat sentiment has served for many in the commentariat as an easy go-to explanation for the stock market’s bubbly performance in the year to date (our own take on the market is a more mundane assessment of momentum feeding on itself, more or less impervious to outside catalysts).
Hard, Hard Road
The sentimental bullishness may yet converge into the subdued hard numbers, but it’s not a given. Take retail sales, which posted a modest gain in February and then fell in March. Now, with consumer sentiment being so jazzed up, shouldn’t some of that effervescence be showing up in the actual spending numbers? You can’t blame the weather for this one: those balmy February days should have been mall and DIY store magnets. In fact, the poor showing of retail sales throughout the first quarter was as good a sign as any that GDP might come up short. Seventy percent of growth in output is driven by consumer spending. If consumers aren’t walking the walk, then all the happy talk in the world isn’t going to move the growth needle.
And Now for the Ugly
Behind all these month-to-month metrics we use to measure the economy’s health is the grim reality that long-term growth remains challenged by three major headwinds: declining population growth, a smaller percentage of the population at work in the labor force, and anemic levels of total factor productivity. Of those three headwinds, the only one that can plausibly deliver growth as we know it is productivity. It was the unique convergence of productivity advances with baby boom demographics that delivered the amazing, historically unprecedented growth rates of the 1950s and 1960s. The demographics are no longer in our favor, so to have any growth at all we will need to see some material evidence that all the technology innovations of the last 10 to 15 years can deliver a new, sustained dose of productivity gains. Until that happens, we should not expect to see the kind of go-go growth being promised by some who should know better (ahem, Treasury Department tax plan crafters). At some point, sooner rather than later, this reality will likely make itself known in the soft data as much as the hard.
How much of an X-factor is European political risk in 2017? We got a partial answer (not much) from the outcome of the Dutch elections last month, which maintained the status quo even as the traditional center right and center left parties fared relatively poorly. We will get another drip-drip of insight this Sunday evening, as election officials tally up the results of the first round of voting in the French contest. There has been some nervous chatter among the pundits, mostly revolving around the scenario – unlikely but plausible – of a second round contest between Marine Le Pen and Jean Luc Mélenchon. Markets, however, appear unfazed. The euro is holding ground at around $1.07, and the spread on the French 10-year yield over the commensurate German Bund is 61 basis points, down from 78 in the wake of a flurry of Mélenchon-friendly polls last week. And, as the chart below shows, Eurozone equities are holding their outperformance gains versus the US S&P 500.
The “what, me worry?” vibe boils down to a singular view that the ultimate winner of the election will be centrist Emmanuel Macron, a former economics minister and investment banker who cobbled together a new political movement to challenge the loathed traditional parties of the Socialists and Republicans. Macron’s platform is in line with the technocratic sensibilities of EU policy institutions and the IMF, focused on the integrity of the EU and the Eurozone with incremental rather than radical policies for dealing with the region’s ongoing difficulties.
Should Macron ultimately prevail, the market’s current positioning could augur for more outperformance ahead. Economic numbers continue to give cheer; the latest PMI readings show both manufacturing and services at a six year high. Growth, inflation and employment trends all continue to move in a positive, if still modestly so, direction. Other political risks lurk, notably in Italy, but the capacity to surprise will be greatly diminished if the French contest plays out as expected.
Zut alors, c’est le surpris!
What if Macron doesn’t win? If for no other reason, 2016 was instructive in explaining the pitfalls of polls and the many random factors that can lead to an outcome other than the highest-probability one. What will markets do on Monday morning if the two candidates left standing are Le Pen and Mélenchon? The short answer, given where markets are priced today, would probably be a pullback of somewhere between 5 – 10 percent for regional equity indexes and a move to haven assets like US Treasuries and German Bunds. That is what happened after the shock delivered by the Brexit vote last June. That pullback, though, as you will recall, was brief and contained. Within weeks of Brexit, equity markets had rebounded and the S&P 500 finally set its first record high in 14 months.
In the long run, we believe a Le Pen or Mélenchon victory would be of enormous consequence for the EU, more so than Britain’s exit. The market’s apparent ability to breezily whistle past every potential calamity would be tested perhaps more than in other recent political risk events. But if we have learned anything about Europe in the last seven years, starting with the wheels coming off the Greek economy, it is that European policymakers are masters of the craft when it comes to kicking the can down the road.
At some point – whether it be from disgruntled citizens voting centrists out of office, a round of financial institution failures or something else – the original flaws of the single currency design will likely deal a potentially deadly blow. But we have no reason to believe that reckoning is any time soon. Our advice to our clients should not surprise any regular reader of this column: resist the impulse to make any rash positioning plays either in advance of or following Sunday’s outcome, or that of the second round in early May.