Posts tagged Current Market Trends
Readers of a certain age might remember a perennial favorite among the many outstanding skits performed by late-night TV host Johnny Carson (hi, kids! – ask your parents or their parents). Playing a manic movie review host named Art Fern, Carson would suddenly display a spaghetti-like road map and start giving inane directions to somewhere, leading to the gag: “And then you come to – a fork in the road” at which moment he points to a space on the map where an actual, eating utensil-style fork is crudely taped over the incoherent network of roads. Ah, kinder, simpler, Twitter-less times, those were.
The fork in the road was a key theme of our annual outlook a couple months ago (no match for Art Fern in wit or delivery, but still…). Are we heading down one path towards above-trend growth powered by an inflationary catalyst, or another one characterized by the kind of below-trend, muted growth to which we have become accustomed in this recovery cycle thus far? For now, the data continue to point to the latter.
No Seventies Show, This
Carson’s heyday as host of the Tonight Show was in the 1970s, that era of cringe-worthy hairstyles, mirror balls and chronic stagflation. When the Bretton Woods framework of fixed currencies and a gold exchange standard fell apart in the early years of the decade it freed countries from their exchange rate constraints and encouraged massive monetary stimulation. The money supply in Britain, to cite one example, grew by 70 percent in 1972-73 alone. More money chasing the same amount of goods is the classic recipe for inflation, which is exactly what happened. OPEC poured flames on the fire when, as a geopolitical show of strength, it raised crude oil prices by a magnitude of five times in late 1973. A crushing global recession soon followed as industrial output and then employment went sharply into reverse, with countries unable to stimulate their way out of the mess caused by inflation.
A popular delusion in the immediate wake of the 2016 US presidential election was that some modern day variation of that early-70s stimulus bonanza was about to flood the economy with hyper-stimulated growth. Interest rates and consumer prices would soar as the new administration tossed out regulations, slashed taxes, lit a fire under massive public infrastructure and induced companies to kick their production facilities into high gear. The “reflation-infrastructure trade” flamed out a couple months into 2017 (though CNBC news hosts never got tired of hopefully invoking the shopworn “Trump trade is back!” mantra for months afterwards, every time financial or materials shares had a good day).
Herd-like investor tendencies aside, though, there was – and to an extent there continues to be – a case to make for the return of higher levels of inflation. Economies around the world are growing more or less in sync, which should push both output and prices higher. Taxes were indeed slashed – the one piece of the reflation trade puzzle that actually transpired – and as a result the consensus estimates for US corporate earnings have moved sharply higher. And yet, the numbers keep telling us something different.
Secular Stagnation Then, and Now
When we say “numbers” we refer generally to the flow of macroeconomic data about growth, production, consumption, labor, prices et al, but we’ve been paying particular attention to inflation. The core (excluding food and energy) Personal Consumption Expenditure (PCE) index, which is how the Fed gauges inflation, has been stuck around 1.5 percent for seemingly forever. This past Tuesday gave us a fresh reading on the core Consumer Price Index (CPI), the one more familiar to households, holding steady at 1.8 percent. We also got another lackluster reading on retail sales this week, suggesting that consumption (the largest driver of GDP growth) is not proceeding at red-hot levels. And last week’s jobs report showed only a modest pace of hourly wage gains despite a much larger than expected increase in payrolls. These numbers all seem to point, at least for now, towards the path of below-trend growth. Perhaps the bond market agrees with this assessment: the yield on the 10-year Treasury has been cooling its heels in a tight range between 2.8 – 2.9 percent for the past several weeks.
The economist Alvin Hansen coined the phrase “secular stagnation” back in the late 1930s, at a time when it seemed that long term growth lacked any catalyst to kick it in to a higher gear. We know what happened next. The war came along and rekindled productive output, followed by the three decades of Pax Americana when we ruled the roost while the rest of the world rebuilt itself from the ashes of destruction. Former Treasury Secretary Lawrence Summers brought the term “secular stagnation” back into popular use earlier in this recovery cycle. The numbers seem to tell us that this remains the default hypothesis.
But the story of the late 1930s reminds us that all a hypothesis needs to knock it off the “most likely” perch is the introduction of new variables and resulting new data. Foremost among those variables would be productivity (hopefully productivity from benign sources, and not from hot geopolitical conflict). It may well be that we have not yet arrived at that “fork in the road” but are still somewhere else on Art Fern’s indecipherable road map – and that a new productivity wave will pull us off the path of secular stagnation. The data, though, aren’t helping much in signaling when, where, and how that might happen.
It hasn’t been quite the V-shaped recovery of many pundit prognostications. The S&P 500 briefly entered technical correction territory last month, and flirted ever so coquettishly with the 200-day moving average, a key technical trend variable. The ensuing relief rally has seen a couple peaks, but is still climbing the wall back to the record close of 2872 reached on January 26. A month and a half may not seem like a long time – and it’s really not a long time, in the great scheme of things. But other recent pullbacks have done a better job at channeling their inner Taylor Swifts to “shake it off.” The chart below show the pace of the current recovery (leftmost diagram) compared to the brief pullbacks experienced after 2016’s Brexit vote (middle) and the mini-freakout over Ebola in 2014 (right).
So at 42 days, we’re a bit behind the brisk pace of the Brexit (30 days) and Ebola (27 days) pullback-recovery events. But it’s not too much of a stretch to imagine the S&P 500 finding itself scaling the rest of that wall to 2872 in the not so very distant future. Over the course of the current recovery, investors have learned to build an impressive immunity to what one might consider to be bad news. In a sense this is an acquired habit, courtesy of the world’s major central banks.
It Was Just Nine Years Ago Today, Ben Bernanke Taught the Band to Play
Speaking of the “current recovery,” today is its nine year anniversary! Three cheers for the bull. On March 9, 2009 US equity markets hit rock-bottom, more than 50 percent down from their previous highs in the largest market reversal since the Great Depression. Investors in early 2009 were catatonic – many who had managed to keep their heads during the freefalls in September and October of the previous year finally capitulated in March, fearing there was potentially no bottom for risk assets.
Those who held off the demons of fear one last time were rewarded mightily as stocks found solid ground and began the long trek back. But it was not exactly easy street for those first tentative years. 2010 witnessed a handful of significant pullbacks and lots of angst. In 2011 the market flirted with bear territory (20 percent or more down) when the Eurozone crisis accelerated and the US Congress came ever so close to defaulting on the national debt. Other potential black swans lurked in the following years, from government shutdowns to the crash in oil prices to fears of a hard landing in China.
But as each news cycle came and went investors learned to stop worrying. Credit for this learned behavior can confidently be laid at the feet of Ben Bernanke, Mario Draghi, Haruhiko Kuroda and Janet Yellen, along with a supporting cast of dovish policymakers in their respective central banks. The “central bank put” was solidly in the money and increased in value throughout the recovery, even as the US Fed started to lead the way out of monetary Eden as it ended quantitative easing and began to raise rates. The investor calculus was simple: things will work out, and if they don’t, the banks will step in and bail us out. This way of thinking finally led to that unreal calm in the markets in 2017. Even the wackiest of political shenanigans failed to make an imprint on investors trained to embrace the Panglossian assurance of the best of all possible worlds for risk assets.
O Brave New World, That Hath Such Creatures In It
If the central bank put is the magic formula for maintaining calm, what to make of the tea leaves from recent statements by Yellen’s successor, Jerome Powell? The new Fed chair has been largely unimpressed by the recent market volatility and appears to see no reason for soothing bedtime stories to global investors. That should be a good sign: if the economy is doing well on its own, then markets should be able to take in stride the upward movement in interest rates and inflation that one would expect to follow from rising corporate sales and earnings. Nonetheless, it is a brave new world from the recent past.
Taken this way, it makes sense to ascribe the February pullback to nothing of any particular importance. The pullback started with a jobs report that showed wages growing at a 2.9 percent annual rate, higher than the recent trendline of 2.5 percent or so (though not particularly hot by historical standards). Trump threw some new fire on the flames last week with the unexpected announcement of punitive new tariffs on steel and aluminum. But the ingrained tendency to remain calm has largely prevailed. The general thinking on tariffs seems to be that they will fail to ignite an all-out hot trade war. Meanwhile, this morning’s jobs report had a double helping of good news, with a whopping 313,000 payroll gains alongside an underwhelming (therefore good!) average wage gain of 2.6 percent.
What if the wisdom of the crowd is wrong? What if dysfunctional politics and misguided fiscal policymaking still do matter? What if that productivity boom that is supposed to arrive any day now fails to show up, relegating the world economy to sub-par growth as far as the eye can see? Will there be another incarnation of the central bank put? Will it be as effective as it was for the last nine years? All questions without answers, for now. For the time being, though, it would appear that the news cycle will continue to leave investors unimpressed, where the smell of bad news must mean there’s a pony nearby. Your portfolio should enjoy this while it lasts.
Every fiscal quarter, publicly traded companies and the securities analysts who cover them engage in a series of time-honored rituals. The rituals follow the elaborate pantomimes of a Japanese Kabuki drama, and the underlying message is almost always the same: Hope Springs Eternal. Consider the chart below, which shows quarterly earnings per share trends for the S&P 500.
How to Speak Kabuki
Here’s how to interpret this chart. The green line represents projected earnings per share for the next twelve months. Basically, analysts project what they think will happen to the companies they analyze in the year ahead, based on the economic context and all the usual industry- and company-specific competitive variables, and those assumptions boil down to the one NTM (next twelve months) EPS figure. This chart shows the composite NTM EPS for all the companies in the S&P 500. For example, on January 31, 2017, the composite estimate for what S&P 500 shares would be worth a year hence (i.e. at the end of January 2018) was $133.17 per share.
The red line illustrates the actual earnings per share for the twelve trailing months, known in finance-speak as LTM (last twelve months). So if the green line represents the hope, then the red line shows the reality, or what actually happened. As you can see, the actual LTM earnings per share for the S&P 500 on January 31, 2018 was $118.08. It wasn’t $133, as the analysts had forecast a year earlier.
Moreover, the chart shows that this “reality gap” plays out in virtually every quarter, year after year. What often happens as earnings season approaches is that analysts start to dial back their earlier predictions to bring them closer to reality. In so doing, they are playing another important role in the Kabuki drama: managing expectations. Earnings season is only partly about the actual growth number; it is also about whether this number is better than, or worse than, what was expected. The downward revision that customarily takes place in the weeks before a company reports has the effect of lowering the bar, so that whatever number the management team actually reports has a better chance of beating expectations.
This Time Is (Sort of) Different
Clear as a bell, right? In summation: expected earnings are usually rosier than the actual figures that come out later, and the elaborate play-acting between management teams (forward guidance) and securities analysts (downward revisions to expectations) contrives to deliver happy surprises to the market.
Except that the script is a bit different this year. Analysts are actually raising – not lowering – their expectations for 2018 earnings performance. Let’s consider the case for Q1 2018. This is the quarter we are currently in, so we don’t know how the companies are actually going to perform. What we do know is that the analysts’ consensus estimate for Q1 S&P 500 earnings as of today is 17.1 percent growth. When the same analysts made their Q1 forecasts at the end of last year, the estimate was 10.9 percent. That’s a big difference! And not just for Q1. The analysts’ Q2 estimate is also significantly higher today than it was seven weeks ago. In fact, the consensus estimate for full year 2018 earnings growth is 18.2 percent, which is 8 percent higher than on December 31, when analysts predicted growth of just 10.3 percent.
That difference – the difference between 18 percent and 10 percent – matters a lot for equity valuation. If companies in the S&P 500 grow their earnings by 18 percent this year, then a similar rise in share prices will not make stocks any more expensive, when measured by the price-earnings multiple variable. That would ease investors’ worries about a potential share price bubble. Double digit price growth matched by double digit earnings growth is arguably the best of all possible worlds for long equity investors.
Here is the one caveat. Much of the apparent optimism in the current earnings projections comes from one single fact – the tax cuts enacted in December that were disproportionately skewed towards corporate tax relief. You can see from the green line in the above chart just how dramatically expectations accelerated right around the time the relief package took shape. More than any other factor, the tax cuts help explain why, contrary to the usual practice, earnings estimates have been raised rather than lowered as reporting dates come closer (though we should also note that a weaker US dollar, should it persist, could also be an earning tailwind for companies with significant overseas activities).
More to Life than Taxes
Investors should take in this seemingly good news with a measure of caution. First, to the extent that the tax relief does make a strong impact on the bottom line (which would be the case for companies that actually pay something close to the previous statutory tax rate, by no means a majority of S&P 500 companies) it will be a one-and-done kind of deal. The growth rate will kick up for one fiscal year cycle of “comps” – comparisons to the previous year – and then stabilize at the new level.
Second, there are other variables in flux that could at least partially offset the tax advantages. Corporate borrowing will be more expensive if (a) interest rates generally continue to rise and (b) credit spreads widen in response to higher market volatility. Companies in more price sensitive industry sectors may have to address issues of how much new inflation they can pass on to their customers. And, of course, corporate top lines (sales) will be dependent on the continuation of global economic growth leading to increased organic demand for their products and services.
Finally, the only way that companies can consistently grow their earnings above the overall rate of GDP growth is through productivity-enhancing innovations to their value chains. There may be a new wave of such innovations just around the corner – or there may not be. How these developments play out over the coming months will determine whether the current rosy predictions of the analyst community play out – or whether they quickly go back to that familiar old Kabuki script of hope and reality.
Watch the bond market: that was a core theme of our recent Annual Outlook and earlier commentaries in this brief, suddenly volatile year to date. Benchmark Treasury yields jumped on the first day of the year and never looked back. For the first month equities kept pace with rising yields, delivering the strongest January for the broad US stock market since 1987. Then it all went pear-shaped. Yields kept rising, while risk-on investors developed a case of the chills and sent stocks into a sharp retreat. The S&P 500 saw its biggest intraday declines since 2011, and the fastest move from high to 10 percent correction – 9 trading days – since 1980. Investors, naturally, want to know if this is just a long-overdue hiccup on the way to ever-greener pastures, or the start of a new, less benign reality.
The Expectations Game
The chart below shows the performance of the S&P 500 and the 10-year yield for the past 12 months through the market close on Thursday.
What caused that abrupt change in sentiment? Investors seemed perfectly happy to watch the 10-year yield rise from 2.05 to 2.45 percent last September and October, and again from 2.4 to 2.7 percent over the course of January. What was it about the move from 2.7 to 2.86 percent to precipitate the freak-out in stocks? The most widely cited catalyst has been the wage growth number that came out in last Friday’s jobs report; after growing at a steady rate of 2.5 percent for seemingly forever, the wage rate ticked up to 2.9 percent in January. According to this train of thought, the wage number raised inflationary expectations, which in turn raised the likelihood of a faster than expected rate move by the Fed, which in turn led to portfolio managers adjusting their cash flow models with higher discount rates, which in turn led to the sell-off in equities this week.
Algos Travel in Packs
There is a kernel of truth to that analysis, but it doesn’t really explain the magnitude or the speed of the pullback. For more insight on that, we turn to the mechanics of what forces are at play behind the actual shares that trade hands on stock exchanges every day. In fact, very few shares trade between actual human hands, while the vast majority (as high as 90 percent by some estimates) trade between algorithm-driven computer models. The “algos,” as they are affectionately known, are wired to respond automatically to triggers coded into the models.
On most days these models tend to cancel each other out, sort of like the interference effect of one wave’s crest colliding with another’s trough. But a key feature of many of these models is to start building a cash position (by selling risk assets) when a certain level of volatility is reached. Even before the selling kicked in last week, the internal volatility of the S&P 500 had climbed steadily for several weeks, while the long-dormant VIX was also slowly creeping up. The wage number may or may not have been a direct trigger, but enough of these models read a sell signal to start the carnage. Rather than waves canceling out, it was more like crests meeting and growing exponentially. More volatility then begat more selling.
The Case for Promise
So we’ve been given a taste of the peril that can come from higher rates. What about the promise? Here we leave the mechanics of short-term market movements and return to the fundamental context. The synchronized growth in the global economy has not changed over the past two weeks. The Q4 earnings season currently under way continues to deliver upside in both sales and earnings growth, while the outlook for Q1 remains promising. If wages and prices grow modestly from current levels – say, for example, so that the Personal Consumption Expenditure index actually rises to the Fed’s 2 percent target – well, that is in no way indicative of runaway inflation.
This should all be good news; in other words, if the current global macro trend is sustainable, it would strongly suggest that the current pullback in risk assets is more like a typical correction (remember that these normally happen relatively frequently) and less like the onset of a bear market (remember that these happen very infrequently). Higher rates have an upside as well, when they reflect positive underlying economic health. With one caveat.
The Debt Factor
Call it the dark side of the “reflation-infrastructure trade” that caught investors’ fancy in late 2016. The US is set to borrow nearly $1 trillion in 2018, much of which is to pay for the fiscal stimulus delivered in the administration’s tax cut package. That borrowing, of course, takes the form of Treasury bond auctions. A weak auction of 10-year Treasuries on Wednesday is credited for pushing yields up (and stocks down) late Wednesday into Thursday. These auctions, of course, are all about supply and demand. Remember that brief freak-out in early January when rumors floated about China scaling back its Treasury purchases? Supply and demand trends stand to weigh heavily on investor sentiment as the year progresses.
Now, a great many other factors will be at play influencing demand for Treasuries, including what other central banks decide to do, or not do, about their own monetary stimulus programs. Higher borrowing by the US may be offset if overseas demand is strong enough to absorb the expected new issuance. Time will tell. In the meantime, we think it quite likely that the surreal quiet we saw in markets last year will give way to more volatility, and to sentiment that may shift several times more as the year goes on between the peril and the promise of higher interest rates.
Something odd has been going on underneath the main headlines in investment markets over the past twelve months. The big story, of course, is how everything has gone up from US stocks to emerging market bonds to industrial metals, fossil fuels and more. All that is true -- and yet, there has been an unusual lack of correlation between the price movements of asset classes that normally track very closely.
Take equities, for example. In most years, the correlations between different equity asset classes, from US style classes to non-US developed and emerging markets, have been very close. Think of a horse race, with all the horses coming out of the gate together and basically running in the same direction at very similar speeds. This past year, though, the correlations between these asset classes have been very weak -- less like horses out of the gate, and more like letting a bunch of cats out of a box to wander around as each one sees fit.
2017’s Odd Math
Exhibit A is emerging markets. In 2017 emerging market equities rose, and so did the S&P 500. But statistically speaking, there was virtually no correlation between the two asset classes. The statistical measure of correlation is a spectrum from 1.0 (perfect positive correlation) to minus 1.0 (perfect negative correlation). A correlation of 0.0 suggests no tangible connection between whatever moved each individual asset over the time period measured -- each marched to its own set of influences.
In 2017 the correlation between the S&P 500 and the MSCI Emerging Markets index was 0.04 -- zero, for all intents and purposes. The average correlation over the past 5 years for these two asset classes was 0.59 -- statistically relevant positive correlation. 2017 was an anomaly. What the correlation tells us is that the fact of the S&P 500 and MSCI EM both going up that year was more coincidental than it was explained by similar driving factors.
An even odder pairing of wandering assets is seen in the US style classes of growth and value. The average correlation between the Russell 3000 Growth index and the Russell 3000 Value index over the past 5 years was 0.87 -- a very strong positive correlation. For 2017 the correlation was 0.23 -- still positive, but very weak. Correlation that weak between these two assets would make any covariance measures -- like alpha and beta -- statistically useless.
PMs Love Wandering Cats
An astute investor might say: So what? All those equity classes rose in 2017. Do I care how closely two assets are correlated? The answer is yes. It is important because portfolio managers make allocation decisions based in part on the correlation properties of the assets they include in a diversified portfolio. And for these managers, a bunch of wandering cats is actually much more attractive for portfolio inclusion than eight horses running in lockstep. The property of low correlation with other asset classes is value-additive; all else being equal, the manager would prefer combining emerging markets with the S&P 500 when the correlation is zero as opposed to when it is 0.6 or more.
So the key question is this: Did something change so structurally in 2017 as to suggest that correlations between historical birds of a feather (e.g. style and geographic equity asset classes) are moving to a lower plateau? Or are the wandering cats a one-off phenomenon, with the customary high correlations set to return in due course?
We’ll have to see what the numbers tell us as 2018 moves along. In the meantime, we will be testing out some hypotheses. One hypothesis is that the growth in passive investing -- primarily through ETFs -- is a catalyst for lower correlations. ETFs make it easier to trade asset classes wholesale, as opposed to the emphasis on individual stocks employed by traditional active managers. It’s entirely possible that this could lead to more pronounced variations between asset classes as the passive strategies, driven by more frequent short-term trading volumes, propel them in different directions on different days.
Now, why that would have only shown up in 2017 is another question, without a convincing answer. We’ll have a better sense of that a few months down the road. Expect to hear more about this from us as the year progresses.