Posts tagged Current Market Trends
It was a giddy era, a time of seemingly endless possibilities. At the beginning of 2000, New Media upstart AOL announced a planned takeover of one of the storied blue-bloods of the print world, Time Warner. Silicon Valley was awash in engineers and secretaries alike cashing in their millions in stock options and buying vineyards in Napa Valley. Affixing a “dot.com” to the name could turn just about any run-of-the-mill business proposition into a high-flying multimillion dollar enterprise.
And then it all ended, horribly. The NASDAQ Composite index, home to virtually all the newly-minted Internet hotshots, crashed through record high after record high on its way to 5048, the March 10, 2000 close. And that was the last time NASDAQ ever saw daylight, to paraphrase the movie Titanic’s Rose Dawson. In fact the trajectory of NASDAQ’s rise and fall bears appropriate resemblance to an iceberg, as shown in the chart below.
The Long Road Back
Well, it may have taken 15 years to get here, but the NASDAQ Composite is now poised to put the final coda on the Great Macro Reversal of the 2000s. The S&P 500 and the Dow Jones Industrial Average both surpassed their previous records in 2013. NASDAQ is the third of the so-called headline U.S. stock indexes, the ones that news announcers unfailingly recite in their daily financial news segments. Of course, there is nothing intrinsically special about 5000 or 5048 – a price by any other name is still just a price. But perception often becomes reality, as long-term students of the ways of markets understand. Round numbers and prior highs matter because they are triggers embedded in the bowels of thousands of algorithms. When the trigger activates, the money flows. Momentum doesn’t last forever, but it can lend a tailwind to near-intermediate term price trends.
Not the NASDAQ of Yore
Beyond the “NASDAQ 5000” headlines there are fundamental differences between the index circa March 2000 and that of today. Nowhere is that more clear than in a valuation comparison. At its 2000 peak, NASDAQ sported an eye-popping LTM (last twelve months) P/E ratio of 100. Of course, many of the most popular trades of the day didn’t even have a meaningful “E” to put in the denominator of the equation – they had no earnings to speak of for as far ahead as the eye could see. Investors bought these first-gen Internet companies on a wing and a prayer.
Today’s NASDAQ includes a handful of survivors from the Fall, as well as others that have made an indelible mark on the world since. The top 15 companies by market cap on the index (which collectively account for just under 40% of the total market cap of all 2500+ companies listed on the Composite) are a veritable Who’s Who of the industry sectors at the forefront of U.S. economic growth. Leading the way is Apple, of course, with a $750 billion market cap and a stranglehold on the smartphone industry. Apple’s share of all global operating profits from smartphone sales was an astounding 89% in the 4th quarter of 2014.
The other names in NASDAQ’s elite bracket are likewise familiar, including Internet giants Google, Amazon and Facebook, biotech leaders Gilead and Amgen, mobile chip maker Qualcomm and still-feisty Microsoft. Now, it’s still not a particularly cheap proposition; the average LTM P/E for this top 15 is 29.1 versus 20.5 for the entire index (which in turn is about a 1.15x premium to the S&P 500’s LTM P/E of 17.8). At the same time, though, it is a very far cry from the silly nosebleed valuations prevailing at the turn of the century.
L’économie, c’est l’Internet
In 2000 the Internet still accounted for only a small sliver of real economic activity. Social media had yet to be born, online retailing was still embryonic, and few companies outside the tech sector had any real clue about how the New Economy affected them, beyond the basic effort of putting up a static corporate website. In the span of fifteen years, the Internet has come in from the periphery to envelop practically every conceivable sphere of economic activity. By all appearances, its influence will only grow more pervasive. Now, this of course does not mean that NASDAQ has nowhere to go but up. At some point a significant correction will likely be in the cards. But it seems hard to imagine how a properly diversified portfolio in the second decade of the 21st century could avoid meaningful strategic exposure to the NASDAQ Composite’s leading lights.
The collapse in oil prices was arguably the headline economic story of 2014. The malaise carried into January of this year, with prices of key benchmark crudes hitting six year lows last month. A sharp rebound in the first two weeks of this month has observers wondering if the slide is over, and, if so, what that may portend for the months ahead. One interesting development, which will be the focus of this post, is a significant widening of the spread between two of the most widely-referenced benchmarks: Brent crude and West Texas Intermediate crude. Why is this seemingly arcane byway of commodities markets of interest? In our opinion it sheds light on some key supply and demand factors at play that may influence economic and asset market trends as the year winds on.
We normally think of commodities as fungible – one person’s barrel of oil or bushel of wheat is the same as the next person’s. While that is true in the abstract, the reality is that the prices of many commodities are strongly influenced by differentiating factors. Crude oil is a case in point. There are many “flavors” of crude oil, measured chiefly by a range of densities (light to heavy) and sulfur content (sweet to sour). These determine how a given barrel of crude is used – for gasoline, jet fuel, home heating oil etc. The location of crude oil sources also matters. Brent crude, a light-sweet variety, comes from the North Sea between Great Britain and western Scandinavia. West Texas Intermediate is also a light-sweet variety, but as the name would suggest it is produced and traded in the U.S. mid-southwest. The chart below shows the price trends for both benchmarks over the past six months.
Brent and WTI crude are quite similar in terms of density and sulfur content, and so all else being equal one would expect them to trade at or close to the same price. All else is not equal, of course. As the above chart shows, Brent crude has traded at a premium to WTI for almost all of the past six months, and in fact the Brent premium has been a staple feature of the market for a much longer period. However, Brent prices plunged at a faster rate in the final throes of the price meltdown, reaching parity with WTI in the middle of last month. It was a brief parity. In the second half of January Brent oil stabilized while WTI continued to fall to new lows. The percentage spread between the two benchmarks is now more than twice its last six months’ average. A barrel of Brent crude is more than 6% dearer today than on January 1, while WTI crude is about flat year to date. What’s behind this divergence?
Texas Hold ‘Em
Both supply and demand are at play here, but the trend of U.S. oil prices is at heart a supply story. We are producing more oil, at a faster rate, than at any time since the early 1980s. Financial media chatter to the contrary, the pace does not appear to be slacking off despite the global plunge in prices. Last week both crude oil production and inventories reached record levels. And domestic oil production is a captive of home-grown demand; the export of U.S. crude to other markets is prohibited by current government policy. Whatever is left over in the storage tanks after U.S. orders have been filled stays in the tanks. Energy-hungry manufacturing economies in Asia and elsewhere get their stuff from other sources, including the North Sea.
A number of the major exploration & production (E&P) companies have announced plans to delay forthcoming U.S. drilling projects, and that may help provide more price support down the road. And there is a reasonable possibility that the export ban may weaken or be eliminated in the not too distant future, which would open new sources of demand. But the supply-demand imbalance shows few signs of going away any time soon. If indeed prices have found a structural floor, they may still face significant headwinds in getting anywhere close to the $100-plus levels where it has traded for most of the past five years. Which may not be a bad thing at all; “stable and low” may turn out to be a pretty nice recipe for consumers, businesses and stocks alike.
Volatility is back. For most of the past two years we have enjoyed a comfortable world of low risk & high returns. Stocks rose steadily with little drama save for an occasional pullback in the neighborhood of 5% with an immediate V-shaped recovery. This environment started to change last fall. Baseline volatility began trending up from its summer lows, and those brief Alpine spikes that look so dramatic on vol charts occurred with more frequency. The chart below illustrates the shift in the volatility landscape over this period, using the CBOE VIX index as a risk proxy.
Measuring Fear (1): Baseline (Normal) Volatility
We look at two things when evaluating volatility trends. First is the baseline trend. This is a measure of “normal” volatility – where it trades most of the time when the market isn’t collectively freaking out about something. The chart above shows that baseline vol trended flat to lower for most of the nineteen months between January 2013 and July 2014. Through early to mid-summer last year the VIX trended down close to historical lows before reaching a trough in early July. Since then the trend in baseline vol has been upward and gathering steam. Even through last year’s turbulent October pullback, baseline vol was not far from – and mostly below – the two year average of 14.4. But it has remained firmly above that average throughout the entire month of January.
Measuring Fear(2): Peak-20 Days
The other metric we consider is peak performance. These are the abnormal days when something – be it a piece of unexpected news or a rogue algorithm or the popular delusions of crowds – sends volatility soaring. We call these “peak-20 days” when the index under observation is the VIX, referring to a closing price of 20 or higher. What we care about are (a) the frequency of peak-20 days; and (b) the magnitude of the peaks. Again, the above chart shows two distinctly different climates. There were only four peak-20 days from the beginning of 2013 through midsummer last year. There have been sixteen peak-20 events in the seven months since. January looks set to establish a new high mark. If the VIX stays above 20 through the 1/30 close today, it will be the seventh peak-20 day for the month, or more than 30% of total trading days. At the same time, the highs are higher. The peak of 26.3 reached last October was the highest since June 2012, just before Mario Draghi bailed out the Eurozone with his “whatever it takes” pronouncement.
Vol Today, Gone Tomorrow?
Volatility is a notably flighty metric; it can appear out of nowhere only to be gone in the blink of an eye. But there are some valid reasons why the current bout of risk may stick around for longer than it has in recent times. There is also a reasonable difference of opinion as to whether higher volatility implies a down year for stock markets or a potential “melt-up”, with money coming off the sidelines for a last, frenetic grasp at returns before this secular bull trend comes to an end.
On the negative side we have the current OK Corral square-off between the Fed and the bond market. If the bond market is right – if current yields are a good indicator of intermediate term price and growth trends – then today’s volatility picture could portend tears for traders. On the other hand, European QE, an export tailwind for euroland exporters and a low rate-led recovery in emerging markets, coupled with more or less okay headline numbers in the U.S., could be the recipe for a last hurrah – party like it’s 1999! Either way, it may time to learn to love the vol.
With a little more than one month left until the Champagne corks pop on New Year’s Eve, it’s a good time to survey the investment landscape and see how we might be ringing out 2014. With U.S. equity market indexes back in double digits, it looks very likely to be another good year for long-only portfolios loaded up with domestic stocks. And fixed income has not disappointed either; the Barclays U.S. Aggregate bonds index is up a bit more than 5% as of the 11/20 close. Not bad for a year which began with an overwhelming consensus among market watchers that bond prices would fall as interest rates continued to rise. Should we flip the cruise control switch and ride the wave into 2015, or are there still some bumps in the road that could make for tricky navigating?
The seasonal phenomenon of Black Friday – and its new twin sister Cyber Monday – puts retail spending firmly in the spotlight. The consumer discretionary sector has underperformed the broader market for most of the year, and there are some signs that mainline and specialty retail names with relatively cheap valuations are attracting investors. The National Retail Federation forecasts a 4.1% growth rate for holiday spending this year, a better performance than last year and well above the average for the past ten years. What may make shares in this sector even more attractive is fund managers looking for ways to beef up their portfolios before year-end. This has been a dreadful year for active fund managers, fewer than 20% of whom have beaten their benchmark in the U.S. large cap space. “Window dressing” is the (somewhat derisory) term of art to describe late-season fund manager scrambling to embellish their numbers, and it would seem to be a likely year for this activity to make the scene.
As good a year as it has been for stocks, commodities have suffered mightily. Oil prices reached a peak in June and began a downward spiral of more than 30% -- good for consumers at the gas pump but unwelcome for oil production companies and emerging markets resource exporters. Investors have been looking for a potential catalyst in this sector that could spur a rally. They may have found one in the surprise announcement this morning that China’s central bank is cutting its benchmark lending rates. While cheaper credit in China could signal building weaknesses for the longer term, the more immediate effect would likely stimulate growth in areas like infrastructure and construction. That would provide a decent tailwind to the prices of commodity inputs for which China is the world’s leading customer.
So far so good – but it is never a good idea to be too complacent. One joker in the deck is the U.S. political landscape, where another deal on the budget and debt ceiling – sound familiar? – will face lawmakers in December. With the executive and legislative branches doing their best imitation of an OK Corral standoff, swift resolution of this deal is anything but certain. Odds are that we’ll wind up with some messy but workable compromise, but we will keep a close eye on how these shenanigans unfold. It’s never a bad idea to expect the unexpected – particularly when it comes to the unfortunate dysfunction of our political system.
For a brief few intraday trading moments last week the S&P 500 fell below the level of 1848 (year of revolutions!) where it started 2014. The ensuing v-shaped rally has pushed the index fairly comfortably back into positive territory. But the price-equity (PE) ratio remains a bit below where it opened the year; the twelve trailing months (TTM) PE ratio as of October 23 is 16.3 as compared to 16.5 at the beginning of January. The chart below shows how the PE ratio has trended over the course of this year.
What the PE Ratio Tells Us
The PE ratio is a valuation metric. Think of it as a yardstick for how much investors are willing to pay for a claim on a company’s earnings. For example, a PE ratio of 10x at ABC Company means that investors are willing to shell out $10 for each dollar of ABC Company’s net earnings per share (EPS). If the PE goes from 10x to 12x it signifies that investor perceptions of ABC company have improved; they are now willing to pay $2 more for that same dollar of earnings. A fall in the PE – say from 10x to 8x – would mean the opposite. Value investors, in particular, analyze companies with low PE multiples (relative to the market or their industry peer group) to see if there is a bargain to be had; to see whether there is value in the company that the market, for whatever reason, is not recognizing.
The Multiple and Its Message
Bringing the discussion back to the above chart, it would seem that investors’ attitude towards stocks in general isn’t far today from where it was in January. There were a couple rallies that pushed the PE higher and a couple pullbacks that brought it back down, but over the course of the year the multiple has repeatedly reverted towards the mean (average) level of 16.5x. In our opinion there is a good reason for this, and potentially a message about where stocks may be heading as we start planning our allocation strategy for 2015.
The consensus growth estimate for S&P 500 earnings in 2014 is around 6%; in other words, earnings per share on average should be around 6% higher at the end of the year than they were at the beginning for the companies that make up the index. As it happens, 6% is not too far from the index’s price appreciation this year. We would not be surprised to see this relationship still largely intact as the year closes: a positive year for stocks in which the PE multiple neither expands nor compresses, with mid-upper single digit gains for both share prices and earnings.
Still Not Cheap
The recent pullback has done little to change the fact that stocks are still expensive, on average, relative to long term valuation levels. In the chart below we see the same PE ratio as in the first chart, but the time period goes back ten years to October 2004.
For the last ten years the average TTM PE ratio was 14.6x, considerably below the current level of 16.3x. Remember that the higher the PE, the more expensive the market. In fact, prices are currently higher than at any time since 2005 (we should note, though, that they are still far below the stratospheric levels achieved in the final frenzied years of the late ‘90s bull market). This prompts us to recall the title of the 2014 Annual Outlook we published back in January: “How Much More?” In other words, how much more multiple expansion could we expect to see given how high the multiple already is?
For the past three years the Fed has been the driving force behind an across-the-board rally in U.S. and, mostly, global equities. With QE3 coming to an end (probably) and rates heading slightly higher next year (probably), stocks will be left more to their own devices. We think it reasonable to assume a base case of positive growth in share prices more or less in line with earnings; in other words, a continuation of the 2014 trend. We also see a good case to make for a return to focus on quality and selectivity – companies with solid cash flows and robust business models – rather than an indiscriminate buy-everywhere approach. We may be wrong. Late-stage bull markets can lure cash in from the sidelines and expand PE levels ever higher, as in 1998-99. Conversely, any number of things from Europe’s economy to a China slowdown to worsening geopolitics could spark more broad sell-offs. When we establish a base case we do so with several alternative scenarios. Our thinking may change – we are data-driven and not ideological. But right now, growth without much multiple expansion seems plausible.