Posts tagged Current Market Trends
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.
Every now and then we go back to the annual market outlook we published back in January, to see where our views have changed and where they are more or less the same. With regard to the economic landscape it appears that our views have changed very little indeed: the story largely remains the same. The recent string of headline macro indicators have been notable for their consistency, leading up to today’s release of yet another upside surprise in job creation. The unemployment rate is below 6% for the first time since before the 2008-09 recession. GDP and consumer confidence readings are robust, and inflation remains tame. Corporate earnings and the S&P 500 are up by about the same amount for the year to date, so valuation levels aren’t much different from where they were when the year began.
Trick or Treat
With such a humdrum top-level picture it would seem easy to make a good case for ambling into the end of the year with few surprises. But we’re in October now, folks, and we all know that this month can be full of nasty scares. There was some jitteriness earlier this week, with the S&P 500 pulling back about 3% from its record high set on September 18. A closer look, though, shows this to be part and parcel of this year’s pattern: intermittent, relatively shallow and brief reversals in an otherwise upwardly moving market with subdued volatility and modest share trading volume. The chart below shows the pullback history for the year so far:
Pullbacks of this magnitude offer little scope for defensive measures. By the time you build the defenses the market is already going back the other way. As the chart above shows, the support level of choice for the S&P 500 this year has been the 100 day moving average. Not that there is anything special about that or any other moving average – but if enough quantitative models are programmed to react to it, then perception creates its own reality. Nor is there any single compelling reason to argue as to why the pullbacks happen at the particular times they do. On any given day there are any number of X-factors in the mix – geopolitical flash points, health scares, currency markets turmoil – that could bubble up to the surface and cause mayhem. But there is no orderly pattern to how and when they impact asset prices. In this realm, chaos theory rules.
What We’re Watching
We are closely paying attention to some trends that could set up some bumps in the road. There is a continuation of flows out of riskier asset classes and a failure to hold technical support levels. Emerging markets equities are at or near 52-week lows. U.S. small caps are trading below their 200-day moving averages, and technical weakness is seeping into the mid cap sector as well. And while U.S. growth is leading the global economy, the picture is less rosy in Europe, Japan and elsewhere.
As long as the fundamental story in the U.S. stays more or less the same – and we don’t see too many data points out there to make a strong case otherwise – we think a little more upside is a likelier outcome than a major pullback. We continue to favor dollar-denominated assets and believe that a potential 25 basis points rate hike by the Fed next year is already baked into the cake (probably more so after today’s job numbers). Of course a larger correction could happen any time and we need to be vigilant. But even with a technical correction of 10% or so, we would see a buying opportunity as a more likely outcome than a slide towards secular bear territory.
On Tuesday this week the S&P 500 closed above 2000 for the first time ever. When we say “above”, we mean “right on top of”: the actual closing price was 2000.02. On Wednesday the index inched slightly upwards to a close of 2000.12. Of course, there is nothing inherently special or magic about a round number like 2000 versus any other kind of number. But perception creates its own reality. Along with moving price averages, signpost numbers like 1900 and 2000 often act as important support and resistance levels for short-intermediate term asset price trends. We call these “event numbers”.
The Event Number Corridor
The following chart provides a snapshot of pullbacks in the S&P 500 in the current year to date. They have been fairly short, shallow and infrequent (only three with a magnitude of 3% or more). Interestingly, all three have occurred around an event number: 1850, 1900 and 2000 (there was a pullback of a smaller magnitude at 1950).
What seems to happen here is that the event numbers act as a sort of catalyst for investors to trade on whatever risk factors may be prevailing at the time. Consider the three 2014 pullbacks shown above. At the beginning of this year the S&P 500 had just come off one of its best years ever, leading to general chatter about whether the market was overbought. The market was trading in a corridor just below 1850. The release of a surprisingly negative jobs report early in the year gave traders the excuse to pull money off the table. A -5.8% pullback ensued taking the index to 1750, where it found support and sharply rebounded.
In April the market stalled for a few days just below 1900, then growing concerns about the situation in Russia and Ukraine helped fence-sitting investors to hop off. Again the fear period was brief, and this time support was found at the 100 day moving average level. In July, the risk factors swirling around in the market were for the most part the same as in April: Ukraine, Middle East, Eurozone…and an event number corridor just below 2000 broke in the last week of the month. That too found support around the 100 day average and rebounded sharply…right back up to 2000, where another corridor is playing out.
The current event number corridor is particularly interesting because we are heading into to the final months of the year, a time when a strong positive or negative trend formation can propel the market right through to the end of the year. Which way do the tea leaves point?
The short term, of course, is unknowable with any kind of surety: every rally and every pullback is different. Given how long it has been since the market last experienced a real correction, in 2011, each new pullback heightens fears of a slide from mere pullback to secular reversal. But we are still seeing daily volatility levels more typical of a middle-stage than a late stage bull market.
In both of the last two secular bulls, from 1994-2000 and 2003-07, volatility started to head higher some time before the market reached its respective high water marks. Late-stage bulls tend to be frenetic, with hold-outs piling in to belatedly grab some of the upside. It is only after those net inflows subside that the reversal tends to gather steam. Even in the immediate wake of the late-July pullback, though, we still appear to be in one of the calmer risk valleys, with the CBOE VIX index not far away from its ten year low.
Still, anything can happen. Summer is over. We expect trading volumes to pick up and, sooner or later, a late-year trend to emerge and test more event number support and resistance levels. We head into the new school year vigilant and focused.
It’s summertime, but the living has been anything but easy for the past couple weeks. A news cycle full of geopolitical flare-ups, health crises and dissension at the Fed has brought volatility and wild intraday price swings back onto center stage. Yet there appears to be less to the daily drama than meets the eye. For all the lead stories spilling out of the world’s trouble spots, the real force driving volatility is the low levels of activity typical of summer. Since the beginning of July, daily volume on the S&P 500 has been below its 200 day moving average 82% of the time. Low volume amplifies price swings. We think this environment is less about news, more about noise.
Geopolitics Priced In (For Now)
Of all the current flashpoints, arguably the escalating tension between Russia and the West is cause for greatest concern. This tension certainly has not helped Europe, which depends on Russia for the majority of its energy imports. Shares in broad Eurozone market indices are down nearly 10% from where they were at the beginning of July. But Russia’s role in the global economy is less impactful than China’s or Brazil’s. Even if economic sanctions between Russia and its main trading partners worsen, the effect is likely to more localized to companies with significant interests in Russia (major international energy companies come to mind) than widespread.
Events in the Middle East are likewise unsettling, but contained in terms of practical economic impact. Crude oil prices – often a barometer for tensions in the Gulf – are at their lowest levels for the year to date. Questions remain about the level of U.S. engagement as the crisis in Iraq creeps towards the oil-rich Kurdish state, but for now any potential use of ground troops is fully off the table.
Support, Resistance and Round Numbers
There is nothing particularly magical about round numbers or 100 day moving averages, but in the capital markets perception creates its own reality. The S&P 500 broke through the 1900 resistance level back in May, and was closing in on 2000 before gravity kicked in late last month. The Dow Jones Industrial Average topped 17,000 before the latest tumble. On the other side, though, the major indexes are all finding support around intermediate-term moving averages: the S&P 500 is currently trading right around the 100-day average.
Bear in mind that over 60% of the daily trading volume on U.S. equity exchanges is machine-driven, reacting to algorithms rather than human decision makers. Many of these algorithms are programmed to react specifically to things like round numbers and moving averages, and that is why they figure so prominently in observed trading patterns. Given the pace of the rally that started in mid-May, it is scarcely surprising that we see a brief pullback and perhaps an extended period of trading in a narrow support-resistance corridor. Whether it turns into something more remains to be seen, but for now the noise factor appears to predominate.