Posts tagged Risk
Spring has come early to the US East Coast this year, with the good citizens of Atlantic seaboard cities ditching their North Faces and donning shorts and flip-flops for outdoor activities normally kept on ice until April. Grilling, anyone? Equity investors, meanwhile, have been enjoying an even longer springtime, full of balmy breezes of hope and animal spirits. But just as a February spring can fall prey to a sudden blast of March coldness, this week has brought a few hints of discontent to the placid realm of the capital markets. Whether these are harbingers of choppy times ahead or simply random head fakes remains to be seen, but we think they are worthy of mention.
Ach, Meine Schatzie!
Fun fact: German two year Bunds go by the nickname Schatz, which is also the German word for “treasure” as well as being a cozy term of endearment for loved ones. Well, these little Teutonic treasures have been exhibiting some odd behavior in the past several days. This includes record low yields, a post-euro record negative spread against the two year US Treasury, and a sudden spike in the gap between French and German benchmark yields. The chart below shows the divergent trends for these three benchmarks in the past couple weeks.
The sudden widening of the German and French yields offers up an easy explanation: a poll released earlier in the week showed National Front candidate (and would-be Eurozone sortienne) Marine Le Pen with a lead over presumed front runner Emmanuel Macron. That was Tuesday’s news; by Wednesday François Bayrou, another independent candidate, had withdrawn and thrown his support to Macron, easing Frexit fears. Yields fell back. Got that?
The Schatz yield also kept falling, though, as the dust settled on the latest French kerfuffle. Since German government debt is one of the more popular go-to markets for risk-off trades, we need to keep an eye on those historically low yields. This would be a good time to note that other European asset classes haven’t shown much fretting. The euro sits around $1.06, off its late-December lows, and equity markets have been fairly placid of late (though major European bourses are trading sharply lower today). But currency option markets suggest a growing number of investors positioning for a sharp reversal in the euro come May.
Gold Bugs and Trump Traders Unite
Bunds are not the only risk-off haven currently in favor; a somewhat odd tango has been going on for most of this year between typically risk-averse gold bugs and the caution-to-the-wind types populating the Trump trade. The chart below shows how closely these two asset classes have correlated since the end of last year.
Now, an astute reader is likely to point out that – sure, if the Trump trade is about reflation and gold is the classic anti-inflation hedge, then why would you not expect them to trend in the same direction? Good question! Which we would answer thus: whatever substantial belief there ever was in the whole idea of a massive dose of infrastructure spending with new money, pushing up inflation, is probably captured in the phase of the rally that started immediately after the election and topped out in December. During that phase, as the chart shows, the price of gold plummeted. That would be odd if gold investors were reacting to (higher) inflationary expectations.
Much more likely is the notion that gold’s post-November pullback was simply the other side of the animal spirits; investors dumped risk-off assets in bulk while loading up on stocks, industrial metals and the like. In that light, we would see the precious metal’s gains in early 2017 more as a signal that, even as Johnny-come-lately investors continue piling into stocks to grab whatever is left of the rally, some of the earlier money is starting to hedge its gains with a sprinkling of risk-off moves, including gold.
None of this should be interpreted as any kind of hard and fast evidence that the risk asset reversal looms large in the immediate future. Market timing, as we never hesitate to point out, is a fool’s errand that only ever looks “obvious” in hindsight. An article in the Financial Times noted today that the recent succession of 10 straight “up” days in the Dow Jones Industrial Average was a feat last achieved in 1987, with the author taking pains to point to the whopping market crash that happened the same year. He waited until the end of the article to deliver the punch line: anyone who took that 10 day streak as a sign to get out at the “top” of the market forfeited the 30 percent of additional gains the Dow made after that before its 20 percent crash in October (do the math). Ours is not a call to action; rather, it is an observation that dormant risk factors may be percolating up ahead of choppier times.
Over the past couple weeks we have been snooping around some of the contrarian corners of the world, to see what those folks not completely enamored of the “Trump trade” have been up to (Eurozone, Brexit, what have you). While we were away, all manner of things has gone down in Washington, often in a most colorful (or concerning, take your pick) fashion. But virtually all the chief planks of that Trump trade – the infrastructure, the corporate tax reform – remain stuck in the sketchbooks and doodlings of Paul Ryan and his band of policymakers, waiting to see the light of day. By this point in his first term, Barack Obama had already passed a $1 trillion stimulus bill, among other legislative accomplishments. Is there a point at which the band of inverse-Murphy’s Law acolytes begin to question their faith that if something can go right, it will? To put it another way, does political risk still matter for asset valuation?
“Vol Val” Alive and Well
If there is a political risk factor stalking the market, it appears to have paid a call on J.K. Rowling and come away with a Hogwarts-style cloak of invisibility. For evidence, we turn to our favorite snapshot of trepidation and animal spirits – those undulating valleys of low volatility occasionally punctuated by brief soaring peaks of fear that make up the CBOE VIX “fear gauge,” shown in relation to the price performance of the S&P 500.
Since the election last November, market volatility as measured by the VIX has subsided to its lowest level since the incredibly somnambulant dog days of summer in 2014. In fact, as the chart shows, the lowest vol readings have actually occurred on and after Inauguration Day (so much for that “sell the Inauguration” meme making the rounds among CNBC chatterboxes a few weeks back). Meanwhile, of course, the S&P 500 has set record high after record high. How many? Sixteen and counting, to date, since November 9, or about one new record for every four days of trading on average.
That by itself is not unheard of though: the index set a new record 25 times (measured over the same time period) following Bill Clinton’s reelection in 1996. But 1996 was a different age, one with arguably less of the “this is unprecedented” type of political headlines to which we have fast become accustomed in the past two months. To a reader of the daily doings of Washington, it would seem that political risk should be clear and present. One of this week’s stories that caught our attention was the good times being had by London bookmakers setting betting markets for the odds of Trump failing to complete his first term (the odds apparently now sit around 2:1). So what gives with this week’s string of record highs and submerged volatility?
The Ryan Run-up
The “Trump bump”, of course, was never about the personality of the 45th president, or anything else that he brings to the table other than a way to facilitate the longstanding economic policy dreams of the Ayn Randian right, represented more fulsomely by House Speaker Paul Ryan than by Donald Trump. Looking at the rally from this standpoint perhaps explains at least in part the absence of visible political risk. So what, goes this line of thinking, if Trump were either to be impeached or somehow removed under the provisions of the 25th Amendment? Vice President Pence ascends to the Oval Office, the Twitter tornadoes subside and America gets on with the business of tax cuts and deregulation in a more orderly fashion (though not much infrastructure spending, as that was never really a Ryan thing). Move along, nothing to see here.
While we understand the logic behind that thinking, we think it is misguided, not least of all because – London oddsmakers notwithstanding – we think that either impeachment or a 25th Amendment removal from office are far out on the tail of any putative distribution of outcomes. We would ascribe a higher likelihood to a different outcome; namely, that political uncertainty will continue to permeate every sphere of activity from foreign policy to global trade to domestic unrest in a bitterly divided, partisan nation. So far we are muddling through – headlines aside, many American institutions are showing their resilience in the face of challenge. That’s good news. But not good enough, in our view, to keep political risk behind its Invisibility Cloak for much longer. We’re not prophesying any kind of imminent market cataclysm, but we do expect to see our old friend volatility make an appearance one of these days in the not too distant future.
So here we are again, nearing one of those seminal milestones in stock market lore. The Dow Jones Industrial Average, comprised of thirty (mostly household name-y) large-cap stocks, is an index whose main claim to fame is that its life span as a barometer of market sentiment extends all the way back to 1896. The Dow is poised to break through 20,000, a number whose main claim to fame is that it contains four zeroes. “Dow 20,000” screamed the entire front cover of Barron’s magazine last week. At the round earth’s imagined corners, blow your trumpets angels!
For portfolio analysts toiling away in the data-dense world of relative value movements, 250-day rolling returns and the like, these periodic “magic number moments” are scarcely worth a second look. That is particularly true when the index in question is the Dow, a much less useful or significant gauge than, say, the S&P 500 or the Russell 3000. Rationally speaking, there is nothing whatsoever of importance in these periodic episodes.
But rationality only counts for so much. In the vulgate of the wider population of investors and kibitzers, “the Dow” and “the market” are virtually interchangeable, and a nice round number like 20,000 has all the cultural significance of a special calendar date like January 1 or July 4. As with much else in the market, perception often becomes reality. Indexes do exhibit somewhat distinct trading patterns around these magic number moments, however silly it may seem. Thus, attention shall be paid.
Uncage the Elephant
The present magic number moment happens to coincide with a period of animal spirits stampeding up and down Wall Street. The Dow is up nine percent since the post-election rally kicked off on November 9. While the index has not actually broken through the threshold as we write this, it is entirely plausible that it will be on the other side by the time we publish. Given the momentum that continues to feed off itself, counterfactuals be damned, it is more likely than not that the melt-up will carry stocks through to year-end. What then? Inquiring minds will want to know.
We have no crystal ball, of course, but we can supply a bit of historical perspective. As it turns out, the last time the Dow reached a four-zero magic moment, we were also in the middle of a market melt-up. Consider the chart below.
This chart tracks the performance of the Dow – with the tech-heavy NASDAQ shown for comparison – during the last gasp of the late-1990s tech bubble and the ensuing bear market. As the chart shows, the Dow (green line and left-hand y axis) broke through the magic number of 10,000 in late March of 1999. Dow 10,000! These round numbers often act as very tough resistance levels, but 1999’s animal spirits pushed through the barrier with relative ease and, for good measure, surged an additional 1,000 points before settling into a brief holding pattern.
Forks in the Road
One interesting feature of this end-game stage of the late-90s melt-up is the pronounced divergence between the Dow and the NASDAQ on several occasions. This observation may have some relevance in thinking about today’s environment. The last gasp of the tech bubble, when investors more or less indiscriminately bought anything that sounded tech-y and Internet-y regardless of valuation or other counterfactuals, started in late summer 1999 and topped out in March 2000. The NASDAQ, as a proxy for the tech rally, enjoyed about seven months of near-unidirectional upward momentum during this melt-up.
The Dow, conversely, fell more than 11 percent from August to October 1999, and experienced another, even more pronounced correction of minus 16 percent from January 17 to March 7, 2000. The trough for this Dow pullback, then, roughly coincided with the NASDAQ’s March 10 bubble peak of 5,048. And, in fact, the Dow proceeded to bounce up by 15 percent from March 14 to April 11, during which time the wheels came off the dot-coms and NASDAQ experienced the first of what would be a series of bone-jarring descents over the next twelve months.
Mass Movements Then…
Why did the Dow diverge so far away from the NASDAQ (and, to a somewhat lesser extent, from the S&P 500) over that last leg of the 1999-2000 melt-up, and what light may that shed on market movements in today’s environment?
The driving narrative of that late-era ‘90s rally was technology. Investors were less concerned about what individual stocks they owned, and more concerned about getting in on the general action. The ability to obtain broad exposure to the tech and Internet sector – either through one of the then-small number of nascent ETFs, a passive index fund or similar pooled vehicle structure – was more important than the relative merits of any given stock.
By contrast to the tech-dominated NASDAQ, the Dow had a relative scarcity of tech names; only IBM, in fact, at the beginning of 1999, with Intel and Microsoft somewhat latterly tossed into the mix in November of that year. The Dow’s pullbacks in late 1999 and early 2000 thus had almost nothing in common with prevailing attitudes about the tech sector, and plausibly much more to do with valuation-wary investors looking for ways to pare back equity holdings without risking their clients’ ire by dumping those beloved shares of Cisco and Pets.com.
…Mass Movements Now
This year’s post-November 8 environment is likewise largely driven by a couple top-down themes. This time, the blessings of the narrative have fallen disproportionately on a couple sectors, in particular financials, but so far the broad indexes continue to move fairly closely in lockstep.
The mass movement vehicle of choice today is the exchange traded fund. ETFs offer exposure to just about any equity or fixed income asset class, including all the major broad indexes. Complex (and not so complex) algorithms employ ETFs for quick and efficient exposure to thematic narratives, such as the reflation-infrastructure trade that has been dominant since November.
But not all indexes attract the same level of interest from the short-term money. Consider that the average daily trading volume of SPY, the SPDR S&P 500 ETF, is about 94 million shares. For XLF, SPDR’s financial sector offering, average daily volume is about 80 million shares, and for QQQ, the PowerShares NASDAQ 100 vehicle, it is a still-respectable 24 million shares.
How Now, Dow?
By contrast, the average daily volume for DIA, the BlackRock iShares ETF for the Dow Jones Industrial Average, is just around 3 million shares – less than five percent of the volume for SPY. This statistic underscores one of our opening observations in this paper: as much as the average investor equates “the Dow” with “the market,” professional investors have little use for this quaint artifact of U.S. stock market history. Since the Dow is really not a ready proxy for either a specific asset class or a wider market gauge, it doesn’t offer much of a compelling reason for use in those algorithm-driven strategies that dominate short-term trading volume.
Which, in turn, may make it worth keeping an eye on the Dow once that magic number moment of 20,000 has receded into the rear view mirror. If those thirty stocks diverge away from their broad index cousins – S&P, Russell, NASDAQ et al – they may again be the canary in the coal mine warning that the fundamentals are out of line with the still-giddy prevailing market narrative. Of course, there is no assurance that this scenario will play out, and we would advise against hanging one’s hat on this outcome. Good investing is about paying attention to lots of moving parts while maintaining the discipline not to rely unduly on one or two. But we will be keeping track of the Dow’s fortunes in the coming weeks, even after the Dow 20,000! hoopla has come and gone.
Happy (Fiscal) Holidays
Opinions among the politico-financial commentariat appear to be converging on the basic idea that “fiscal policy is the new monetary policy.” Out with the obsession over FOMC dot-plots, in with infrastructure! Does a more robust fiscal policy, if in fact implemented, presage a structural bump-up in GDP? The stock market seems to think so, with a strangely high degree of conviction, as illustrated in the chart below.
This chart, one of our periodic favorites, shows what we like to call the “risk gap” between stock prices (the solid blue line showing S&P 500 price performance for the past two years) and volatility (the green dotted line shows the CBOE VIX index, the market’s so-called “fear gauge”). The wider the risk gap, the more complacent the market. As of late the gap has turned into a chasm, with stock prices setting all-time highs on a near-daily basis while the fear gauge slumbers at or near recent lows, and well below the threshold of twenty indicating a high-risk environment.
The takeaway from the chart would appear to be this: not only are we absolutely, positively going to get a bracing jolt of stimulative fiscal policy in the near future, but that new policy is going to translate into higher GDP growth, higher wages and prices, and who knows what else. Maybe a groundbreaking new proof for Fermat’s last theorem?
If you kept your nerve during the seven day run-up to last month’s election (where you see that big stock price dip and brief spike in the VIX), then you are no doubt pleased as punch that Mr. Market decided to react thus. But you may also be concerned about whether this reaction is a rational assessment of the impact of future fiscal policy, or alternatively a sugar high that will leave in its wake a sensation not unlike overindulging in Krispy Kremes.
Three Pillars of Fiscal Wisdom
The fiscal policy measures being lobbed around Washington think tanks and spin rooms these days fall into three broad categories: taxes, regulations and infrastructure. Call them the Three Pillars of fiscal policy in Paul Ryan’s brave new world of one-party rule. As we noted above, the market’s near-immediate response to the prospect of the Three Pillars was ebullient optimism. This attitude is partly understandable. After all, we have had to endure eight years of gridlock in Washington during which very little got done. Central banks, which did all the heavy lifting during this time, are understandably receptive to the prospect of some burden-sharing.
But two questions pose themselves. First, how much of whatever comes out of the abstract Three Pillars and into actual policy will be stimulative? Second, as Fed Chair Yellen herself has asked, how much stimulus does the economy even need? Job growth is close to what economists typically regard as “full employment.” Moreover, despite a somewhat weaker wage figure in the last batch of jobs numbers, hourly earnings have trended above core and headline inflation for the last year. GDP in the third quarter was above expectations, and even the long-beleaguered, all-important productivity number beat expectations in Q3. These are not exactly conditions screaming out for a redoubling of stimulus (though, to the point made by many central bankers, when it does become time for more stimulus in the future, it would be preferable for the burden to be shared between monetary and fiscal sources).
Given that the economy is, in fact, not falling off a cliff, by nature austerity-loving Republicans in the House are likely to push back on initiatives that add significantly to the budget deficit. Tax cuts will always be a priority over new spending on the right-hand side of the Congressional aisle. Of the Three Pillars, tax cuts are probably the most likely to be first out of the gate. But even here, as we read the (admittedly confusing) tea leaves of current chatter, the outcome is not likely to be as simple as was the last batch of significant cuts under George Bush. Not only individual and corporate taxes are under consideration, but some kind of a value-added sales tax as well, as a partial offset measure. Strangely a VAT tax – generally considered regressive – seems to have a measure of Democratic support.
We will have quite a bit to say about the progress, or lack thereof, of the Three Pillars in forthcoming commentaries. Where we always want to take the discussion, though, is back to how these measures ultimately connect to anything that drives actual cash flows for publicly traded companies. Connecting these dots is what helps us understand whether there is anything fundamental behind temporal stock price movements or not.
Right now our assessment tends more towards the “not.” That “risk gap” illustration above strikes us as being unsustainable. Either volatility will pick up at some point – most likely as the pre-inauguration honeymoon winds down and the real business of governing looms large – or markets will resume the kind of drift patterns along a trading corridor such as we saw for much of 2015 and 2016.
A period of corridor drift could be preceded by a sizable pullback of five to ten percent, such as the ones we experienced in August 2015 and January 2016. We tend to think that such a pullback would more likely be the result of an external surprise – another plunge in the renminbi, say, or even a geopolitical shock from a global trouble-spot – rather than anything directly connected with the still-healthy U.S. economy. While we don’t see the makings of a sustained downturn ahead, it is worth remembering that stock price valuations remain at decade-plus highs.
Only a sharp upturn in corporate earnings in the coming quarters will supply the justification needed to be comfortable with those high valuations. That upturn, should it come, will be the result of continuing improvements in productivity and a revival of global demand. Not from a fiscal stimulus program that may or may not happen.
We’re halfway through September and markets have gone a bit wobbly, as some random character in a Bridget Jones sequel might say. Nothing yet to require the smelling salts, but the VIX volatility index has perked up into the high teens while the S&P 500 is back to flirting with that May 2015 ceiling of 2130 it had finally broken through back in July. If you were a reader of our weekly commentary back in the first half of this year, you would recall our frequent use of the phrase “valuation ceiling” in this context. This was how we described the stiff resistance headwinds US large cap stocks faced in managing a sustained price rally given the lackluster pace of earnings growth.
Fast forward to the present. While 2130 is now more of a loose support level than a hard price ceiling, not much has changed on the sales or earnings front. Indeed, share valuations remain very close to decade-long highs. The chart below shows the ten year price to earnings and price to sales ratios (based on next twelve months estimates). We consider why these valuation levels might – and might not – matter to near-term price performance.
The Expectations Game
According to FactSet consensus projections, average Q3 earnings for S&P 500 companies are estimated to come in at -2.2 percent, which is quite a bit lower than the 0.3 percent increase projected by the same consensus group back in June. At face value that is not good news for already expensive stock prices. There are a couple caveats, however.
First, earnings season is essentially an elaborate Kabuki dance between the sell-side securities firm analysts who make up that “consensus” and the corporate management teams who talk the analysts through their financial results each quarter. The formula is every bit as stylized and predictable as the 1,000th retelling of the Tale of Genji on an actual Kabuki stage. Companies “guide light” on sales and earnings over the course of the previous quarter, and analysts steadily lower their projections in response. Then, lo and behold, the results come in and the companies manage to jump over that lowered expectations bar. These “upside surprises,” in Wall Street earnings-speak, usually account for more than 70 percent of the total variance between expected and actual earnings per share results.
Averages and Outliers
So the fact that earnings are projected to drop another 2.2 percent doesn’t mean much as the Q3 season gets under way. We fully expect that figure to trend up and potentially turn positive as more results come in (thus far only one company has reported). More importantly, though, is that the average skews negative almost entirely due to the residual heavy losses being experienced by the energy sector. Earnings in this sector are projected to decline by 68 percent, for reasons already widely known and largely priced in. Energy stocks may look wildly expensive, given how far the denominator of the P/E equation has plunged over the last twelve months, but investors by now have largely discounted the misery of last year’s oil price drop and assume more stability ahead, if not necessarily robust growth.
Energy stocks at this point make up about 6.5 percent of the S&P 500’s total market capitalization. By contrast, the four leading sectors by this metric – technology, health care, financials and consumer discretionary – account for more than 65 percent of the index’s total market cap. Q3 earnings growth for these for sectors is expected to be in the low-mid single digits. The Q4 outlook (for what it’s worth, given that Q4 earnings Kabuki hasn’t even started yet) has these four leading sectors growing a bit more than eight percent.
Valuation Matters, But Not for Timing
Does any of this matter? Yes, valuation does matter, because in the long run a company’s stock price is no more and no less than a function of the company’s future ability to generate cash flows with its assets in place. In the short run, though, the valuation ceiling may be as hard as a rock or as porous as a sponge. Today’s NTM P/E of 16.8 times is expensive, but nowhere near the nosebleed mid-20s levels it reached at the height of the technology bubble in early 2000. In fact, as we have noted in previous commentaries, the late stages of a bull market often come with a giddy disregard for valuations as late money and animal spirits chase performance with a “greater fool” mentality. That has not yet happened in this bull run. After the twists and turns of September and October, though, we’ll see whether Santa Claus is ready to come out and play.