Posts tagged Risk
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.
Remember the Flash Crash of 1962? Of course you don’t. Neither do we. But it happened. On May 28th, 1962 the S&P 500 plunged 6.7 percent in a single day, seemingly out of the blue. Concerned investors noted immediately that this was the biggest single day retreat in the stock market since 1933, with more shares changing hands than since those panicky October days of the Great Crash of 1929. No shortage of commentators at the time wrote about the near inevitability of a sustained period of panic selling.
Pretenders to the Bear
That chronic downturn never happened, of course. The Flash Crash of ’62 came and went. A few weeks later saw the end of the ephemeral bear market that spanned December 1961 – June 1962 and the resumption of a long-running macro bull environment. That “bear” had no material impact on the economy and no lasting effect on anyone’s memory save small clusters of Wall Street vets swapping yarns about the olden days over Old Fashions at Harry’s Bar. It was, in our lexicon, a pretend bear.
So why are we taking the trouble to write about the 1962 event today, 54 years later? Our theme this week takes direct aim at the incessant chatter in today’s environment about the “length” of the current bull market and whether investors should be worried that the bull has run its course. We use the example of the Flash Crash of ’62, along with a handful of other pretend bears and near-misses, to argue that the entire technical construct of a bear market is arbitrary and has nothing to do with where the stock market is in the context of a long term macro environment.
In other words, there may be plenty of things about which to worry in regard to the current market. The rate of economic growth, the limits of central bank monetary policy and the prospects for corporate earnings are all legitimate causes for concern. The fact that – at seven years, five months and counting – this is one of the longest “bull markets” on record is not a legitimate cause for concern.
A Macro Framework
Since the end of the Second World War there have been four macro environments for US equities. There was the Great Postwar Boom of 1949 – 1968, followed by the Stagnation Bear of 1968 – 1982. Then we had the Great Moderation of 1982 – 2000, which finally ushered in the Time of Troubles that ran from 2000 to at least 2009 and possibly longer. Hold that thought, as we will come back to it at the end of this piece.
This framework is key to how we at MVF Research think about markets. It is our frame of reference for growth and non-growth (gap) environments much more than is the arbitrary construct of a 20 percent pullback from the previous high, which is the conventional industry definition of a “bear” market. Consider that postwar boom environment of 1949-68. There were three conventional bear markets over that span of time: a 21.5 percent pullback from August ’56 to October ’57, then the aforementioned six month retreat of 28 percent from December ’61 to June ’62 that included the Flash Crash, and finally another 22.2 percent drop from February to October, 1966. Of those three bear markets only one – the fourteen month stretch over 1956-57 – coincided with an actual recession.
That last point is important. What we can learn from the past is that the worst sustained market environments – the ones where investors really do benefit from added downside protection – tend to coincide with genuine problems in the broader economy. In 1962 there were few signs of economic stress, while in 1966 you had the first slight signs of the overheating that would lead to massive inflation a few years later. Investors who stayed put during this period came out fine; the S&P 500 gained a cumulative 178 percent from the 1957 market bottom to the 1968 peak.
Perhaps no example serves better as an admonishment against pretend bears, though, than October 1987.
The Roaring Eighties
The Great Moderation ran from August 1982 to March 2000. Over this time period the S&P 500 returned a staggering and unprecedented 1,391 percent in cumulative price accumulation (which does not even include the return from dividends paid over the period). But this span of 17 years and 8 months does not technically qualify as the “longest bull market on record.” It was broken up once in 1987 by a technical (read: pretend) bear, and experienced two near-misses with a 19.9 percent pullback in 1990-91 and another of 19.3 percent in 1998. In fact, if you were to use intraday highs and lows rather than closing prices, then both the 1990 and the 1998 events counted as bears.
The 1987 event, of course, was driven by the one-day freak crash of October 19. This was of an even bigger magnitude than that of May 28, 1962; major indexes closed down more than 20 percent from where they opened. All told, the S&P 500 would lose 33.5 percent from peak to trough. But it was all over less than four months after it started. And – like the instances of 1962 and 1966 – there was little in the way of macroeconomic data to suggest a sea change from the generally favorable growth conditions that prevailed at the time. In fact the next recession would not happen for another three years (and it turned out to be mild one).
The Benefit of Hindsight
Now we come back to the present environment. When we look at past market environments we can comfortably put start and end dates around them; the passage of time affords us that opportunity. For example, we know today that the difference between 1966 and 1968 was that only the latter pullback was accompanied by a real change in the economy that precipitated more than a decade of stagnation and a real, as opposed to pretend, bear market. We know that the 1929 market crash had an immediate effect on the economic decisions of businesses and consumers, with industrial production falling by double digits within a matter of weeks, while the 1987 crash barely registered in the real economy.
We know that because of where we stand today relative to those events. An investor in October 1987 or October 1929 (or May 1962 for that matter) had no such luxury, of course, and neither do we as we ponder where markets go from August 2016. We can’t even define where we are today relative to that framework for macro environments we described earlier. Are we in the beginning stages of a new third macro growth environment, a successor to the Postwar Boom and the Great Moderation? Or are we still in the Time of Troubles, with the other shoe yet to drop when the world’s central banks run out of ammunition? We do not yet have the luxury of hindsight with which to offer up a definitive answer to that question. There were plenty of false dawns during the 14 year Stagnation Bear and another interregnum during the 2003-07 phase of the Time of Troubles.
What we do know, though, is that while the world economy is in a slow-growth phase it is still, by and large, growing. We do not see evidence for the US heading into recession, or for the Eurozone to get sucked into a deflationary spiral. We are in a much more managed economic environment than that of the liberalizing 1980s and 1990s, but so far, at least, managed monetary policy has managed to keep potential crises at bay.
We know that pullbacks are a regular part of the market landscape, and sometimes these pullbacks can push over that arbitrary 20 percent threshold into technical bear territory. In the absence of compelling evidence to the contrary, though, we will have a general tendency to see such pullbacks more likely than not as pretend bears. The fact that the current bull has run since March 2009 means essentially nothing to us as any kind of a signal. Our job is the hard work of piecing together disparate data into a composite view of where we may be in the larger macro context. Real bear markets happen rarely. We do not yet see the data telling us we are entering another one.
It has been, to say the least, an exceedingly strange summer in the world of risk asset markets. Alongside a near-daily stream of general news items suggesting that the basic rules of the world as we have long known them no longer apply – from the price of money to the usefulness of an economic union to the mechanisms of political parties and so on – alongside this theater of the bizarre has been one of the most placid summers in recent memory for capital markets. Put the UK FTSE or the S&P 500 on the cover of Alfred E. Neuman’s Mad Magazine with a smugly cheesy “what, me worry?” grin and you have the mood of the moment. Intrepid event risk hunters must feel tempted to throw in the towel, head for the hills or the shore, and wake up again in a month. Those still holding onto the notion that something – anything! – may have the ability to shake markets out of their complacency could do worse than look at the brewing trouble spot of Italy’s financial system.
In 1472 Christopher Columbus was still 20 years away from setting sail for the New World. England was still engulfed in the Wars of the Roses. In the principalities of northern Italy, though, the cornerstones of modern finance were being laid with the emergence of a structured, institutional market for borrowing and lending. One of the institutions founded that year, Banca Monte dei Paschi di Siena, is still in existence and as such is the world’s oldest bank. But prospects for another half-millennium of life are anything but certain. After a stress test last week showed Monte dei Paschi to have negative capital adequacy under simulated adverse conditions, the storied institution and its regulators are scrambling for a solution to avoid an ignominious end. As the chart below shows, detailing the bank’s stock price for the last year versus the MSCI Italy stock index, investors are anything but confident in their prospects.
Monte dei Paschi’s troubles are those of the entire Italian banking sector writ large: an unsustainably high level of nonperforming loans supported by unacceptably low levels of provisional reserves. The IMF estimates the size of Italy’s bad loans to be €360 billion. That is a whopping 18 percent of the country’s total volume of loans outstanding. Loan loss provisions – the reserves banks set aside to cover bad debts – are estimated to be capable of absorbing less than half that amount, leaving a €200 billion overhang on the financial system. The IMF quite rightly considers Italy’s banking system, and Monte dei Paschi in particular, to be a significant risk to global growth.
Italian for “Kick the Can”
This being Europe, of course, there is no shortage of effort being applied to prevent Italy’s bad debt problem from forcing any kind of drastic action in the here and now. There are no easy options, however, and that is partly due to some quirks in the Italian banking system. In Italy millions of retail investors – ordinary households like you and me – own debt issued by Italian banks in their savings portfolios. This makes it difficult for policymakers to contemplate a “bail-in” – a rescue plan in which the shareholders and junior creditors of the rescued institution suffer losses. Attempts to orchestrate an earlier bail-in in Italy for a handful of smaller banks was met with widespread protests and even one suicide. Matteo Renzi, Italy’s prime minister who has staked his political future on a referendum on constitutional reform this October, wants to avoid a bail-in at all costs.
The problem is that new EU rules implemented at the start of this year insist on such bail-in provisions for any recapitalization of a troubled corporation or financial institution involving state aid. EU policymakers, particularly those of a less forgiving nature in Berlin and Brussels, would be loath to bend the rules so soon after their implementation. As a result, creative minds have concocted a plan that would potentially recapitalize Monte dei Paschi with €5 billion in new capital and spin €9 billion in bad debt out into a “bad bank” arrangement, all funded by private sector investors. The deal, as it emerges, will be shopped to investors later this year. Interested parties hope that will be enough time to calm frayed nerves and avert another chapter in the ongoing Eurozone financial crisis.
Alfredo E. Uomonuovo
Investors in Italian sovereign debt appear uninclined to see any major event risk in Italy’s financial sector woes. Perhaps unsurprisingly for this summer of Alfred E. Neuman, the 10 year Italian benchmark bond yield is close to a three year low, as shown in the chart below.
In fact, Italian bond risk spreads relative to safe haven German Bunds have remained nearly unchanged in the six weeks or so since the Brexit shock, and a similar pattern holds for other peripheral Eurozone debt. The signal to investors would thus appear to be “no event risk here, carry on.” And it may well be that the proposed recap plan for Monte dei Paschi succeeds and keeps the wolves at bay for yet another spell of time. At the same time, though, the situation in Italy should serve as a reminder that Europe’s economic troubles are not over, and the future of the single currency union is not a given. The banking sector will not fundamentally improve until economic conditions on the Continent facilitate an environment where some measure of normal borrowing and lending activity can occur. In this most unruffled of capital market summers, one is always well advised to remember that calm seas can give way to tempests in the blink of an eye. Kicking the can down the road is fine, but all roads have an end.
The punch bowl was not even half empty after Mario Draghi served up another round of stimulus last week, but Janet Yellen & Co. filled it right back to the brim on Wednesday and the party rolled on. The surprisingly dovish statement after this week’s FOMC meeting acknowledged what credit markets had already priced in: the cadence of rate hikes is going to be much gentler than December’s “dot plots” suggested. The brisk central bank tailwinds of late, along with a general absence of anything truly bad having happened for some time, have pushed the S&P 500 through some key resistance points. The index now finds itself…right back in the corridor where it has been for much of the past 15 months. The question for investors now is what it will take to push stocks through the corridor’s ceiling. We believe a sustained second leg of this rally will be considerably more difficult than the first.
Relief Rallies of a Feather
The two conspicuous banishments from the corridor share some characteristic patterns of intermittent bull market corrections: an initial steep drop followed by a sequence of tentative rallies and selling waves, and finally a double-digit relief rally to reclaim the lost ground. The chart above shows that the market finally kicked into gear in October 2015, rallying 13 percent back to the middle of the trading corridor. Similarly, shares recently have pushed up nearly 12 percent from their February 11 low point. The recovery has been fairly broad, as noted in some of our recent commentaries. Market breadth indicators like the advance-decline and 52 week high/low ratios are reasonably healthy. Higher risk areas like small caps and emerging markets are going gangbusters; to cite one example, Brazil’s Bovespa index is up 35 percent since its late January lows. That’s a bit surprising given that the economy is mired in a deep recession and the country’s political system is falling apart. Animal spirits and all that.
Given those animal spirits (and the auto-refilling central bank punch bowl), it is not hard to imagine that there is a bit more near-term upside for U.S. large caps. The S&P 500 is about 4.4 percent away from the all-time high it reached 301 days ago. Can it get there? Anything is possible, of course, but we imagine the headwinds are going to start getting stiffer if shares manage to get back to the middle of that corridor. That is when investors will have to start asking themselves whether this bull market still has room for another burst of the valuation multiple expansion we saw in 2013 and 2014.
The Valuation Ceiling
In 2013 stock prices soared, while earnings moved ahead at a more leisurely pace. Earnings per share on the S&P 500 advanced 5.6 percent that year, while share prices topped 30 percent for their giddiest year since 1996. Prices kept going up in 2014 and the first half of 2015, while earnings gradually tapered off and eventually turned negative. The chart below shows the 10 year trend for the next twelve months (NTM) price to earnings (P/E) and price to sales (P/S) ratios for the S&P 500.
Both the P/E and the P/S ratios remain considerably above their 10 year averages. Even at the low point of the recent correction the P/E ratio was only briefly below its pre-crisis 2007 high, while the P/S ratio didn’t even come close to approaching its 2007 levels. Now let us consider the outlook for the rest of this year. The most recent consensus outlook for Q1 2016 earnings per share according to FactSet is -7.9 percent, while the EPS outlook for the full year is 3.2 percent. Sales are expected to be slightly negative in Q1 and to grow by about 1.5 percent for the year. Now, it is plausible that sales could enjoy a light tailwind if the dollar continues to weaken in response to a more dovish Fed. And some recent price and wage data suggest at least the possibility of a brisker than expected pickup in consumer activity in the U.S. (though this data was largely downplayed by the Fed this week).
Even so, though, we see little to suggest that the cadence of EPS and sales growth will be strong enough to lift prices too far off their current levels without pushing the valuation metrics closer to bubble territory. For that to happen, we think we would need to see some random confluence of events acting as a catalyst for a melt-up. That’s not out of the question – melt-ups have served as the codas for previous multi-year bull markets. But predicting the timing of such a melt-up is a fool’s errand. Meanwhile, that valuation ceiling looks fairly imposing.