Posts tagged Trends
The unseen world is a very strange place. Quantum mechanics, the physics that describes the way things work at the subatomic level, has been validated as a scientific theory again and again since its discovery in the early 20th century. Quantum mechanical laws perfectly describe the workings of literally everything electronic and technology-related in our lives. For all its mainstream applications, though, the implications of quantum mechanics are positively exotic.
Particles exist here, there and everywhere. Pairs of entangled particles instantaneously affect each other across light years of distance. Single photons display wave interference patterns until observed, at which point the wave collapses into a particle with a definitive position in space. This act of observation informs the standard explanation taught to students of quantum physics. Known as the Copenhagen theory, after the home of pioneering scientist Niels Bohr, it posits that all matter exists in a state of superposition (i.e. here, there and everywhere) until observed, at which point it collapses into recognizable forms like trees, cute puppies and Bloomberg workstations. Don’t try to understand the deeper meaning of the Copenhagen theory. Bohr and his fellow pioneers didn’t. “Just shut up and calculate” is how they, and those following, have instructed every new generation of fresh-faced (and confused) physics students.
Don’t Look Now
The subtext of the Copenhagen theory – that observation creates its own reality – resonates in the present day world of stock market volatility. It has come as a painful lesson to investors who came late to the low-volatility party of late 2017 and took bets that the calm seas would carry on. The chart below shows the price trend for the CBOE VIX, the market’s so-called “fear gauge,” over the past twelve months.
When the VIX jumps in price, as it did towards the end of January, it implies a higher risk environment for equities. To look at the above chart is to surmise that something earth-shaking caused risk to jump nearly overnight as the calendar turned from January to February. And, yet, what actually happened? A jobs report showed that hourly wages had ticked up slightly more than expected in the previous month (2.9 percent versus the consensus estimate of 2.6 percent). An “inflation is back!” meme went viral and off to the races went the VIX. Pity the poor punter holding XIV, an exchange-traded note (ETN) designed to profit from a calm VIX. That ill-fated security lost 94 percent – not a typo – of its value in one day, and the ETN’s fund manager announced that the fund would shut down as a result.
Ninety four percent. On account of one lousy wages number. How could this happen? The answer, dear reader, lies in the observer. Risk is a statistical property, a measurement of variance in price. But – as we can see from securities like that poor XIV – it is also an object, a monetized claim. And that has deep implications for equity and other asset markets.
Goodhardt’s Law and the VIX
Charles Goodhardt was an economist who in 1975 made the following observation: “Once a measure becomes a target, it loses the very properties that made it a good gauge to begin with.” Goodhardt’s Law could also be called the Copenhagen Theory of Market Risk. Once you treat risk – volatility – as an object of buying and selling rather than just as a passive statistical measure, you distort what that measure is telling you. Referring back to the chart above, the world did not change in any meaningful way between Friday, February 2 and Monday, February 5. No macroeconomic statistic other than that one random wage number suggested that the economy had changed in any radical way. And yet if you held an asset on Friday morning betting on things staying more or less the same, you were wiped out by the end of the day the next Monday (even though things had more or less stayed the same). Fundamental risk hadn’t changed. But the perception – the observation – of risk created the reality of a 94 percent price drop.
This fact has profound implications for asset markets. The measurement of risk is absolutely fundamental to the models that have informed the construction of portfolios since Harry Markowitz and William Sharpe pioneered the concepts of mean-variance analysis in the 1950s and 1960s. When that measurement ceases to be a “good gauge,” in Goodhardt’s formulation, the ability to arrive at informed valuations for many other assets is itself at risk. Modern Portfolio Theory is the name given to Markowitz’s and Sharpe’s legacy. Increasingly, though, that legacy has to navigate a postmodern financial marketplace.
In the stock market, as in life, all is not equal. In the case of the S&P 500, the inequality derives from that simplest of mathematical formulas: share price times number of shares outstanding – i.e., market capitalization. The importance of any industry sector – from the standpoint of its influence on the total market – is simply a function of the market caps of all the companies in that sector added up. Simply put: the larger the market cap of an individual company or industry sector, the more impact their price movements have on the broader index.
Market Cap Economics 101
Investors have been getting a crash course in market cap economics over the past several weeks as the most dominant sector – and that sector’s most dominant constituents – have battled some unusually strong headwinds. Information technology – one of ten primary industry sectors in the S&P 500 – makes up just under 25 percent of that benchmark index’s total market cap. That is by far the largest single sector: financial institutions, the second largest, make up just 14.3 percent of total market cap at current values. Moreover, the four largest companies in the S&P 500 tech sector – Apple, Alphabet, Facebook and Microsoft – account for 11.1 percent of the total. Add in Amazon – widely considered a tech company although formally listed in the consumer discretionary sector – and you have five companies with a collective market cap of 14.1 percent of the S&P 500 – nearly as much as the entire financial sector. That explains why the following chart has so many investors on edge today:
The main tale of woe has centered around just one of these behemoths, Facebook, which is caught in the crosshairs of a rapidly evolving controversy over its data privacy policies. The story of Cambridge Analytica, a secretive data firm with an affinity for right wing politics and a 2016 mission to help get Trump elected, has been given thorough coverage in mainstream media outlets and does not need rehashing here. The issue is why this story, which at first glance would appear to be company-specific, has thrown such a wet blanket over the entire sector. As the chart above shows, the decline of the tech powerhouses in late January and early February was more or less in line with the market, while the sector’s decline in March has been relatively far more severe.
The answer is that, while Facebook has one business model, Alphabet (Google) another and Apple another still, issues like data privacy and network effects (which can potentially lock in users and lead to concerns about monopolistic practices) affect all the so-called “major platform companies.” In a sense, these recent developments are the flip side of the very reason for which investors have been in love with these companies for so long. Their platforms have radically changed the way a majority of Americans go about spending their days and nights. Actively managed investment funds, seeking that elusive (and probably illusory) “alpha” to beat the market, have swarmed into the so-called “FAANG” stocks like moths to a flame in the belief that these platforms are nearly impervious to competitive challenge.
Beware the Grim Regulator
If the tech heavies have in the recent past seemed like a free lunch, the recent travails are a reminder that free lunches don’t exist. Readers of US economic history know that the best laid plans of monopolists past have been dashed by regulatory push-back. It is by no means clear that a grim reaping is in store for the platform companies, but neither is it clear that they will continue to be given free reign to operate with no fundamental changes to their business models. As global companies, they are at the mercy not only of regulators at home, but arguably more antagonistic ones in the EU and elsewhere. It may be a stretch to imagine Facebook as a regulated utility (a theory which has surprisingly garnered considerable recent press coverage), but it’s worth remembering that strange things do sometimes happen.
In a practical sense, the uncertainty around tech adds a variable to the volatility equation that has become a constant companion in 2018. The CBOE VIX has not fallen below 15 since the original spike in early February, and currently hovers just around 20, the level considered to be a high-risk threshold. We’re seeing lots of those strange days when stock indexes spike up in morning trading and then plummet in the trading day’s final 30 minutes – signs of a jittery market with knee-jerk algorithms calling the shots.
Amid all of this, there is still little in the way of change to the dominant narrative of steady positive growth, a strong jobs market, solid corporate earnings and inflation kept in check. That may be sufficient to yet hold the downside in check. But those volatility variables, including the fog of uncertainty around that market cap-dominant tech sector, are keeping us very busy with our scenario analytics as the year’s second quarter beckons.
Readers of a certain age might remember a perennial favorite among the many outstanding skits performed by late-night TV host Johnny Carson (hi, kids! – ask your parents or their parents). Playing a manic movie review host named Art Fern, Carson would suddenly display a spaghetti-like road map and start giving inane directions to somewhere, leading to the gag: “And then you come to – a fork in the road” at which moment he points to a space on the map where an actual, eating utensil-style fork is crudely taped over the incoherent network of roads. Ah, kinder, simpler, Twitter-less times, those were.
The fork in the road was a key theme of our annual outlook a couple months ago (no match for Art Fern in wit or delivery, but still…). Are we heading down one path towards above-trend growth powered by an inflationary catalyst, or another one characterized by the kind of below-trend, muted growth to which we have become accustomed in this recovery cycle thus far? For now, the data continue to point to the latter.
No Seventies Show, This
Carson’s heyday as host of the Tonight Show was in the 1970s, that era of cringe-worthy hairstyles, mirror balls and chronic stagflation. When the Bretton Woods framework of fixed currencies and a gold exchange standard fell apart in the early years of the decade it freed countries from their exchange rate constraints and encouraged massive monetary stimulation. The money supply in Britain, to cite one example, grew by 70 percent in 1972-73 alone. More money chasing the same amount of goods is the classic recipe for inflation, which is exactly what happened. OPEC poured flames on the fire when, as a geopolitical show of strength, it raised crude oil prices by a magnitude of five times in late 1973. A crushing global recession soon followed as industrial output and then employment went sharply into reverse, with countries unable to stimulate their way out of the mess caused by inflation.
A popular delusion in the immediate wake of the 2016 US presidential election was that some modern day variation of that early-70s stimulus bonanza was about to flood the economy with hyper-stimulated growth. Interest rates and consumer prices would soar as the new administration tossed out regulations, slashed taxes, lit a fire under massive public infrastructure and induced companies to kick their production facilities into high gear. The “reflation-infrastructure trade” flamed out a couple months into 2017 (though CNBC news hosts never got tired of hopefully invoking the shopworn “Trump trade is back!” mantra for months afterwards, every time financial or materials shares had a good day).
Herd-like investor tendencies aside, though, there was – and to an extent there continues to be – a case to make for the return of higher levels of inflation. Economies around the world are growing more or less in sync, which should push both output and prices higher. Taxes were indeed slashed – the one piece of the reflation trade puzzle that actually transpired – and as a result the consensus estimates for US corporate earnings have moved sharply higher. And yet, the numbers keep telling us something different.
Secular Stagnation Then, and Now
When we say “numbers” we refer generally to the flow of macroeconomic data about growth, production, consumption, labor, prices et al, but we’ve been paying particular attention to inflation. The core (excluding food and energy) Personal Consumption Expenditure (PCE) index, which is how the Fed gauges inflation, has been stuck around 1.5 percent for seemingly forever. This past Tuesday gave us a fresh reading on the core Consumer Price Index (CPI), the one more familiar to households, holding steady at 1.8 percent. We also got another lackluster reading on retail sales this week, suggesting that consumption (the largest driver of GDP growth) is not proceeding at red-hot levels. And last week’s jobs report showed only a modest pace of hourly wage gains despite a much larger than expected increase in payrolls. These numbers all seem to point, at least for now, towards the path of below-trend growth. Perhaps the bond market agrees with this assessment: the yield on the 10-year Treasury has been cooling its heels in a tight range between 2.8 – 2.9 percent for the past several weeks.
The economist Alvin Hansen coined the phrase “secular stagnation” back in the late 1930s, at a time when it seemed that long term growth lacked any catalyst to kick it in to a higher gear. We know what happened next. The war came along and rekindled productive output, followed by the three decades of Pax Americana when we ruled the roost while the rest of the world rebuilt itself from the ashes of destruction. Former Treasury Secretary Lawrence Summers brought the term “secular stagnation” back into popular use earlier in this recovery cycle. The numbers seem to tell us that this remains the default hypothesis.
But the story of the late 1930s reminds us that all a hypothesis needs to knock it off the “most likely” perch is the introduction of new variables and resulting new data. Foremost among those variables would be productivity (hopefully productivity from benign sources, and not from hot geopolitical conflict). It may well be that we have not yet arrived at that “fork in the road” but are still somewhere else on Art Fern’s indecipherable road map – and that a new productivity wave will pull us off the path of secular stagnation. The data, though, aren’t helping much in signaling when, where, and how that might happen.
It hasn’t been quite the V-shaped recovery of many pundit prognostications. The S&P 500 briefly entered technical correction territory last month, and flirted ever so coquettishly with the 200-day moving average, a key technical trend variable. The ensuing relief rally has seen a couple peaks, but is still climbing the wall back to the record close of 2872 reached on January 26. A month and a half may not seem like a long time – and it’s really not a long time, in the great scheme of things. But other recent pullbacks have done a better job at channeling their inner Taylor Swifts to “shake it off.” The chart below show the pace of the current recovery (leftmost diagram) compared to the brief pullbacks experienced after 2016’s Brexit vote (middle) and the mini-freakout over Ebola in 2014 (right).
So at 42 days, we’re a bit behind the brisk pace of the Brexit (30 days) and Ebola (27 days) pullback-recovery events. But it’s not too much of a stretch to imagine the S&P 500 finding itself scaling the rest of that wall to 2872 in the not so very distant future. Over the course of the current recovery, investors have learned to build an impressive immunity to what one might consider to be bad news. In a sense this is an acquired habit, courtesy of the world’s major central banks.
It Was Just Nine Years Ago Today, Ben Bernanke Taught the Band to Play
Speaking of the “current recovery,” today is its nine year anniversary! Three cheers for the bull. On March 9, 2009 US equity markets hit rock-bottom, more than 50 percent down from their previous highs in the largest market reversal since the Great Depression. Investors in early 2009 were catatonic – many who had managed to keep their heads during the freefalls in September and October of the previous year finally capitulated in March, fearing there was potentially no bottom for risk assets.
Those who held off the demons of fear one last time were rewarded mightily as stocks found solid ground and began the long trek back. But it was not exactly easy street for those first tentative years. 2010 witnessed a handful of significant pullbacks and lots of angst. In 2011 the market flirted with bear territory (20 percent or more down) when the Eurozone crisis accelerated and the US Congress came ever so close to defaulting on the national debt. Other potential black swans lurked in the following years, from government shutdowns to the crash in oil prices to fears of a hard landing in China.
But as each news cycle came and went investors learned to stop worrying. Credit for this learned behavior can confidently be laid at the feet of Ben Bernanke, Mario Draghi, Haruhiko Kuroda and Janet Yellen, along with a supporting cast of dovish policymakers in their respective central banks. The “central bank put” was solidly in the money and increased in value throughout the recovery, even as the US Fed started to lead the way out of monetary Eden as it ended quantitative easing and began to raise rates. The investor calculus was simple: things will work out, and if they don’t, the banks will step in and bail us out. This way of thinking finally led to that unreal calm in the markets in 2017. Even the wackiest of political shenanigans failed to make an imprint on investors trained to embrace the Panglossian assurance of the best of all possible worlds for risk assets.
O Brave New World, That Hath Such Creatures In It
If the central bank put is the magic formula for maintaining calm, what to make of the tea leaves from recent statements by Yellen’s successor, Jerome Powell? The new Fed chair has been largely unimpressed by the recent market volatility and appears to see no reason for soothing bedtime stories to global investors. That should be a good sign: if the economy is doing well on its own, then markets should be able to take in stride the upward movement in interest rates and inflation that one would expect to follow from rising corporate sales and earnings. Nonetheless, it is a brave new world from the recent past.
Taken this way, it makes sense to ascribe the February pullback to nothing of any particular importance. The pullback started with a jobs report that showed wages growing at a 2.9 percent annual rate, higher than the recent trendline of 2.5 percent or so (though not particularly hot by historical standards). Trump threw some new fire on the flames last week with the unexpected announcement of punitive new tariffs on steel and aluminum. But the ingrained tendency to remain calm has largely prevailed. The general thinking on tariffs seems to be that they will fail to ignite an all-out hot trade war. Meanwhile, this morning’s jobs report had a double helping of good news, with a whopping 313,000 payroll gains alongside an underwhelming (therefore good!) average wage gain of 2.6 percent.
What if the wisdom of the crowd is wrong? What if dysfunctional politics and misguided fiscal policymaking still do matter? What if that productivity boom that is supposed to arrive any day now fails to show up, relegating the world economy to sub-par growth as far as the eye can see? Will there be another incarnation of the central bank put? Will it be as effective as it was for the last nine years? All questions without answers, for now. For the time being, though, it would appear that the news cycle will continue to leave investors unimpressed, where the smell of bad news must mean there’s a pony nearby. Your portfolio should enjoy this while it lasts.
Every fiscal quarter, publicly traded companies and the securities analysts who cover them engage in a series of time-honored rituals. The rituals follow the elaborate pantomimes of a Japanese Kabuki drama, and the underlying message is almost always the same: Hope Springs Eternal. Consider the chart below, which shows quarterly earnings per share trends for the S&P 500.
How to Speak Kabuki
Here’s how to interpret this chart. The green line represents projected earnings per share for the next twelve months. Basically, analysts project what they think will happen to the companies they analyze in the year ahead, based on the economic context and all the usual industry- and company-specific competitive variables, and those assumptions boil down to the one NTM (next twelve months) EPS figure. This chart shows the composite NTM EPS for all the companies in the S&P 500. For example, on January 31, 2017, the composite estimate for what S&P 500 shares would be worth a year hence (i.e. at the end of January 2018) was $133.17 per share.
The red line illustrates the actual earnings per share for the twelve trailing months, known in finance-speak as LTM (last twelve months). So if the green line represents the hope, then the red line shows the reality, or what actually happened. As you can see, the actual LTM earnings per share for the S&P 500 on January 31, 2018 was $118.08. It wasn’t $133, as the analysts had forecast a year earlier.
Moreover, the chart shows that this “reality gap” plays out in virtually every quarter, year after year. What often happens as earnings season approaches is that analysts start to dial back their earlier predictions to bring them closer to reality. In so doing, they are playing another important role in the Kabuki drama: managing expectations. Earnings season is only partly about the actual growth number; it is also about whether this number is better than, or worse than, what was expected. The downward revision that customarily takes place in the weeks before a company reports has the effect of lowering the bar, so that whatever number the management team actually reports has a better chance of beating expectations.
This Time Is (Sort of) Different
Clear as a bell, right? In summation: expected earnings are usually rosier than the actual figures that come out later, and the elaborate play-acting between management teams (forward guidance) and securities analysts (downward revisions to expectations) contrives to deliver happy surprises to the market.
Except that the script is a bit different this year. Analysts are actually raising – not lowering – their expectations for 2018 earnings performance. Let’s consider the case for Q1 2018. This is the quarter we are currently in, so we don’t know how the companies are actually going to perform. What we do know is that the analysts’ consensus estimate for Q1 S&P 500 earnings as of today is 17.1 percent growth. When the same analysts made their Q1 forecasts at the end of last year, the estimate was 10.9 percent. That’s a big difference! And not just for Q1. The analysts’ Q2 estimate is also significantly higher today than it was seven weeks ago. In fact, the consensus estimate for full year 2018 earnings growth is 18.2 percent, which is 8 percent higher than on December 31, when analysts predicted growth of just 10.3 percent.
That difference – the difference between 18 percent and 10 percent – matters a lot for equity valuation. If companies in the S&P 500 grow their earnings by 18 percent this year, then a similar rise in share prices will not make stocks any more expensive, when measured by the price-earnings multiple variable. That would ease investors’ worries about a potential share price bubble. Double digit price growth matched by double digit earnings growth is arguably the best of all possible worlds for long equity investors.
Here is the one caveat. Much of the apparent optimism in the current earnings projections comes from one single fact – the tax cuts enacted in December that were disproportionately skewed towards corporate tax relief. You can see from the green line in the above chart just how dramatically expectations accelerated right around the time the relief package took shape. More than any other factor, the tax cuts help explain why, contrary to the usual practice, earnings estimates have been raised rather than lowered as reporting dates come closer (though we should also note that a weaker US dollar, should it persist, could also be an earning tailwind for companies with significant overseas activities).
More to Life than Taxes
Investors should take in this seemingly good news with a measure of caution. First, to the extent that the tax relief does make a strong impact on the bottom line (which would be the case for companies that actually pay something close to the previous statutory tax rate, by no means a majority of S&P 500 companies) it will be a one-and-done kind of deal. The growth rate will kick up for one fiscal year cycle of “comps” – comparisons to the previous year – and then stabilize at the new level.
Second, there are other variables in flux that could at least partially offset the tax advantages. Corporate borrowing will be more expensive if (a) interest rates generally continue to rise and (b) credit spreads widen in response to higher market volatility. Companies in more price sensitive industry sectors may have to address issues of how much new inflation they can pass on to their customers. And, of course, corporate top lines (sales) will be dependent on the continuation of global economic growth leading to increased organic demand for their products and services.
Finally, the only way that companies can consistently grow their earnings above the overall rate of GDP growth is through productivity-enhancing innovations to their value chains. There may be a new wave of such innovations just around the corner – or there may not be. How these developments play out over the coming months will determine whether the current rosy predictions of the analyst community play out – or whether they quickly go back to that familiar old Kabuki script of hope and reality.