Posts tagged Us Equity Market
It’s never too early to start thinking about next year. Sure, we still have a holiday season and a Fed decision, among other fun-filled events, to get through before 2015 rings out. But now is when we start to focus on our strategic allocation models and plan out scenarios for what the year may, or may not, have in store. Unfortunately, the calendar-gazing habit tends to bring out the silly side of investing. No small number of “experts” habitually hold forth on the airwaves with a gravitas-laced analysis of the January effect or some other variation of “when X (calendar event) happens, expect Y (stocks to go up, down, all around)”. Next year is 2016, meaning of course that it is once again time to elect a US president. And presidential years take calendar-centric silliness to a whole new level. Not only is there an imagined pattern to presidential election years, as the pundits would have it, but there are “rational” explanations as to why this is so. Fact or fable? Let’s do what we always do, and examine the data.
Presidential Years and Market Math
It is true that recent elections have not coincided with great times for investors. We looked at rolling twelve month returns for the Dow Jones Industrial Average going back to 1900, and found that the average nominal return for this period (through the rolling twelve month period ended September 30, 2015) is 7.7 percent. Compared to that average, the twelve month periods coinciding with the calendar years of 2012, 2008, 2004 and 2000 have all been below average (3.7 percent, -33.8 percent, 3.1 percent and -6.2 percent respectively). Case closed, right?
Not so fast. Humans have a tendency to seize on easily-recalled data and make generalized conclusions from them. It’s called the “availability bias” in the lexicon of behavioral economics. Most of us have a better recollection of the Obama-McCain election of 2008 than of, say, the Hoover-Smith campaign of 1928. That does not make the 2008 outcome a whit more statistically relevant than that of 1928. And in case you are wondering, the Dow delivered a 48.2 percent return that year, at the giddy height of the Roaring Twenties.
In fact, the average return for all presidential election years since (and including) 1900 is 7.3 percent – statistically indistinct from that 7.7 percent average for all 1,387 rolling twelve month periods since January 1900. Please keep this in mind the next time some portentous pundit solemnly holds forth on the “facts” of presidential years and the stock market. Lots of things will impact the market next year, of which the election will be just one variable.
The Law of Small Numbers
How about mean reversion? Are we “due” for a better-than-average election year given the recent streak of poor performance? Sadly, no. The presence of an improbable recent streak does not affect the odds of the next outcome. If you roll a die and it comes up with the six facing ten times in a row, the probability of getting a six on the eleventh roll is still 1/6. The law of large numbers says that mean reversion works over time, with large numbers of observations. The law of small numbers, by contrast, cautions against reading anything meaningful into a small handful of outcomes.
So where does that leave us as we look ahead to 2016? As we noted in our commentary last week, we see a reasonably compelling case for further upside before the current bull run peters out. That could take the form of leadership by high quality stocks or an end-of-cycle “melt-up” (or something else entirely). Among the factors we consider critical are: monetary policy divergence, emerging market growth trends, commodity prices, and geopolitical flashpoints in the Middle East and the South China Sea, among others. Yes, we will also be closely following the US election, the policies articulated by the contenders and the sentiments of the voting public. But we discount any kind of a foregone effect the election year will have on market performance.
Investors in US large caps have more treats than tricks in their candy bags so far this October. Since testing the current correction’s lows in late September, the S&P 500 has rallied by a bit more than 9 percent, and seems poised to extend those gains even further heading to the Friday close. The index has managed to repair much, though not all, of the technical damage sustained during this pullback. The chart below highlights some of the salient features of this pullback and recovery period.
Back to Black
Notably, as the chart illustrates, the S&P 500 has moved back above its 2013 trendline (i.e. the trend off the previous low water marks going back to 2013) and also above the key 200 day moving average. Always remember that there is nothing magical about any of these trendlines or moving averages. But in the perception-is-reality world of short-term trading they do tend to call the algorithm bots to action, and are thus useful as technical metrics. Next obstacle to surmount is the trendline from the last correction of more than 10 percent, in 2011. That’s also right about where we are likely to experience some resistance from the sideways corridor that kept stocks range-bound from February to the August pullback.
Volatility has also subsided rapidly. Compare the performance of the CBOE VIX index, the market’s so-called “fear gauge”, in the current environment with that of the 2011 correction:
The magnitude of the VIX’s spike was similar in the 2011 and 2015 corrections, but the fear gauge stayed higher for much longer in the former. Fully three months after the initial shock in August 2011, the VIX was still habitually closing over 30 (indicating an unusually high risk environment). This time around, the index is back in the docile mid-teens just two months after the initial onset, and has not risen above 20 since October 6. In many ways, this pullback looks somewhat more like the 2014 flash in the pan – the famous “Ebola freak-out” – than it does the more substantial 2011 correction.
With all that said, the key question on everyone’s mind is what happens next. We have a handful of potential scenarios in play as we look through the rest of this quarter and start to plan for next year. Although we certainly cannot rule out another downturn, we think there is a reasonable case for more upside ahead. Two possible variations of an upside scenario are: a rally led by high quality large caps; or a broad-based melt-up. Which of these (if either) may plausibly be more likely?
The Case for Quality
In some areas of the market we are already seeing a quality rally – or at least an environment where shaky business models are feeling the heat. In other words, the market is starting to do what it did not do very much of during the peak Fed-driven rallies of 2013-14: make a distinction between companies with a demonstrated competitive advantage in a rapidly changing economic landscape, and those more vulnerable to the potential negative consequences of such change.
This trend is particularly notable in the consumer sector. Consider the relative performance of two competitors which have been prominent in the news of late: Amazon and Wal-Mart. The chart below shows their respective price trends over the past seven months.
Now, this comparison is only one slice of the market and does not necessarily a dominant trend make. But we are starting to see the market make sharper distinctions between potential winners and losers in the war for consumer dollars and brand loyalty. Wal-Mart knows this terrain well: arguably the last major paradigm shift in consumer retail was its own domination of the big box space through its tight, efficient control of every stage of the supply chain. For that it has been amply rewarded by the market over the years. But Wal-Mart is a laggard as online becomes the dominant trend – barely 2.5 percent of its total sales come from e-tail. Investors appear increasingly skeptical about the company’s ability to make a serious bid for share against the Amazons of the world.
As this dynamic plays out in consumer, tech and other key sectors, 2016 could be the year of the old-fashioned rally where fundamental analysis and stock selection actually pay off. But that is not the only possible outcome.
The Case for Melt-Up
Alan Greenspan memorably uttered the phrase “irrational exuberance” in 1996, a time when the stock market had been soaring along without a care in the world for nearly two years. The sentiment was right, but the timing was off. The market would hit some event-driven speedbumps in the next two years, including a major event-driven correction of more than 19 percent in 1998 that caused immense amounts of hand-wringing. As we all now know, those who panicked in ’98 missed out on one of the great melt-ups of all time in 1999. Melt-ups happen when the money that has sat on the sidelines during an extended bull run finally decides to get in and make up for lost time.
While it would be a stretch to make too much of a comparison between 1999 and 2015, there are some factors which could help pave the way for a melt-up. Easy money leads the way: from the Eurozone to China, and possibly Japan later this month, the central bank spigots are poised to flow at maximum strength. The bond market appears increasingly doubtful that the Fed will follow through with a rate hike in 2015, or even into the first quarter of next year. In this environment a short-term cyclical recovery in emerging markets would be plausible, with hot money flowing back into recently beaten-down destinations in Latin America and Asia Pacific. In this case the quality rally we described above may not materialize, as the Johnny-come-latelies indiscriminately chase anything that moves.
The rational side of our brains tells us that the quality rally is the more logical scenario to plan for. But we also know that markets are generally far from rational, and we cannot rule out the possibility of a wild melt-up. Or, of course, something else entirely. These are interesting times, to say the least.
It seems like the easiest trade in the world: interest rates go up and the price of high dividend stocks go down. Yield-intensive shares have taken a beating this year, none more so than the beleaguered utilities sector. While the S&P 500 is struggling to stay above break-even for the year to date, investors who took on exposure to high dividends are firmly in negative territory: DVY (the iShares ETF) is down by almost 5% as of yesterday’s close. XLU, the SPDR ETF which seems to have become a proxy for a pure play on the dividends-rates trade, is down by almost 12% for the same period.
As investors contemplate a likely secular environment of rising rates, it would seem sensible to reduce the enhanced dividend slice of a diversified portfolio, no? That approach could be a smart tactical play heading into the fall, with possible rate action on the calendar for the September and December meetings of the FOMC. But with below-trend growth likely to keep interest rates below historical norms for some time to come, we would caution against reading last rites on high yielding stocks.
In the chart below we use XLU, the SPDR Select Utilities Sector ETF, to illustrate the uncannily tight negative correlation to bond yields that has characterized high dividend shares’ performance so far this year. This chart plots XLU’s price performance against movement in the 10-year Treasury yield.
The 10-year yield rose from 2.17% at the beginning of January to 2.42% as of the July 1 close. The average dividend yield for the S&P 500 utilities sector is 3.9%. Clearly, the negative correlation between rates and dividend shares has little to do with rational expressions of income preference. Traders make use of ready proxies like XLU simply to trade the day’s news on rates. Many algorithms in this trade key off events like FOMC meetings and the monthly release of jobs numbers. For example, the jobs report released back on February 6 contained a number of upside surprises, indicating a healthier than expected economy. On that day the 10-year yield spiked up 7.7 percent, from 1.82 percent to 1.96 percent, while XLU shares tanked by 4.1 percent. Irrational? Sure, but that’s the way of things in short-term trading. This rate-dividend pattern continued to be reliable as interest rates resumed their upward trend in late April, this time with US benchmarks following the unexpected reversal in Eurozone bond prices.
Give, Give, Give
Dividends, of course, are only part of the widely-followed metric of Total Shareholder Returns (TSR), the other and often larger component of that metric being share buybacks. The two often go hand in hand: as companies move off the steep stage of their growth cycle (the famous S-curve), they tend to give increasing portions of their earnings back to shareholders through buybacks as well as increases in the dividend rate. Over the course of the current six year bull market, top-line revenue growth has waned for a growing number of companies across all industry sectors. During the same time the pace of shareholder returns has quickened; companies are set to return over $1 trillion in buybacks for 2015, a record level representing more than 90% of total S&P 500 operating profits.
Critics will note that buybacks are easy in an environment where borrowing costs are ridiculously low. Rising rates could bring the buyback bonanza to an end, which would seem to be one more reason to be wary of overexposure to stocks and sectors with higher than average TSR yields. While we see logic in that argument we believe it oversimplifies the situation.
Quality, Not Quantity
We believe TSR will continue to be an important metric in evaluating the relative attractiveness of shares, but that the quality of TSR programs will become increasingly important. Companies that can meet their TSR goals largely with free cash flow (FCF) rather than tapping the debt markets will, all else being equal, be preferable to those with growing amounts of net debt on their balance sheets. Investors should also be able to see that buyback programs are being used for more than just insider stock and option awards. A good way to track this is by monitoring the number of fully diluted shares outstanding from quarter to quarter. Large buyback programs without a commensurate reduction in shares outstanding are likely going right into the pockets of options-holding insiders, and doing little to benefit outside shareholders.
Bond yields may be headed north from the historically low floor of the past six years. But “lower for longer” is still in our opinion the most likely scenario for the intermediate term. Lower for longer means that investors should continue to place a premium on shareholder returns. Once the short-term frenzy over the first rate hikes settles down, we expect that premium will come back into clearer view.
Britney Spears and ‘N Sync were blowing up the charts, President Clinton was dominating the headlines in a most unfortunate way, and households all across the country were lovingly attending to their pet Furbys. 1998 seems a world away from that which we inhabit today, seventeen years later. Yet the economic headlines, if not exactly repeating, do seem to rhyme a bit. There are some history lessons here worth bearing in mind as our attention turns to managing our portfolios through the second half of this year.
Here We Go
In 1998 we were well into the multi-year bull market in US equities that began in 1995, but there were serious concerns elsewhere in the world that investors feared would spill over and spoil our party. Following the collapse of the Thai baht in the summer of 1997, East Asian currencies fell by as much as 80 percent against the US dollar over the next year. Their stock markets were likewise pummeled as foreign portfolio capital made a mad scramble for the exit. The S&P 500, shown in the chart below, was stuck in a three month rut as the 1998 calendar flipped to June. It would enjoy an upside breakout through the first half of July, but more ugliness lay in store.
Summertime ended early for traders in 1998 with word that Russia was defaulting on its sovereign debt. Russian government bonds (GKOs) with their generous yields were a favorite asset holding among foreign investors. After the Russian government liberalized the GKO market in 1997, foreigners grabbed around 30 percent of the total market. The likes of Goldman Sachs and Morgan Stanley opened Moscow offices and competed furiously for mandates, right up to the end of the party on August 17 when the government announced its intention to default.
Nowhere was the demise of the Russian bond market felt with more dismay than in the plush offices of Long Term Capital Management, the prominent hedge fund run by ex-Salomon Brothers star trader John Meriwether and options guru Myron Scholes, one half of the Black-Scholes formula that begat the modern derivatives industry. LTCM’s exposure to Russia led to its bankruptcy and – foreshadowing the Lehman Brothers menace of ten years later – fears of an industry-wide contagion. The specter of a bear market loomed, and indeed the 20% peak-to-trough threshold was tested in early October.
…and Shock Absorbers
As we all know now, that bear never got traction. Policymakers and bankers figured out how to put LTCM out of its misery without taking the rest of the industry down with it. All hailed Messrs. Greenspan, Rubin and Summers as the “Committee to Save the World”. With the US economy continuing to hum along nicely and with continuing problems elsewhere in the world, US stocks once again looked like a pretty good comparative bet. The party would roar along for a couple more years, until “Oops! I did it again” would come to describe the vibe in the worlds of both pop music and capital markets in 2000. Investors who bailed out in the late 1998 turmoil missed out on another 59% of capital gains from the 10/8 trough to the March 2000 peak.
Lessons for Today
What can the 1998 experience tell us about today? Clearly the world is a different place. The US economy is growing, with low unemployment and tame inflation, but it is not growing at anything like the pace of the late 1990s. Still, the US continues to look pretty good compared with other parts of the world. The Greek crisis could yet throw cold water on the recent spate of relative good news in the Eurozone. China’s domestic stock market is a bubble showing an unhealthy uptick in volatility, as seen in the chart below.
The Shenzhen A Share index booked a year-to-date gain of 122 percent on June 12, but experienced back-to-back losses of 3.5 percent and 5.9 percent over the last two trading days. China – which comprises about 25 percent of the MSCI Emerging Markets index – has done the lion’s share of the lifting in pulling EM stocks up this year. A collapse in Chinese equities would be likely to bring the rest of the asset class down with it. The herd effect of portfolio capital that tanked emerging markets in 1997-98 is alive and well.
Greece and/or China could be a catalyst for the long-expected pullback in US stocks. The S&P 500 has not closed 10% or more below the last peak since 2011. But – and here is where we see the usefulness of the 1998 parallel – any such pullback is in our opinion likely to play out relatively quickly and present the potential for further gains before this bull fully plays out. Investors have to put their money somewhere. If the rest of the world looks more unsettling than our home market – and this in the context of a bond market that is, if anything, harder to navigate than equities – we do not see a compelling script for a secular bear in US stocks. Navigating pullbacks requires discipline, but history shows there can be rewards for those who keep their emotions in check.
We are now one third of the way into 2015. What can we say about the state of things in the capital markets? US equities would appear to merit little more than “meh”. The S&P 500 saw out the month of April with a 1 percent drop and the Nasdaq pulled back 1.6 percent. As the chart below shows, stocks have spent most of the year so far alternatively bouncing off support and resistance levels. The longest breakout trend so far was the rally that started and ended almost precisely within the calendar confines of February. A directional move one way or the other will eventually happen, but the sluggish current conditions could persist for some time yet.
Unenthusiastic and Confused
If one could attribute human characteristics to the stock market, Mr. or Ms. Market would merit the sobriquets “unenthusiastic” and “confused”. These two attributes derive from already-expensive valuation levels, uninspiring company earnings, and a muddied picture of the overall economy in the wake of some recent soft headline numbers. At 17.0 times next twelve months (NTM) earnings, the S&P 500 is considerably more expensive than it was at the peak of the 2003-07 bull market, when the NTM P/E failed to breach 16 times. At the beginning of 2012 the NTM P/E was 11.6 times. After three years of multiple-busting expansion, investors’ current lack of conviction would hardly seem irrational.
Earnings: Clearing a Very Low Bar
This brings us to earnings. Expectations were grim as the Q1 earnings season got under way, with analysts forecasting negative growth in the neighborhood of -4 percent. That appears to have been a rather exaggerated take on the impact of the dollar, oil prices and other factors on earnings. With 72 percent of S&P 500 companies reporting, earnings per share (EPS) growth is 2.2 percent. The current consensus is for EPS growth to be more or less flat year-on-year when the results are all in (40 percent of energy companies have not yet posted, and their contribution will be largely negative). But zero percent growth, even if better than expectations, is not euphoria-inducing. The current EPS growth consensus for the full year is 1.5 percent. That’s roughly equal to the S&P 500’s price appreciation for the year to date, which may help to explain the stickiness of the current resistance levels.
Growth or No Growth?
Finally, an increasingly mixed picture of the US economy is stumping pundits and Fed governors alike. The Q1 GDP numbers released this week add another data point to the case for weak growth, joining the March jobs numbers, a string of below-trend retail sales figures, a downtick in consumer confidence, and soft manufacturing data. The question is whether this is merely a repeat of 2014 or something more enduring. Last year, an unusually cold winter helped drive negative Q1 GDP growth, but the economy snapped back nicely to grow at an average rate of 4.8 percent over the ensuing two quarters. Such was the gist of the Fed’s post-FOMC message this week: let’s wait and see what happens once the effects of winter and West Coast port problems are removed from the equation.
Since Q2 GDP will not be known before the Fed’s June conclave, we see almost no likelihood of any action on rates coming out of that meeting. That in turn will keep markets guessing for longer – potentially prolonging the duration of this uninspired “meh” market.