Posts tagged Us Equity Market
The Passover holiday starts this evening, and children in Jewish households around the world will be preparing for a traditional rite of passage in reciting the Four Questions to their elders. Investors watching the two month-long rally in equity markets may well have a question of their own: Why is this rally different from all other breakout rallies since the S&P 500 reached an all-time high of 2130 nearly one year ago, in May 2015? To put it a different way, is there anything plausible to suggest a sustained move above a fiercely resistant valuation ceiling? After the three year-plus multiple expansion rally topped out last year there have been five upside breakout attempts that have fallen short, including the current one thus far. The chart below illustrates this topping-out effect.
Tiptoeing Over the Low Bar
Much of the current focus is, rightfully, on first quarter earnings. There are two ways to interpret the results that have come in so far (about 27 percent of all S&P 500 companies have reported Q1 earnings as of today). The first is the expectations game: a number of firms thus far have managed to clear an exceedingly low expectations bar. Back in December, the consensus among analysts was that earnings per share growth would be more or less flat for the first quarter. Today, the same analysts expect Q1 EPS to decline by nine percent from their levels one year ago, when all is said and done. So all that a company has to do in order to give the market an “upside surprise” is to report earnings slightly higher than these sharply reduced expectations.
We have seen this reduced-expectations narrative play out among early reports in the financial and metals & mining sectors, two of the more beaten-down industry groups of late. For example the market takeaway from JPMorgan Chase, which led off earnings for the major banks last week, could be summed up thus: “bad, but could have been worse.” Bank stocks rallied sharply following the JPMorgan release, and were no less giddy a week later when Goldman Sachs reported a decline of 56 percent in net income from the period one year ago. If bad news is not awful news it must be good news, the convoluted logic seems to go.
Math Is Still Math
The second way to interpret Q1 earnings results is to ignore the Kabuki-like theatrics of the expectations game and point out that, however you want to frame the context, low earnings are still low earnings. Stocks are therefore still expensive. At the beginning of 2012 the ratio of the S&P 500 price index to average earnings per share for the last twelve months (LTM P/E) was 12.4 times. Investors would pay $12.40 for each dollar of average per share earnings. Over the subsequent three and a half years the LTM P/E ratio jumped from 12.4 times to 18.1 times – a “multiple expansion” rally where prices grow faster than earnings.
Today, despite two market corrections of more than 10 percent and the repeated failure to regain last year’s high water mark, the S&P 500 is as expensive as it was a year ago. It is more expensive than it ever was at the peak of the previous bull market of 2003-07. It is even dearer on a price-to-sales (P/S) basis; the current LTM P/S ratio of 1.8 times is the highest this ratio has been since the immediate aftermath of the late-1990s tech bubble.
Animal Spirits, to a Point
The fact that the market remains expensive does not necessarily preclude a breakout to the upside into new record high territory. Stranger things have happened; asset markets are the stomping grounds of John Maynard Keynes’ “animal spirits” far more than they are the purview of the fictitious rational actors of economics textbooks. The vague but often telling indicator of investor sentiment seems tilted to the upside. The question, though, is how sustainable a strong upside breakout would be in the absence of improvement in corporate earnings prospects.
We are unlikely to see the earnings math for Q1 make much of a compelling growth case. It remains to be seen whether some of the headwinds that have clipped sales and earnings prospects of late will abate further into the year – perhaps driven by a softer US dollar and a demand pickup in key consumer markets. Until then, we tend to believe that this rally is not much different from the four post-high rallies which preceded it, and that it would be a good idea to keep one’s animal spirits in check. Not in a defensive crouch, but in check.
In a fundamental sense, not a whole lot has changed for the global economy since the beginning of the year. Economic growth remains below trend just about everywhere, hindered by the well-known headwinds of weak demand, stagnant wage growth and supply-demand imbalances among others. US companies continue to experience earnings headwinds from a strong dollar. X-factors abound, from capital outflows in China to the refugee crisis in Europe and the unusually volatile political climate in the US.
When we surveyed this landscape back in early January we could see a plausible case to make for a continuation of the kind of quality rally that had characterized a good bit of the second half of 2015. Sales growth a challenge? Opt for the companies with a demonstrated model for growing the top line by double digits despite the headwinds. Productivity not what it used to be? Focus on those enterprises able to sustain strong operating profit margins.
Nice idea in theory. In practice, not so much. We are indeed experiencing a rally in global equities now, after the rocky start to the year. But a quality rally it is not. Perhaps our January outlook will be vindicated before the end of the year, but for now the market appears reactive to anything other than fundamental quality measures.
A glance at some key performance metrics for S&P 500 constituents bears testament to the seeming disregard for quality. The top ten percent of companies in the index, ranked by total stock price return for the year to date, showed average revenue growth for the last twelve months of minus 4.2 percent. By contrast sales growth for the bottom ten percent – i.e. the companies with the lowest total stock price return for the year to date – was a positive 2.3 percent for the last twelve months. Same goes for EBIT (earnings before interest & taxes): this year’s outperformers grew by negative 4.8 percent compared to a positive 3.0 percent for the dogs of 2016.
But markets are forward looking, right? Maybe investors are more interested in next twelve months’ growth prospects than in last twelve months. Then again, maybe not. The consensus estimate for next twelve months EPS (earnings per share) growth for that top decile cohort is 4.7 percent. For the bottom decile the consensus outlook is more than twice that, at 10.7 percent. And that bottom contingent is also less leveraged, with a debt-to-total capital burden of 47 percent versus 53 percent for the top decile.
Super Mario’s Bright New Shiny Objects
If investors are not paying any attention to fundamentals, it’s a pretty good bet that what they are focused on rhymes with “ventral tanks”. By all accounts the central bank in question this week is Mario Draghi’s European Central Bank. The ECB made headlines on Thursday when it announced a raft of new stimulus measures, including some genuine novelties. The market expected the deposit rate cut to minus 0.4 percent. Rather less expected, though, was an easing of the terms by which the ECB provides liquidity to banks through long-term refinancing operations (LTRFOs). Essentially, Draghi & Co. will pay banks to make loans through rates as low as minus 0.4 percent on LTRFO facilities. Other goodies in the ECB swag bag included an expansion of monthly QE purchases from €70 billion to €80 billon, and a broadening of QE-eligible instruments to include corporate debt. Draghi seemed to be at pains to emphasize his goal to see this round of stimulus actually work its way into the real economy through a higher level of credit creation.
Market reaction was predictably all over the place. The euro plunged within microseconds of the ECB announcement on Thursday morning, then turned around and rallied hard, finishing up more than two percent against the dollar. Likewise for equity markets, which condensed a “best of times/worst of times” sentiment into a single day of trading. After sleeping on it, Mr. Market seemed to like what he saw, and European bourses chugged ahead with gains of mostly two percent or more on Friday trading.
There and Back Again
That kind of intraday volatility is characteristic of an environment entirely at the mercy of central bank announcements and other macro events. It is what keeps our own sentiment in check and wary of reading too much into any directional trends. There are plenty more central bank moments on tap this year, starting with the Fed next week. How will Janet Yellen and her colleagues explain their thinking about the appropriate trajectory for rate policy here at home? The policy divergence theme – with the Fed going one way and the rest of the world going another – is back on center stage. We don’t expect the Fed to move next week, though it is worth noting that the February inflation numbers will be released just as discussions are getting underway on the second day of the event. If the recent string of upbeat numbers continues, there will be some tough decisions ahead for the FOMC.
Unfortunately, the takeaway from all this is that expectations for markets to wean themselves off central bank dependence were premature. We’ve reverted back there after an oh-so-brief flirtation last year with free cash flows and return on invested capital and the like. If this rally continues, though, at some point someone is likely to look up and notice that, gasp, valuations are really stretched. The results may not be pretty. In the end, fundamentals do matter.
Since setting a multi-year low on February 11 the S&P 500 has enjoyed a robust relief rally, gaining 6.7 percent through the 2/25 close. The rally has garnered plenty of skepticism, but there are some impressive aspects. It has been fairly broad, with seven of the ten major industry sectors posting gains of more than six percent. Consumer discretionary – an important sector given its central role as a driver of GDP growth – is up more than nine percent since that February 11 low. Industrials and tech have also done well: the SPDR Exchange Traded Funds for those two sectors (XLI and XLK) gained 7.5 percent and 6.9 percent respectively in the same time period. This rally is not, as some observers have argued, simply a dead cat bounce for oversold energy and financial shares.
The technical damage is far from repaired: the index is still almost four percent below its 200 day moving average, for example. But it has managed to break through both the fifty day moving average and a key resistance threshold level of 1950. Since the 2/11 low the index has closed up by more than one percent five times, and down by more than one percent just once. Reasonable people might want to know: is the pain over? Despite the positive attributes, we would caution against settling too comfortably into the good vibes. Plenty of headwinds remain.
Volatility’s Two Faces
For starters, let’s take a closer look at those one percent-plus days we mentioned in the last paragraph. There have been a lot of them this year. Twenty three, to be exact, which is about sixty five percent of the total number of trading days thus far in 2016. By comparison, the index experienced a daily gain or loss of one percent or more just fifteen percent of the time in both 2013 and 2014. In 2011, the last year in which a pullback of a similar magnitude to this year’s took place, the market registered a gain or loss of one percent about thirty eight percent of the time.
To be sure, we are not inclined to assume that the volatile patterns of the year’s first two months will be sustained for the next ten. Other risk measures like the CBOE VIX index and the S&P 500’s rolling thirty day standard deviation have come down substantially over the past two weeks. But those daily lurches of one percent or more are symptomatic of environments driven largely by events rather than fundamentals. The unhealthy correlation between equity gains and oil prices hasn’t gone away. Off-the-cuff remarks by Venezuelan oil officials appear able to drive intraday prices more than durable goods reports or GDP revisions. What the headlines giveth, the headlines taketh away. There is no way of knowing which way tomorrow’s headlines will galvanize animal spirits.
An Earnings & Valuation Ceiling?
Not that anybody is paying much attention to the fundamentals today, but they are likely to present a formidable obstacle to overcome at some point if the current rally continues. The S&P 500 currently trades at a 15.9 times multiple to projected next twelve months’ (NTM) earnings. That is roughly the same multiple at which it traded in late 2014. At the beginning of 2012, as the index was embarking on a vigorous three year expansion rally, the P/E ratio was 11.6 times NTM earnings. Valuations today are not in bubble territory, but neither are they cheap or even average (the average NTM P/E for the last ten years is 13.9 times). Analysts’ expectations for 2016 full year earnings are predicated on a strong pickup in the second half of the year after posting declines in the first half. If the consensus turns out to be rosier than reality – as often happens – then valuations will be even more expensive.
In this kind of environment we recommend paying more attention to risk-adjusted return than to absolute outperformance. A mix of a modest amount of cash and exposure to low-correlated strategies like market neutral or merger arbitrage, while underweighting riskier equity styles, can be a sensible approach for long term diversified portfolios to ride out the volatility while still being positioned to participate in upside growth.
Our Annual Outlook will be published next week. Below is the executive summary.
2015 was a key transitional year in capital markets. In the US the year signified the end of an era. From 2009 through 2014 US equity markets grew at an average annual rate of 12.6 percent largely due to the efforts of the US central bank – the Federal Reserve – to stimulate markets through a combination of zero-level interest rates and outright open market purchases of fixed income securities. The Fed wound down QE (quantitative easing, the term for its bond-buying programs) in 2014. At the end of 2015 it raised interest rates for the first time since 2006, albeit very gently. With the training wheels of monetary policy stimulus coming off, US stock markets returned last year to a focus on fundamentals. For better or for worse, we expect that trend to continue in 2016.
The economic backdrop in which US equities will perform this year is little different from the trend of the past couple years. The economy is growing, albeit modestly in comparison to historical norms. We are close to what economists would consider to be “full employment”, with the strongest consecutive periods of job creation since the late 1990s. Upward movement in wages is still elusive, though it bears mentioning that wage growth did slightly outpace inflation in 2015. Consumer spending, which makes up the lion’s share of US GDP, continues to grow although there was a general sense of disappointment with the 2015 holiday season. We see little reason to believe that GDP will grow by more than three percent this year or by less than one percent. Overall, US economic fundamentals should remain favorable this year.
Elsewhere in the world the story is quite different. The European Central Bank launched an expanded monetary stimulus program early last year, extended the terms of the program yet again towards year-end, and is expected to do more again this year to lift Europe out of its economic funk. China is also contending with the realities of slowing growth and looking for ways to manage a very tricky economic rebalancing away from investment towards consumer activity. In essence, the global economy’s path is diverging, with the US on one track and the rest of the world on another. The related uncertainty suggests the potential for more volatility than we have seen in recent years.
The aforementioned China rebalancing looms large as the year gets under way. The world’s second largest economy continues to grow, if not at the double-digit levels to which it was accustomed in the previous decade. Retail sales and other measures of activity are healthy. But slowing growth is a concern for a variety of reasons. China’s non-financial debt-to-GDP ratio is approximately 250 percent. A sharp growth contraction could have a negative knock-on effect among other Asian economies. And China has the potential to roil international credit markets if it feels compelled to sell off large amounts of FX reserves (mostly US Treasuries and other sovereign debt) to prevent a currency rout.
At the same time, China’s shift away from the massive public and private investment programs which drove its earlier phase of growth has major implications that reach far beyond its own borders. In particular, the growth boom of 2000-14 drove a massive commodities supercycle. It will likely take a very long time for the energy and industrial commodities which rode the boom to approach anything close to their peak prices. In the meantime, stabilization at lower trading ranges is the most optimistic case for a wide range of commodities in 2016. Resource exporters from Brazil to Australia and Russia will feel the pain. And companies in the energy and mining sectors will continue to deal with downsizing, project cancellations and, in some cases, potential for debt defaults.
As headline-grabbing as China’s predicament is, the situation is more dire still in other emerging markets. Brazil and Russia, which alongside China and India make up the once-dynamic BRICs, are both in protracted economic and (in Brazil’s case) political crises. Other erstwhile engines of growth from Turkey to South Africa, Malaysia to Indonesia, have seen their currencies collapse by the largest amount since the 1997 Asian currency crisis. Dollar-denominated debt obligations remain a potent overhang. And with weak demand seemingly a chronic feature just about everywhere, opportunities to export one’s way out of trouble seem limited. Emerging markets as an asset class has disappointed for several years; we do not see that changing significantly this year.
How will the monetary policy divergence noted above affect interest rates in 2016? The short end of the yield curve is probably more predictable. The spread between US and Eurozone yields, with the latter firmly ensconced in negative territory, could widen further still if the Fed sticks to its plan of gradual rate hikes. The intermediate/long term is subject to other variables, not the least of which is the potential for foreign central bank sales of US Treasuries to support their beleaguered currencies. Finally, expect credit quality spreads to be a continuing story in 2016. The sorry state of resource sectors like exploration & production and mining has taken a toll on the high yield market. But spreads continue to widen as well between higher-and lower-rated investment grade securities. Tightening credit conditions could also have an effect on corporate decision-making. Stock buybacks and M&A, both of which rely heavily on debt financing, could feel the impact of more stringent credit conditions.
X-factors – our shorthand for latent risks that could turn into live threats – abound in 2016. The Middle East, never the world’s most calmest region, looks less stable than ever. Europe faces a potential humanitarian crisis as refugees continue to arrive in droves. In the US, the Presidential election reflects a sharply divided and dissatisfied populace, with the potential to throw out the playbook on the usual rules of the game. Russia’s foreign policy adventurism continues apace. These are just a few of the prominent potential threats we know; there very probably are others. Always remember, though, that X-factors can be both positive and negative. Market sentiment can change very quickly as the landscape changes.
In summary, we believe 2016 will likely be a year of trend continuation rather than mean reversion, with dominant trends like monetary policy divergence, a strong dollar, commodities prices and uncertainty about China shaping the sentiment. We expect US equity markets to be strongly influenced by earnings. Rationally, that would imply the potential for price gains in the low single digits. However, as bull markets get old – the current one is in its seventh year – rationality often gives way to volatility. Volatility can work on both the upside and the downside – melt-ups are as common as melt-downs. We believe the right response to the uncertainty of this environment is to remain diversified across a spectrum of low-correlated asset exposures, and to avoid large concentrations in any given area.
Since its inception in 1990 the CBOE VIX index – the so-called “fear gauge” – has shown itself to be a fairly good barometer of market risk. The index’s mean reversion tendency is particularly useful; the long term average value of 20 (shown as the dotted green line in the chart below) fairly neatly separates lower risk and higher risk environments. A value of 20 or higher signals a relatively high perception of risk, while extended periods below that threshold generally suggest benign conditions for equities. In view of the recent market correction and (partial) recovery, what can the VIX tell us about where we may be headed as 2016 approaches?
Let’s start with the most dramatic – and most often misused – feature of the VIX, namely those periodic Andean peaks spiking into the stratosphere. A VIX peak over 20 will typically be accompanied by a stock market pullback of several percent or more. More often than not, though, the risk reflected in that pullback is short-term and event-driven, rather than a signal of a more sustained bear market environment. Consider October 2014. The VIX had been sleepy for most of the summer and early fall, hovering in the low-mid teens as October got under way. A confluence of several events – among them falling oil prices, a weird “flash crash” in Treasury yields and an inchoate panic over reports of an Ebola outbreak in Sierra Leone – managed to rouse the trading bot armies into sell mode. The VIX spiked to 26 and the S&P 500 gave up close to eight percent. Then, as quickly as it appeared, the risk vanished, leaving a great many hedge strategies much the worse for wear.
In analyzing the VIX we care more about the baseline trend than the peaks. The above chart shows three distinct, sustained periods of relatively low volatility to which we refer as “valleys”: mid-decade in the 1990s and 2000s, and the better part of the past four years. Not surprisingly, all three valleys have coincided with favorable tailwinds for stocks. However, the baseline in the most recent valley is somewhat higher than that for the previous two. The average VIX level from 2012 to the present is about 15.6, compared to 13.7 for the 2004-06 period and 13.8 from 1993-96. While part of this difference is explained by a handful of higher peaks (notably those associated with the pullbacks of 2014 and 2015), there have also been – as clearly seen in the chart – fewer “tween” days (where the VIX closed between 10 and 12). This has been a somewhat jittery recovery despite the strong gains.
This brings us to the VIX characteristic we regard as most instructive: the mesa formations. On the above chart these are the two examples of the VIX maintaining a baseline level of 20 or higher for a sustained period of time. The two mesa environments since 1990 have both coincided with bear markets, but the more salient fact is that both mesas formed well before the bear took shape. During the 1990s bull market, the VIX was setting regular baseline closes above 20 from the middle of 1997 on. Practically the entire final phase of that great bull took place in an elevated risk environment. In a somewhat similar vein, the VIX was already in a mesa formation by the time the S&P 500 set its final pre-crash record high in October 2007.
A VIX mesa is not by itself a sell signal. Clearly, it would have been a poor strategy to sell out of the market between 1997 and 1999. Any technical signal needs to be considered in the context of other signals, and only when enough of them are flashing does it make sense to execute a defensive position. We do not see a sufficient number of flashing signals today to suggest putting up the ramparts. But we are watching the VIX trend. A mesa formation is a plausible scenario for 2016, even if the bear is (as we imagine) still some ways away. It would be consistent with both a narrow rally led by a few high quality performers, which is our base case scenario, as well as a “melt-up” reminiscent of 1999. Time will tell.