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MV Weekly Market Flash: Right Back Where We Started From

October 24, 2014

By Masood Vojdani & Katrina Lamb, CFA

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For a brief few intraday trading moments last week the S&P 500 fell below the level of 1848 (year of revolutions!) where it started 2014. The ensuing v-shaped rally has pushed the index fairly comfortably back into positive territory. But the price-equity (PE) ratio remains a bit below where it opened the year; the twelve trailing months (TTM) PE ratio as of October 23 is 16.3 as compared to 16.5 at the beginning of January. The chart below shows how the PE ratio has trended over the course of this year.

What the PE Ratio Tells Us

The PE ratio is a valuation metric. Think of it as a yardstick for how much investors are willing to pay for a claim on a company’s earnings. For example, a PE ratio of 10x at ABC Company means that investors are willing to shell out $10 for each dollar of ABC Company’s net earnings per share (EPS). If the PE goes from 10x to 12x it signifies that investor perceptions of ABC company have improved; they are now willing to pay $2 more for that same dollar of earnings. A fall in the PE – say from 10x to 8x – would mean the opposite. Value investors, in particular, analyze companies with low PE multiples (relative to the market or their industry peer group) to see if there is a bargain to be had; to see whether there is value in the company that the market, for whatever reason, is not recognizing.

The Multiple and Its Message

Bringing the discussion back to the above chart, it would seem that investors’ attitude towards stocks in general isn’t far today from where it was in January. There were a couple rallies that pushed the PE higher and a couple pullbacks that brought it back down, but over the course of the year the multiple has repeatedly reverted towards the mean (average) level of 16.5x. In our opinion there is a good reason for this, and potentially a message about where stocks may be heading as we start planning our allocation strategy for 2015.

The consensus growth estimate for S&P 500 earnings in 2014 is around 6%; in other words, earnings per share on average should be around 6% higher at the end of the year than they were at the beginning for the companies that make up the index. As it happens, 6% is not too far from the index’s price appreciation this year. We would not be surprised to see this relationship still largely intact as the year closes: a positive year for stocks in which the PE multiple neither expands nor compresses, with mid-upper single digit gains for both share prices and earnings.

Still Not Cheap

The recent pullback has done little to change the fact that stocks are still expensive, on average, relative to long term valuation levels. In the chart below we see the same PE ratio as in the first chart, but the time period goes back ten years to October 2004.

For the last ten years the average TTM PE ratio was 14.6x, considerably below the current level of 16.3x. Remember that the higher the PE, the more expensive the market. In fact, prices are currently higher than at any time since 2005 (we should note, though, that they are still far below the stratospheric levels achieved in the final frenzied years of the late ‘90s bull market). This prompts us to recall the title of the 2014 Annual Outlook we published back in January: “How Much More?” In other words, how much more multiple expansion could we expect to see given how high the multiple already is?

For the past three years the Fed has been the driving force behind an across-the-board rally in U.S. and, mostly, global equities. With QE3 coming to an end (probably) and rates heading slightly higher next year (probably), stocks will be left more to their own devices. We think it reasonable to assume a base case of positive growth in share prices more or less in line with earnings; in other words, a continuation of the 2014 trend. We also see a good case to make for a return to focus on quality and selectivity – companies with solid cash flows and robust business models – rather than an indiscriminate buy-everywhere approach. We may be wrong. Late-stage bull markets can lure cash in from the sidelines and expand PE levels ever higher, as in 1998-99. Conversely, any number of things from Europe’s economy to a China slowdown to worsening geopolitics could spark more broad sell-offs. When we establish a base case we do so with several alternative scenarios. Our thinking may change – we are data-driven and not ideological. But right now, growth without much multiple expansion seems plausible.

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MV Weekly Market Flash: The Cupertino Circus

September 12, 2014

By Masood Vojdani & Katrina Lamb, CFA

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Apple is a phenomenally successful company, and at $607 billion it is also the world’s most valuable enterprise. So it is probably not surprising that new product announcements would command Wall Street’s attention. But there is a level of showmanship and high drama to Apple’s product launches unparalleled in the annals of modern markets. The effect these feats of corporate kabuki have on the stock market should put the definitive nail in the coffin of the Efficient Market Hypothesis and the idea that the market is in any meaningful way rational. 

Fanboys and Haters

This past Tuesday Apple convened a conference in its Cupertino hometown to announce a sequence of new offerings: new versions of the iPhone, a new payment application called Apple Pay, and its debut into the so-called “wearables” market with Apple Watch. How did the markets react? A picture says a thousand words. 

 

“Don’t fall in love with a stock” is a timeless maxim, but one seemingly lost on the vast legions of Apple devotees as well as the less populous but still prominent haters of everything Jobs, Cook & Co. The skeptics had the upper hand as CEO Cook described the features of the new iPhone 6 and 6 Plus. Perhaps the market’s dour take on the new 4.7 and 5.5 inch screens is that they address a market where Apple’s rivals, notably Samsung, have an existing advantage. In any event, the bulls regrouped when Cook moved on to the second innovation, a payment system aimed at nothing less than consigning the credit card to the dustbin of economic history. Finally came the product tech blogs and fanboy sites have been chatting about for weeks: the Apple Watch. Some observers seemed to like it – the Financial Times correspondent Tim Bradshaw spent part of his liveblog coverage doing a selfie/demo of his Watch-adorned wrist. Oh, and U2 performed live! But Wall Street turned its nose up and the share price plummeted.

Intraday Ranges and Small Countries

Let’s put some quantitative context into that wild roller coaster of a price ride. The intraday spread between the high point reached after the Apple Pay announcement and the post-Watch low was 7.2%. Now, 7.2% of $607 billion is about $44 billion. By comparison the total Gross Domestic Product of Botswana is about $34 billion. Yes, more money changed hands in reaction to a single company’s product launch than the total economic worth of several dozen sovereign nations.

Did the net present value of Apple’s future cash flows really change by a magnitude of $44 billion in the space of an hour? After all, the fundamental value of any stock is nothing more or less than the sum total of the expected future cash generated by its assets, discounted at an appropriate cost of capital. Now, these new products will very likely make a significant contribution to Apple’s earnings for years to come. But there is plenty of uncertainty about the future for any business, including category-killing Apple. That uncertainty should in theory keep a lid on immediate changes in the stock price. But financial theory is often starkly at odds with financial practice.

The Wisdom of Crowds

Is there anything useful to be gained from this snapshot of the collective response to Apple’s new products? We do think the crowd got it right in one sense, which is that Apple Pay was probably the most interesting, and potentially game-changing, announcement of the day. Although the technical details are still coming out, one of the apparent features of this platform is a security function giving added protection to customers’ financial data. Neither Apple nor the merchant will collect user data during a transaction; payment approval will be transmitted by a unique code. Given the unsettling, and likely continuing, rise in cyber fraud, Pay could prove to be a very strong addition to the Apple product line.

But that remains to be seen. Apple is best known for sleek, engaging and user-addicting consumer technology. Apple Pay is a deviation from the standard playbook that Steve Jobs handed off to Tim Cook. We probably will not know for some time whether the crowds truly were wise in their insta-valuation of Apple Pay.

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MV Weekly Market Flash: Magic Numbers, Catalysts and Pullbacks

August 29, 2014

By Masood Vojdani & Katrina Lamb, CFA

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On Tuesday this week the S&P 500 closed above 2000 for the first time ever. When we say “above”, we mean “right on top of”: the actual closing price was 2000.02. On Wednesday the index inched slightly upwards to a close of 2000.12. Of course, there is nothing inherently special or magic about a round number like 2000 versus any other kind of number. But perception creates its own reality. Along with moving price averages, signpost numbers like 1900 and 2000 often act as important support and resistance levels for short-intermediate term asset price trends. We call these “event numbers”. 

The Event Number Corridor

The following chart provides a snapshot of pullbacks in the S&P 500 in the current year to date. They have been fairly short, shallow and infrequent (only three with a magnitude of 3% or more). Interestingly, all three have occurred around an event number: 1850, 1900 and 2000 (there was a pullback of a smaller magnitude at 1950).

What seems to happen here is that the event numbers act as a sort of catalyst for investors to trade on whatever risk factors may be prevailing at the time. Consider the three 2014 pullbacks shown above. At the beginning of this year the S&P 500 had just come off one of its best years ever, leading to general chatter about whether the market was overbought. The market was trading in a corridor just below 1850. The release of a surprisingly negative jobs report early in the year gave traders the excuse to pull money off the table. A -5.8% pullback ensued taking the index to 1750, where it found support and sharply rebounded.

In April the market stalled for a few days just below 1900, then growing concerns about the situation in Russia and Ukraine helped fence-sitting investors to hop off. Again the fear period was brief, and this time support was found at the 100 day moving average level. In July, the risk factors swirling around in the market were for the most part the same as in April: Ukraine, Middle East, Eurozone…and an event number corridor just below 2000 broke in the last week of the month.  That too found support around the 100 day average and rebounded sharply…right back up to 2000, where another corridor is playing out.

What Next?

The current event number corridor is particularly interesting because we are heading into to the final months of the year, a time when a strong positive or negative trend formation can propel the market right through to the end of the year. Which way do the tea leaves point?

The short term, of course, is unknowable with any kind of surety: every rally and every pullback is different. Given how long it has been since the market last experienced a real correction, in 2011, each new pullback heightens fears of a slide from mere pullback to secular reversal. But we are still seeing daily volatility levels more typical of a middle-stage than a late stage bull market.

In both of the last two secular bulls, from 1994-2000 and 2003-07, volatility started to head higher some time before the market reached its respective high water marks. Late-stage bulls tend to be frenetic, with hold-outs piling in to belatedly grab some of the upside. It is only after those net inflows subside that the reversal tends to gather steam. Even in the immediate wake of the late-July pullback, though, we still appear to be in one of the calmer risk valleys, with the CBOE VIX index not far away from its ten year low.

Still, anything can happen. Summer is over. We expect trading volumes to pick up and, sooner or later, a late-year trend to emerge and test more event number support and resistance levels. We head into the new school year vigilant and focused.

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MV Weekly Market Flash: Stocks & Bonds: Everyone Gets a Trophy

June 27, 2014

By Masood Vojdani & Katrina Lamb, CFA

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One of the many unusual exhibits on display in today’s asset markets is the seemingly tandem performance of U.S. stocks and bonds through the first half of 2014. Consider the two side-by-side charts below, both showing the price performance of the S&P 500 and the 20+ year Treasury bond. The leftmost chart depicts the trend from January 2012 to December 2013; on the right we see the 2014 year to date pattern.

The left chart is what we normally expect from the relationship between stocks and bonds: one goes up, the other goes down. Treasury yields soared in the first half of 2012 as the world still fretted over the uncertain fate of the Eurozone. In 2013 U.S. large cap equities had their best year since 1997, while bond markets went into a panic over the prospect of the Fed’s winding down its QE program. By contrast, these two asset classes have both enjoyed the investment climes of 1H 2014, causing a great deal of chatter and head-scratching among market participants. Should we expect this trend to continue? If not, which asset is more likely to fall out of favor?

All Quiet on the Correlation Front

As is often the case with short term asset trends there is less here than meets the eye. For one thing, there is not much difference in the correlation between stocks and bonds this year versus long term patterns. The fact of both assets moving in the same general direction this year would imply positive correlation. In fact, the YTD correlation between the two assets shown above, measured by rolling one month returns, is -0.75. That is actually a higher negative correlation than the -0.45 level for the 2012-13 period.

A closer look at the rightmost chart above should explain why this is so. While both stocks and bonds have gained ground this year, they have not done so at the same time. There have been a few classic risk on / risk off trades in the year to date, notably at the end of January when stocks experienced a 5%-plus pullback. There really is not much of a mystery here: stocks and bonds have benefitted from some of the same tailwinds (accommodative Fed, temperate inflation), but also from many independent factors.

Treasuries: Unlikely Yield Oasis

One of the distinct factors driving the bond market is foreign purchases of U.S. Treasuries. According to the Financial Times, foreigners hold a record $5.96 trillion, or just about half of the total volume of outstanding Treasury bills, notes and bonds. This is important: bear in mind that the Fed is reducing its own purchases of long-dated government bonds by $10 billion after each Open Market Committee meeting, taking $50 billion off the table since tapering began last December. Increased bond purchases by non-U.S. investors have thus stabilized bond flows, especially at the longer end of the curve. That helps explain why the U.S. 10-year yield remains far below where it started the year, while shorter term yields like the 2-year note are at or near their YTD highs.

And why are Treasuries so attractive to the rest of the world, given that rates are still far below historic norms? Partly because rates are even lower elsewhere. The chart below shows the yield spread between the U.S. 10-year and the Eurozone 10-year benchmarks.

.5% looks like a good yield when compared to 1.3%. On a risk-adjusted basis Uncle Sam would look even more attractive, given that Eurozone credits share a mix of the stable (Germany) and the shaky (France, Italy et al). In Japan, which shares with China the status of top global Treasuries investor, yields are even lower, and U.S. bonds offer the additional sweetener of a strong currency. The yen is about 17% lower today than it was at the beginning of 2013, thanks to an orchestrated weak currency policy. The Financial Times article cited above notes that the Japanese have bought $33 billion in Treasuries since mid-April – that alone more than makes up for the QE taper.

What’s In the 2H Tea Leaves?

Equities look expensive by historical standards; for example, the price-to-sales (P/S) ratio for the S&P 500 is currently at a ten year high. And credit market watchers are still waiting for what they see as the inevitable rise in rates as the Fed’s likely decision window of late 2015 to early 2016 approaches. It is possible that both asset classes could follow each other on a downward trajectory in the coming months – a reversal of the 1H pattern.

But don’t count on that as a given. For as much as stocks have risen virtually uninterrupted in the past two years, for as many days have gone by without large cap indexes being anywhere near their 200-day moving averages, the market is not yet exhibiting much in the way of final-stage bull rally characteristics. Volatility is tepid, intraday spreads are miniscule, and volume is consistently light. There may yet be another buying wave or two before the end of the year – though another 5%-plus pullback along the way would be far from surprising in our opinion.

On the bond side, we see headline macro data points as the most telling tea leaves. The Personal Consumption Indicator, the Fed’s preferred inflation gauge, clocked in at 1.8% for May. That’s nearing the central bank’s 2% target, and (as we noted in last week’s Market Flash) the Consumer Price Index is already above the 2% watermark. June unemployment numbers will be out in a couple weeks, and as earnings season gets into full swing we’ll see how companies are rebounding from the weather and other headwinds experienced earlier in the year. Stocks up, bonds down? No-one knows for sure, of course, but it may be a reasonable base case.

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MV Weekly Market Flash: Where Did All The Risk Go?

May 23, 2014

By Masood Vojdani & Katrina Lamb, CFA

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2013 was a very good year for U.S. equities. Even more impressive than the 32% total return on the S&P 500 was the very low level of risk that accompanied it. Based on the Sharpe ratio, a widely-used measure of risk-adjusted return, the S&P 500’s 2013 performance was in a class by itself, far outpacing even the heady days of the late-90s technology bubble (see chart below). In the world of investment performance measurement, a Sharpe ratio above 3.0 is just about as close as you can get to having your cake and eating it too. Is low volatility here to stay, or is this just an unusual period of  calm before the next storm clouds appear?

Not Much Fear in the “Fear Gauge”

In 2014 to date there have been pockets of risk, notably in certain small cap growth sectors. But the story in the broader market hasn’t changed much: subdued baseline risk with a few intermittent spikes when unexpected X-factors briefly flash onto the radar screen. The following chart illustrates this story. On the leftmost side we show the standard deviation of daily S&P 500 returns over rolling 30-day intervals. The right side presents the daily closing price of the CBOE VIX index, which reflects a weighted average of puts and calls on the S&P 500 over a range of strike prices. Standard deviation provides a useful picture of intrinsic volatility, while the VIX gives us a good read on market perceptions of risk; for this reason it is popularly known as Wall Street’s “fear gauge”.

Stuck in the Corridor

It is perhaps somewhat surprising to see this continuing pattern of low risk in the broad U.S. equity market. After last year’s big gains the market has mostly traded in a narrow and choppy corridor this year. Lack of direction can often mean heightened volatility. But apart from one brief spike during the late January pullback, the VIX has not even come close to breaching its lifetime average closing price of 20.1. Investors have largely taken in stride whatever the world has served up: from a harsh U.S. winter that impacted many corporate earnings results, to geopolitical turmoil in Ukraine, to a Eurozone flirting dangerously with price deflation. Support has been remarkably firm around intermediate moving averages, as the chart below illustrates.

Ready for a Breakout?

On the other side of the 50-day moving average support level, the index has several times bumped up against a psychological “round number resistance” point of 1900. At some point we would expect to see a directional trend form one way or the other; either a resurgent X-factor that brings back volatility and another pullback of 5% or more, or a continued rally driven by the meta-narrative of continuing benign economic data, double-digit 2H earnings growth and no new surprises from Ukraine, China or elsewhere. We need to be prepared for either outcome; that being said, the volatility signals are for the time being at least nowhere to be seen. “Sell in May” may not be a particularly helpful strategy this year.

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