Posts tagged Us Equity Market
Round numbers and anniversaries…the little human foibles so beloved of our financial chattering class. This past week, of course, marked the 10-year anniversary of the great collapse of the House of Lehman. No surprise, then, that the print and digital channels were all atwitter (pun partially intended) with reminiscing and ruminating about the crash and all that has happened since. There is a plentiful supply of topics, to be sure. Channeling the Mike Myers’ “Coffee Talk” character on SNL: “Negative interest rates led us to the other side of the Looking Glass. Tawk amuhngst yuh-selves.”
Supercalifragilistic S&P 500
One fact of life to which we and everyone else who manages money are highly attuned is the remarkable outperformance of US equities relative to the rest of the world over this time period. For a while in the early years of the recovery geographic asset classes traded off market leadership in the usual way, rewarding traditional asset class diversification strategies. But sometime in 2012 that all changed. US stocks went on a tear and haven’t looked back. The chart below shows the trajectory of the S&P 500 against broad market indexes for developed Europe, Asia and emerging markets from 2009 to the present.
That’s a huge delta. The S&P 500 cumulatively returned about twice what the non-US indexes earned over this nine and a half year span of time. The difference is even more profound when you adjust for risk. All three non-US indexes exhibited higher volatility (i.e. risk) than the US benchmark. The standard deviation of returns for the MSCI EM index was more than 19 percent, just under 18 percent for developed Europe and 14 percent for developed Asia, while it was just 12.3 percent for the S&P 500. Twice the return for much less risk…sounds like one of those free lunches that are supposed to never exist, doesn’t it?
What Goes Up…Right?
And that, of course, is the big question. Since we are trained to believe that free lunches only exist at picnics hosted by the tooth fairy and the Easter bunny, we look at that chart and wonder when the law of gravity will reassert itself. Asset class price patterns over a long enough time horizon typically revert to mean. What goes up eventually comes down.
But asset prices are not bound by the same fixed laws as those governing physical objects in actual space-time. Economists and financial market theorists may suffer from all the “physics envy” they want – it won’t make asset prices any more rational or predictable. In fact, the “higher risk, higher return” mantra fails in the case of emerging markets versus US stocks over even longer periods, going back to when the former became a sufficiently liquid tradable asset to be a candidate for long-term diversified portfolios.
Mean reversion tends to work best when the primary evaluation criterion is the relative valuation metric between two assets. If Company ABC has a price to earnings (P/E) ratio of 30 and Company XYZ, a competitor in the same industry, has a price to earnings ratio of 10, then investors would at some point expect the price of XYZ to rise relative to ABC. But increasingly we see evidence that daily market trading is not dominated by stock-specific valuation considerations but rather by macro narratives. Continued demand for US equities is simply driven by a better “story” according to this narrative – strong corporate financial results and an economy that is growing faster than elsewhere in the developed world. The same thinking says that the US is a safer bet than elsewhere if the worst-case scenario for a trade war plays out. ETFs and other passive investment vehicles afford the opportunity to take these kinds of broad bets without paying any attention to whether, say, Unilever (a Dutch company) has a more attractive valuation profile than US-domiciled Procter & Gamble.
There are plenty of individual assets in many non-US markets that look attractive on the basis of relative valuations. We do not sense, however, that we are at a clear and compelling turning point justifying a significant re-weighting of asset class weights among diverse geographies.
This past Wednesday, apparently, was one of those red-letter special days in US stock market history. The current bull market, which began in 2009, became the longest on record, based on the daily closing price of the S&P 500. So said the chattering heads, not just on CNBC but on your friendly local news channel. Hooray! Or should we worry, perhaps, that the good times are coming to an end?
The right answer to that question and all others about the bull market’s record longevity is to ignore it, because technically it didn’t happen. Nope, this is not the longest bull market on record, not by a long shot. Now, some may quibble when we present the facts, arguing that we are splitting hairs. Well, sorry, but ours is supposed to be a precise business where performance measurements are concerned. And facts, surprisingly enough in this day and age, are still facts.
So, to be precise, the bull market that reached its peak on March 24, 2000 (the one we supposedly beat on Wednesday) did not in fact begin on October 11, 1990. That was a span of 3,452 days. The basis for “longest bull market ever” claims made this week is that 3,453 days elapsed from March 9, 2009 (the low point of the last bear market) to August 22, 2018. However! Based on the technical definition of bulls and bears, the bull that peaked in March 2000 actually began, not in 1990, but on December 4, 1987. That’s a total span of 4,494 days, or 1,041 days (about 2.8 years if you prefer) longer than our current bull market.
So why did the media spend so much energy this week talking about the “longest bull market?” Because (a) it’s more fun to talk about things grand and historical than about the daily grind of random market movements, and (b) on October 11, 1990 the S&P 500 closed down 19.9 percent from the previous record high set in July of that year, and, well, 19.9 percent is close enough to 20 percent, which is the commonly accepted technical threshold of a bear market.
Let the quibbling begin! 19.9 percent is close to 20 percent, certainly. But it never passed that threshold. More importantly, the stock market pullback of 1990 (which started with the recession of that year but had recovered before the recession was over) never spent a single day – not a single day! – in actual bear market territory. You can’t say that a bull market began the day after a bear market ended when that bear market never even began.
So, again sticking to the definition of a 20 percent pullback from the prior high, the last bear market before the dot-com crash of 2000 occurred after Black Monday in 1987. On December 4 of that year the S&P 500 had retreated 33.5 percent from the prior record high reached in August. That wasn’t a super-long bear, lasting less than a couple months from the breaching of 20 percent, but it was certainly impactful.
The Music of the Market
Here’s the more important reason why we’re not just splitting hairs over the 19.9 versus 20 percent, though. If you look at the way markets trend over a long enough period of time you notice a certain pattern – a tune, if you will, the music of the market. Every bull market experiences periodic pullbacks. These happen for a variety of reasons, some of which may seem frivolous and some of which may seem more serious at the time. Traders in the market are highly attuned to how far these pullbacks draw down from the previous bull market high. A 5 percent pullback is deemed significant. The 10 percent threshold has its own special name – correction. And the 20 percent level, as we noted above, is the event horizon for a bear market.
What tends to happen during the more severe bull market corrections is that they get ever so close to the 20 percent threshold without actually going over it. This happened in October 1990, as we showed above. It also happened in August 1998 with a 19.3 percent pullback (this coincided with the Russian debt default and subsequent meltdown of hedge fund LTCM). More recently, it happened in 2011 with a 19.4 percent pullback in the S&P 500 while the Eurozone crisis and US debt ceiling debacle played out simultaneously.
It’s not accidental that these pullbacks flirt with bear markets but refrain from going all the way. It’s how short term trading programs, which make up the lion’s share of day to day liquidity, are set up to work. A correction or bear market threshold is considered to be a technical support level. If prices approach, but don’t breach the support level it means that the net consensus of the market supports the status quo; in other words, that conditions continue to justify a bull market. These pullback-recovery movements happen frequently. Real bear markets are much rarer, and more durable when they do happen.
The chart below provides a good illustration of this “music” – it shows the price trend of the S&P 500 from 1987 to the present (lognormal scale to provide consistency in magnitude of returns over time).
This chart is instructive for another reason. To paraphrase Tolstoy, every pullback has its own dysfunctional story. What causes a pullback to become a full-on bear market? It’s not always a recession – witness 1990, when we had an economic downturn but only a limited market pullback. It’s not always a financial crisis – we had one of those in 1998 and again in 2011 but in both cases economic growth stayed positive. In 1987 financial markets came close to shutting down, but again the economy was still resilient and the drawdown, while intense, turned out to be brief. By contrast, in 2000-02 and again in 2007-09 we got a double-dose of financial crisis and recession in roughly the same time frame (the grey bands in the above chart signify recession periods). Both the magnitude and the duration of these drawdowns, of course, were more severe.
In any event, with all apologies to financial market pundits everywhere, there was nothing particularly historical about this week. Perhaps our good fortune will last another 1,039 (and counting) days and we will have a real, actual “longest bull” to celebrate. Or maybe not. Expect more pullbacks along the way in either case. Remember that most pullbacks do not end up in a real bear market, and also remember that while we humans have a need to read meaning into calendar events, markets themselves do not.
The languid dog days of August are truly upon us. Risk asset markets would seem to be feeling the soul-draining humidity as much as runners and cyclists slogging through day after day of relentlessly damp blankets of heat while training for fall goal races. The S&P 500 hovers just below its January record high, while volatility has resumed last year’s deep slumber. The 10-year Treasury yield casts a sleepy glance every now and then at the 3 percent level, yawns and goes supine again somewhere around 2.95 percent.
Random headlines make a splash on these days where nothing much from macroeconomic or corporate earnings data releases manage to perk up investor attention. This week’s little diversion came – as seemingly all diversions in 2018 must come – from Twitter and specifically from the account of Elon Musk, founder of Tesla, as he mused about the likelihood of taking his $60 billion enterprise private. Now, once upon a time a major strategic undertaking like taking a public company private would have simmered under the radar in boardrooms and hushed discussions with bankers, lawyers and advisors before proceeding in an orderly fashion into the public domain. But such are the times in which we live.
Mind The (Listing) Gap
While Musk’s method of communication may have been unusual (and quite possibly illegal), the decision itself – to take a public company private – is anything but an anomaly. Our interest piqued, we went hunting for some data on the subject and came across a 2017 Credit Suisse paper entitled “The Incredible Shrinking Universe of U.S. Stocks” with some eye-opening facts and figures. The universe of publicly traded equities – i.e. shares of common stock traded on an accredited stock exchange, compliant with SEC disclosure and transparency regulations, and available for purchase by any institutional or retail investor – has radically diminished over the past several decades.
Here’s a good illustration of what this means in practical terms. How many stocks do you think make up the Wilshire 5000 Total Market Index? Ah – you were about to say “5,000, of course!” but then realized it must be a trick question if we’re asking it. Indeed, this bellwether index launched in 1970 to represent the “total US stock market” does not consist of 5,000 companies. It consists of 3,486 companies as of June 30, 2018. Why? Because that is roughly how many publicly traded companies exist in the United States. In 1976 there were about 4,800 companies with publicly traded stock, and in 1998 that number soared to more than 7,500. The Wilshire 5000 reached its peak holdings with 7,562 names on July 31 of that year.
Where Did They All Go?
Why are there so many fewer listed companies now, and how much does it actually matter from the standpoint of an investor seeking to capture as wide a swath of global wealth as possible through portfolio diversification? The answer to the first question is relatively straightforward. The second – not so much.
The main reason why there are fewer companies on stock exchanges in 2018 than there were in 1998 or 1978 is twofold. First, mergers & acquisitions (M&A) activity has gone gangbusters over this period, and has been the main driver for delisting (a company, when acquired, naturally retires its stock ticker at the signing ceremony). Second, initial public offering (IPO) activity has fallen. If M&A is the main way that a company falls off the stock exchange, then IPOs are the main source for new supply. According to the Credit Suisse report we noted above, the average number of IPOs every year from 1976 to 2000 was 282. From 2000 to the present the average annual number was a mere 114.
Long story short – M&A fever has raged while the IPO market has slumbered. This in itself is unusual. Historically, strong equity markets tended to encourage both M&A and IPOs. That makes sense – companies feeling flush look to bulk up by taking out competitors or to buy their way into new industries, while start-up founders want to cash in with the high valuations available in bull markets. But that positive correlation no longer holds. From 1976 to 2000 the correlation between M&A and IPO activity was 0.87 (1.0 being perfect positive correlation). From 2007 to 2016, the correlation is actually negative: minus 0.08. Those start-up founders apparently have other, more enticing options for cashing in.
The Changing Market For Private Capital
And indeed, those alternatives exist. Probably the most noteworthy, in terms of explaining the diminished attractiveness of IPOs, is the growth of late-stage venture capital / private equity. Venture capital used to be concentrated in the early years of a start-up company’s history, with the VCs motivated to get their investments through successive funding rounds and out the door into the public markets via IPO as fast as possible. Now there is a whole distinct asset class of late-stage private investors. This includes most of the major mutual fund families, like Fidelity and BlackRock, that operate dedicated late stage private equity funds. This asset class provides a level of liquidity that previously could be found only in public markets. For example, late stage private deals allow start-up founders and their employees to cash out some of their stock and options – again, reducing the natural pressure to go public.
The Implications for Asset Allocation
So the story about how we wound up with so many fewer public companies is relatively easy to understand. But that second question we posed a few paragraphs ago remains outstanding. Is the long term investor with a diversified portfolio missing out on a major asset class exposure by not being invested in private equity?
This is a question we take seriously: after all, our primary job is to construct portfolios with a prudent level of diversification aligned with each client’s specific investment objectives and risk considerations. The data thus far are somewhat inconclusive, with attendant benefits and costs.
For example, while there may be fewer publicly traded companies out there, the total market capitalization of the US stock market is more than 1.35 times the value of US real gross domestic product (GDP). By comparison, total market cap in 1976 was just 0.47 times GDP, and in the late 1990s, when the number of listed firms peaked, it was 1.05 times. The collective profits of all listed firms today is close to 9 percent of GDP versus 7 percent in 1976. And share volume – hence liquidity – is at record levels today.
For investors there are other potential downsides to owning private equity, including reduced transparency and less consistent, available data for performance benchmarking. On the other hand, it is not possible to simply dismiss the reality of a new structure to the US capital market and the existence of distinct new asset classes large enough to demand consideration, if not inclusion, for long term diversified portfolios. We will have more to say about this in the coming weeks and months.
The financial news headlines on this, the first Friday of the second half of 2018, seem fitting. Appropriately contradictory, one might say, providing a taste for what may lie ahead in these next six months. First, we have news that Donald Trump’s splendid little trade war is happening, for real now! Tariffs have been slapped on the first $34 billion worth of products imported from China. On the other side of the ledger, an American ship full of soya beans was steaming full-on to reach the Chinese port of Dalian in time to offload its supply before facing the retaliatory tariffs mandated from Beijing. Too bad, so sad, missed the deadline. Apparently the fate of the ship, the Peak Pegasus, was all the rage on Chinese social media. The trade war will be Twitterized.
The second headline today, of course, was another month of bang-up jobs numbers led by 213K worth of payroll gains (and upward revisions for prior months). Even the labor force participation rate, a more structural reading of labor market health, ticked up (more people coming back into the jobs pool is also why the headline unemployment rate nudged up a tad from 3.8 to 4.0 percent). Hourly wages, a closely followed metric as a sign of potential inflation, recorded another modest year-on-year gain of 2.7 percent.
So there it is: the economy continues to carry on in good health, much as before, but the trade war has moved from the theoretical periphery to the actual center. How is this going to play out in asset markets?
Manufacturers Feel the Pain
The products covered by this first round of $34 billion in tariffs are not the ones that tend to show up in Wal-Mart or Best Buy – so the practical impact of the trade war will not yet be fully felt on the US consumer. The products on this first list include mostly manufacturing components like industrial lathes, heating equipment, oil and gas drilling platform parts and harvester-thresher combines. If you look at that list and think “Hmm, I wonder how that affects companies like Caterpillar, John Deere and Boeing” – well, you can see for yourself by looking at the troubled performance of these companies’ shares in the stock market. As of today those components will cost US manufacturers 25 percent more than they did yesterday. That’s a lot of pressure on profit margins, not to mention the added expense of time and money in trying to figure out how to reconfigure supply chains and locate alternative vendor sources.
Consumers Up Next
The question – and probably one of the keys to whether this trade war inflicts real damage on risk asset portfolios – is whether the next slates of tariffs move from theoretical to actual. These are the lists that will affect you and me as consumers. In total, the US has drawn up lists amounting to $500 billion in tariffs for Chinese imports. In 2017 the US imported $505 billion from China – we’re basically talking about the sum total of everything with a “Made in China” label on it. Consumers will feel the pain.
If it comes to pass. The collective wisdom of investors today has not yet bought into the inevitability of an all-out trade war. US stocks are on track to notch decent gains for this first week of the second half. The job numbers seem to be holding the upper hand in terms of investor sentiment. Sell-side equity analysts have not made meaningful downward revisions to their sunny outlook for corporate sales and earnings. Sales for S&P 500 companies are expected to grow at a rate of 7.3 percent this year. That reflects an improved assessment from the 6.5 percent those same analysts were projecting three months ago – before the trade war heated up. The good times, apparently, can continue to roll.
Since we haven’t had a global trade war since the 1920s, we can’t model out just how these tariffs, in part or in full, will impact the global economy. Maybe the positive headline macro numbers, along with healthy corporate sales and profits, can power through this. Perhaps the trade war will turn out to be little more than a tempest in a teapot. We may be about to find out.
Did you hear the news this week? General Electric, one of the world’s oldest going concerns, was dropped from its august perch in the Dow Jones Industrial Average. That index of 30 companies will no longer include the only company still in business today that was a constituent member of the Dow Twelve – the companies Charles Dow fashioned into a market index back in 1896. GE will be replaced by Walgreens, which is probably not a bad idea since retail pharmacy is currently under-represented in the index (Wal-Mart being the only company in the heretofore 30 where you can get a prescription filled).
As with just about anything Dow-related, though, the news about GE and Walgreens matters more for stock market historians and storytellers than it does for actual investors.
A Quaint Relic
To the mind of the typical retail investor, “the Dow” is interchangeable with “the market.” Round number days on this index – when it, say, breaks 20,000 for the first time – are feted like national holidays in the financial media. When the stock market experienced a technical correction earlier this year, commentators were breathless with the report that the Dow had fallen by more points (1,179 to be exact) than ever before in its history.
None of which matters for any reason other than idle water cooler gossip. In fact, the media’s fixation on the Dow’s points loss on February 5 was not only pointless, but potentially harmful if it induced anyone to actually sell out in a panic. The percentage loss corresponding to that decline of 1,179 points was nowhere close to the all-time record loss of 22 percent, on October 19 1987.
Yes, it’s fun to study the Dow to gain a perspective on how the US economy has evolved over the last 122 years. It’s nice to arrive at cocktail parties armed with trivia like Distilling & Cattle Feeding or Standard Rope & Twine (two of the original twelve companies that didn’t have quite the staying power of GE). But that’s where the usefulness ends. Consider the fact that of today’s market-moving FAANG companies (Facebook, Amazon, Apple, Netflix and Google) only one – Apple – is represented in the Dow. Technology stocks make up about 25 percent of the total market capitalization of the S&P 500 (and an even greater percentage of the NASDAQ Composite). The tech names represented on the Dow – Apple, IBM, Cisco Systems, Microsoft and Visa – are not exactly unimportant, but they are less representative of the full spectrum of what is arguably the most influential sector of the US economy in 2018.
Price of Everything, Value of Nothing
The other major problem with the Dow, in addition to the somewhat arbitrary and backward-looking nature of the 30 constituent names, is the way the index’s performance is calculated. Whereas the S&P 500, NASDAQ and most other broad market indexes calculate performance based on market capitalization (number of shares outstanding times share price), the Dow is a price-based index. This means adding up all the share prices of the 30 stocks and dividing them by a divisor (which changes over time to reflect share splits, share dividends and the like).
The basic flaw in the price methodology is that it gives stocks with a higher price more impact on returns than stocks with a lower price. If Company A has a stock price of $100 and Company B has a stock price of $10, then Company A’s share price movements have a bigger impact on the index than those of Company B. But those raw share prices tell you absolutely nothing about the economics of either company. If Company A has 1,000 shares of stock outstanding and Company B has 10,000 shares of stock outstanding then both companies have the same market capitalization -- $100,000. In a market cap-weighted index like the S&P 500 their share price movements would have the same impact, not the skewed outcomes they produce on a price index like the Dow.
Here Today, Here Tomorrow
Of course, we do realize that all our carping about the Dow Jones Industrial Average will not stop it from being “the market” in the popular lexicon. Humans gonna be humans, after all. And that’s fine, as long as you make sure that your actual portfolio pays more attention to today’s economy than to the colorful past chapters of US stock market history. Now, there are times, of course, when the Dow will outperform the broader benchmarks, and there are times when it will underperform. As the chart below shows, right now is one of those times when it is underperforming – actually in negative territory for the year to date while both the S&P 500 and the NASDAQ Composite are in the black.
It’s a nice bit of history, but there’s no reason to have it in your portfolio. Exposure to large cap US stocks is best achieved through a broad market cap index like the S&P 500 or the Russell 1000. Adding other distinct asset classes like small caps, developed and emerging international equities can help achieve long term risk-adjusted return goals. That’s prudent diversification, to which the Dow is just a frivolous sideshow. A fun sideshow (hello, Nash Motors, inductee of 1932!), but a sideshow all the same.