Posts tagged Us Equity Market
Investors tend to be predisposed to a “follow the leader” mentality -- to latch onto a narrative that purports to explain why company ABC or sector XYZ is running out ahead of the pack. Unfortunately for those in search of a leadership theme on the cusp of the summer of ’17, there really isn’t one anymore. There was one until last week: the mega cap stocks led by Facebook, Amazon, Alphabet (Google) and Apple took the helm back in the first quarter as the “reflation trade,” the previous narrative, faltered. The chart below shows the ascendance of these FAGA stocks when financials, the reflation trade’s leader, turned south in March (represented by XLF, the SPDR ETF). The chart also shows the carnage of June 8, when those high flying mega caps suddenly got pummeled on an otherwise nondescript trading day. They have continued to struggle in the days since.
The fizzling out of the reflation trade (or the “Trump bump” in the vulgate) as a leadership theme is easy to understand. The financial sector led that narrative, along with materials, industrials and (for a while late last year) energy. The premise was that a burst of pro-growth fiscal policy, headlined by tax reform, deregulation and a massive infrastructure stimulus would unleash an inflationary tsunami. Financial institutions would benefit from improved net interest margins, while industrial producers and resource firms would ride the infrastructure bandwagon. That premise, never particularly strong in a reality-based sense to begin with, looked increasingly like a bad bet as the legislative degree of difficulty presented itself to a team of political novices. Financials and other reflation-theme names topped out in early March and the broader market drifted for a spell.
FAGA (the aforementioned mega cap stocks) and their fellow travelers in the tech sector picked up where the Trump trade left off. What was the narrative driving this leadership rotation? Little, in our opinion, other than a general go-to argument that these enterprises are part of an elite cohort able to deliver consistently fast top-line growth in a world of modest economic prospects. The FAGA trade is sort of a lazy, modern take on the “Nifty Fifty” of days yore: in the absence of any other overarching narrative, go with the brand-name leaders of the day. And what, exactly, was the catalyst for that mass exodus from FAGA on June 8? Again, nothing that is glaringly obvious. Pundits put forth the “crowded trade” theme, which may be as good a reason as any. But they are not especially overvalued; Apple still trades at a P/E discount to the broader market, and the P/E premia of the other three FAGA names to the S&P 500 are well below their highs for the past five years.
Whatever the reasons were for bailing from tech on June 8, it is by now evident that it was not a one-day event; the sector has underperformed in the days since, as the above chart illustrates. The question now turns to the prospects for the broader market absent another leadership story. Candidates for such a story are rather scarce. The many ills plaguing the retail sector again came into sharp relief this week when supermarket chain Kroger’s radically cut its earnings outlook and saw its stock price get beaten down more than 18 percent. Healthcare waxes and wanes amid a fog of fundamental, sector-specific uncertainties. Financials face the headwinds of lower than expected inflation and the attendant opinion by many that the Fed was mistaken to move ahead with its rate cut this week.
The antidote for the confusion is TINA – There Is No Alternative. Forget the Trump trade, or tech stocks, or any other leadership narrative. It’s enough, this argument goes, to stay in the market when there are no compelling reasons to get out. As long as there is growth, however modest, and as long as there are central banks with the means to limit the downside, there should be no need to start building up the cash position. That logic has served investors well to now. But watch those narrowing spreads between short and intermediate term bonds. They don’t necessarily signal anything in terms of a major market shift. But they are not moving in the right direction.
Every profession has its core mantra. The mandarins of medicine solemnly invoke the Hippocratic oath (first of all, do no harm). “Equality under the law” say the Doctors of Jurisprudence. In the practice of investment management, generations of money men and women since the 1930s have been trained thus: “in the long run, value outperforms growth.” The value effect has gone through some iterations since Benjamin Graham and David Dodd bestowed their masterpiece “Security Analysis” on the investment world in 1934, but it has largely stood the test of time. It’s not a difficult premise to grasp: buying stocks whose price is relatively cheap when compared to certain fundamental valuation measures – like book value, cash flow or net earnings – is on average a better long term investment approach than favoring the more expensive stocks that get red-hot and then flame out just as quickly.
Anomaly, or New Normal?
So far in 2017, value investors are taking cold comfort in the time-tested wisdom of their philosophy. The Russell 3000 Value index, a broad-market measure of value stocks, is up 2.50 percent for the year to date. Its counterpart, the Russell 3000 Growth index, is up a whopping 13.68 percent. That is the kind of performance gap that will make the most lackadaisical of investors do a double-take when their quarterly statements show up in the mail. And their value fund managers are reliving the nightmare that was the late 1990s, when ticky-tack dot-coms regularly crushed “old economy” stocks and made instant (if very short-lived) experts out of amateur punters the nation over.
Now, we all know that it is inadvisable to draw larger conclusions from a relatively small time window. But the value effect’s failure to stick the landing extends much further than the current market environment. The chart below shows the relative performance of these same two Russell value and growth indexes over the past fifteen years.
These fifteen years encompass multiple market cycles, from the depths of the dot-com crash to the commodity boom cycle of the mid-2000s, then the 2008 market crash and subsequent recovery (which itself contains at least three sub-cycles). As the chart shows, investors who stuck with a growth discipline performed substantially better than their value counterparts over the course of this period.
The Fleetingness of Factors
Is the value effect dead? Or is it “just resting,” like the Norwegian blue parrot in the Monty Python sketch? When we look at the long-term durability of factors, we tend to follow the methodology of prior generations in using a 30 year window of analysis. When Eugene Fama and Kenneth French (then at the University of Chicago) produced their groundbreaking analysis in 1992 of the value effect and the small cap effect (“The Cross Section of Expected Stock Returns”, published in the Journal of Finance), 30 years was the duration of their time series. Fama and French concluded that both value (defined as low market-to-book value) and small market capitalization were long-term outperformers relative to the broad market.
Looking back 30 years from today, value still retains a small edge over growth, while small cap appears to have lost the performance edge that Fama and French reported. The chart below shows the performance of the Russell 3000 Value and Growth, along with the Russell 2000 Small Cap index, over this 30 year period from 1987 to the present.
Value stocks (the blue dot just up and to the left of the broad market benchmark) returned 9.99 percent per annum on average over this 30 year period, which amounts to 0.21 percent more than the broad market. Now, 21 basis points per annum is nothing to sneeze at, particularly as it came with slightly less volatility. But, as the earlier 15 year performance chart showed, growth stocks have outperformed consistently over virtually the entirety of the period from 2009 to the present. The 1992 insights of Fama and French do appear to have diluted somewhat over time.
It’s too early to pronounce the value effect as dead. But factors – even the most durable ones – are never a guaranteed win. Today’s investors on the receiving end of pitches by “smart beta” managers – those sexy factor-based approaches that are currently all the rage – should always remember what is in our opinion the only investment mantra worth its salt: “there is no such thing as a free lunch.”
Another week, another record for stocks. Sadly for those of us inclined to jump at “buy the dip” opportunities, the window now appears to bangs shut almost before we even know it’s open. It took a mere five trading days to fully atone for last Wednesday’s mini-squall, with two new all-time highs following in quick succession. C’mon stockpickers, haven’t you ever heard the phrase “sell in May?” Throw us bargain hunters a bone or two!
Bond Bears, Beleaguered
Whatever is in the water in equity-world still has not made it over to the more subdued climes of fixed income. While the S&P 500 is just shy of eight percent in price appreciation this year, the yield on 10 year Treasury securities ambles along in the neighborhood of 2.25 percent, well below where it started the year and further still below the 52 week high of 2.6 percent. The chart below illustrates the alternative mentalities driving stock and bond trends this year.
The dourness is showing up in other credit markets as well. Average rates for 30 year mortgages finished this week at their lowest level for the year. Long-dated Eurodollar futures contracts, which reflect what traders think Libor levels will be up to 10 years in the future, indicate that we should expect a world of low inflation and low real interest rates well into our senescent years. The “10-2 spread” – the difference between intermediate and short term yields that we discussed in some detail a couple weeks back – is narrower than at any time since last November’s election. Reflation trade, we hardly knew ye!
On one level, the bond market’s lackadaisical drift is not all that surprising. It dovetails with the relentless monotony of an overall macroeconomic narrative that – at least according to the usual “hard” data points of labor, prices and output – has barely changed over the past twelve months. Low growth and restrained inflation are entirely consistent with sub-3 percent 10 year yields (unsurprisingly, the forecasting mandarins at banks such as JP Morgan and Goldman Sachs have lowered their 2017 expectations accordingly). The shiny veneer of the reflation trade has been wiped clean to reveal the same old undercoat of modest growth, with no evidence of a productivity-driven catalyst to bring the growth trend closer to the norms of decades past. Yes, the world’s major economies are aligned to a remarkable extent in their growth trajectories – GDP growth rates are trending in near-lockstep in the US, Europe and Japan. That alignment alone, though, does not suggest some emergent property to drive the trend higher.
And then there was the other dog that didn’t bark this week to send yields soaring. The minutes from the FOMC’s last meeting earlier this month made their way into public hands on Wednesday, offering a peek into the Fed’s thinking about starting to wind down its $4.5 trillion balance sheet in the coming months (the vast majority of which is in the form of Treasuries and mortgage backed securities). This winding down, many have noted, will involve some fancy footwork on the Fed’s part to avoid the kind of tantrums that sent bond markets into a tizzy back in 2013.
As it happened, though, the minutes gave little indication of anything other than that the Fed feels comfortable getting the process underway sometime in 2017. There’s also a question about how much “winding down” will actually happen. A recent study by the New York Fed suggests that a “normalized” balance sheet of $2.8 trillion should be achieved by 2021. Now, in 2010, before the second and third quantitative easing programs kicked in, the Fed had about $2.1 trillion on its balance sheet. So “winding down” would not mean going back to anything close to earlier “normal” balance sheet levels. Higher for longer. Tantrum fears may once again be somewhat overblown.
Red Bull and Tech Stocks
So what’s still driving equities? “No reason to sell” is about as good an answer as any, and that sentiment was clear in the market’s quick snap-back from last week. Tech stocks continue to lead the way while the former reflation trade darlings – financials, industrials and materials – lag. We appear to have reached the point where politics and global events are utterly irrelevant to market movements (the VIX’s retreat from last Wednesday’s spike was even brisker than the stock market recovery). Q2 earnings are expected to be decent, no recessions as far as the eye can see…what’s not to love? As Jo Dee Messina would say – “it’s a beautiful day, not a cloud in sight so I guess I’m doin’ alright.” For now, at least.
From the beginning of January to the beginning of March, the S&P 500 set a total of 13 new record highs. Twelve of them happened after January 20, which no doubt made for an unhappy crowd of “sell the Inauguration” traders. Since March 1, though, it’s been all crickets. The benchmark index is a bit more than two percent down from that March 1 high, with the erstwhile down and out defensive sectors of consumer staples and utilities outperforming yesterday’s financial, industrial and materials darlings.
More interesting than the raw price numbers, though, is the risk-adjusted trend of late. To us, the remarkable thing about the reflation trade – other than investors’ boundless faith in the pony-out-back siren song of “soft” data – was the total absence of volatility that accompanied it. The reflation trade reflected a complacency that struck us as somewhat out of alignment with what was actually going on in the world. In the past several days, though, the CBOE VIX index – the market’s so-called “fear gauge” – has ticked above 15 for the first time since last November’s election. Half a (pre-holiday) week doth not a trend make – and the VIX is still nowhere near the threshold of 20 that signifies an elevated risk environment – but there may be reason to suspect that the complacency trade has run its course.
Equity markets have been expensive for some time, with traditional valuation metrics like price-earnings (P/E) and price-sales (P/S) higher than they have been since the early years of the last decade. But they remain below the nosebleed levels of the dot-com bubble of the late 1990s…unless you add in a risk adjustment factor. Consider the chart below, showing Robert Shiller’s cyclically adjusted P/E ratio (CAPE) divided by the VIX. The data run from January 1990 (when the VIX was incepted) to the end of March 2017.
When adjusted for risk this way, the market recently has been more expensive than it was at the peak of both earlier bubbles – the dot-com fiesta and then the real estate-fueled frenzy of 2006-07. The late 1990s may have been devil-may-care as far as unrealistic P/E ratios go, but there was an appropriate underpinning of volatility; the average VIX level for 1998 was a whopping 25.6, and for 1999 it was 24.4. Quite a difference from the fear gauge’s tepid 12.6 average between November 2016 and March of this year.
Killing Me Softly
In our era of “alternative facts” it is perhaps unsurprising that the term “soft data” took firm root in the lexicon of financial markets over the past months. The normal go-to data points we analyze from month to month – real GDP growth, inflation, employment, corporate earnings and the like – have not given us any reason to believe some paradigm shift is underway. Meanwhile the soft platitudes of massive infrastructure build-out and historical changes to the tax code have ceded way to the hard realities of crafting legislature in the highly divisive political environment of Washington. Survey-based indicators like consumer or business owner sentiment, which have been behind some of the market’s recent era of good feelings, are not entirely useless, but they don’t always translate into hard numbers like retail sales or business investment.
The good news is that the hard data continue to tell a reasonably upbeat story: moderate growth in output here and abroad, a relatively tight labor market and inflation very close to that Goldilocks zone of two percent. This should continue to put limits on downside risk and make any sudden pullback a healthy buying opportunity. But we believe that further overall upside will be limited by today’s valuation realities, with an attendant likelihood that investors will return their attention to quality stocks and away from effervescent themes. And, yes, with a bit more sobriety and a bit less complacency.
It is something of an annual tradition: at some point, usually in the middle of a humid and lazy Atlantic Seaboard August, we will write something about the “dog days” of summer in investment markets. You know – light trading volume and mostly listless price direction, occasionally punctuated by an exaggerated surge or plunge based on some rumor or stray macro data point. Well, this year the dog days have arrived early. A couple one percent-plus days – one down and one up, for reasons that are barely remembered – provided some color to an otherwise tepid month long on political headlines and short on directional action. As the second quarter gets underway, we consider what might – or might not – puncture the market’s smug haze of mellow.
The Beta Economy
The present occupant of 1600 Pennsylvania Avenue may fancy himself an alpha human, but the economy in which his administration finds itself is decisively beta. That’s not a bad thing, mind you. A beta economy means real growth somewhere around two percent – nothing like the alpha economy of the 1990s, but perfectly acceptable, with modest price inflation and a mostly healthy labor market. Much of the rest of the world is enjoying a similar beta vibe. GDP is actually a bit higher in the EU than it is at home, Japan is managing to stay out of recession, and China’s factories are humming along nicely with recent PMI readings for services and manufacturing comfortably above the growth threshold number of 50.
Importantly for investors, a beta economy supplies the most compelling reason not to get fooled by a momentary sell-off like the little one last week. With no sign of a recession in sight, at home or anywhere consequential abroad, there simply isn’t much of a case to make to run for the hills. But what about the upside? Can businesses crank out alpha earnings in a beta economy?
Those Elusive Double Digits
Q4 2016 earnings season is over, and the 5.1 percent growth registered by S&P 500 companies falls well within our definition of “beta,” in the context of the last couple decades of quarterly results. Surprisingly, 5.1 percent is also very close to what analysts were predicting last fall: the FactSet consensus of analyst projections on September 30 pegged Q4 earnings growth at 5.2 percent. Reasonable! But that same consensus group also gave their Q1 2017 estimates on that same day, and that number was a very alpha-like 13.9 percent. Do they still feel that way? Not so much – the revised Q1 consensus number as of today, right before the actual figures start to come out, is 9.1 percent.
That’s still not bad, but it’s not the double digits investors would prefer to see to validate those valuations nearing nosebleed territory. The last twelve months (LTM) P/E ratio touched 20 this week, a level last seen in the post-trough recovery following the 2001-02 recession. The price to sales (P/S) ratio, is at levels last seen in the heady final days of the dot-com bubble at the beginning of the 2000s. We have believed for some time that the “valuation ceiling” remains the biggest headwind to substantial upside gains. Of course, this view has taken quite a bit of flak of late from the ever-popular “reflation-infrastructure trade” that has dominated market chatter for the past five months. Which brings us to our final musing about Q2 market direction…whither the animal spirits?
Momentum Is Its Own Momentum, Until It’s Not
What market pundits continue to call the “Trump trade” has been durable, even as prospects for any kind of sweeping, historic tax reform and massive new spending on infrastructure build out – never an obvious outcome to begin with – have looked less and less likely. But, as we have noted elsewhere in recent commentaries, such upside as there has been for the past couple months really has less to do with those reflation-infrastructure themes than it does with plain old momentum and those robust animal spirits.
Consider industry sectors. Sector-wise, the Four Horsemen of the reflation trade that ignited after the election were financials, materials, industrials and energy. These also happen to be the four sectors trailing the market in 2017 year-to-date, while technology, healthcare and consumer discretionary have all outperformed. Tech and discretionary, in particular, seem like pretty reasonable places to be if you’re comfortable with that beta economy and looking for a low-impact way to continue participating in equities. This low-key sector rotation has kept the rally going even as the original theme behind it went stale.
The problem, of course, is what happens when momentum wanes, as it eventually does? The first thing to watch out for is signs of the return of volatility, which as we all know has been strangely absent for the duration of this most recent phase of the bull market. Even that one-day pullback last week failed to elicit much more than a shrug from the supine VIX index. The market’s vaunted “fear gauge” has stayed in a volatility valley well below 15 for the entire year thus far (compare that with an average level above 20 for the first two months of 2016).
We tend to pay less attention to the VIX’s occasional sharp peaks than to the mesas – those extended periods of baseline elevation around 15-17. A new mesa formation on the VIX would, in our opinion, raise the prospects of a sizable near-term pullback in the 5 – 10 percent range. At which time we could, mercifully, shake off the dog days and get into some desirable new positions at more reasonable values.