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MV Weekly Market Flash: The Insurance Cut and the Melt-Up

June 21, 2019

By Masood Vojdani & Katrina Lamb, CFA

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Here’s a quote from a mainstream media fixture. How recent is it? “Financial markets have soared during the last month on expectations of a cut in rates. The Federal Reserve’s top officials…may have grown increasingly reluctant in the last several weeks to risk causing turmoil on Wall Street by leaving rates unchanged, analysts said.”

That little blurb from a New York Times article certainly sounds like it could have been written sometime within the past, oh, forty-eight hours. In fact, that article came out on July 7, 1995, two days after the Alan Greenspan Fed cut interest rates for the first time since 1992 (the article’s subtitle “Stocks and Bonds Soar” of course would be no less appropriate for anything written during the week ending June 21, 2019). The 1995 event was a particular flavor of monetary policy action called an “insurance cut,” and it has some instructive value for what might be going through the minds of the Powell Fed today.

Anatomy of an Insurance Cut

In the chart below we illustrate the context in which the 1995 rate (and two subsequent cuts ending in February 1996) took place. What we think of today as the “Roaring ‘90s” had not yet gotten into gear (in fact it was just about to start with the initial public offering of Netscape, the Internet browser, just one month after the Fed’s rate cut). In July 1995 the Fed had just capped off a series of seven rate hikes that had begun in 1994 and that had taken the stock market by surprise. Core inflation had crept back up above three percent, and a handful of economic indicators warned of a potential slowdown.

Despite the upturn in inflation, many observers at the time – on Wall Street, in corporate executive suites and in the Clinton White House alike – complained that the Fed’s rate hike program in 1994-95 had gone too far, too fast. Politics were certainly part of this mix, summer 1995 being a bit over a year away from the next presidential election (stop us if you’ve heard this one before). While the headline numbers didn’t suggest that a recession was imminent, there were indications that business investment had slowed with a build-up in inventories. The index of leading indicators, often used as a predictive signal for a downturn, had come in negative for four consecutive months. In announcing the rate cut, the Greenspan Fed emphasized that this move was more about getting out in front of any potential downturn, and less about the looming imminence of such a reversal.

Again, any of this sound familiar?

It’s a Different World

Equity investors, of course, would dearly love to imagine that a Fed insurance cut policy will always lead to the kind of outcome seen in the latter years of that chart above; namely, the stock market melt-up that roared through the late ‘90s and into the first couple months of the new millennium. Such an outcome is certainly possible. But before putting on one’s “party like it’s 1999” hat, it would be advisable to consider the differences between then and now.

The most glaring difference, in looking at the above charts, is the vast amount of blank space between the Fed funds rate and inflation. Yes, there was positive purchasing power for fixed income investors back in those days. Moreover, the US economy was able to grow, and grow quite nicely, with nominal interest rates in the mid/upper-single digits. This was real, organic economic growth. Yes – it’s easy to conflate the economic growth cycle of the late 1990s with the Internet bubble. But that bubble didn’t really take off until the very last part of the cycle – and in actual economic terms, Internet-related commerce was not a major contributor to total gross domestic product. This was a solid growth cycle.

The Greenspan insurance cuts, then, were undertaken with a fairly high degree of confidence in the economy’s underlying resilience. Today’s message is starkly different. What the market and the Fed apparently both conclude is that the present economic growth cycle cannot withstand the pressure of interest rates much or at all higher than the 2.5 percent upper bound where the Fed funds rate currently resides (and forget about positive purchasing power for anyone invested in high-grade fixed income securities). It’s a signal that, if the economy does turn negative, then central banks are going to have to get even more creative than they did back in the wake of the 2008 recession, because a rate cut policy from today’s already anemic levels won’t carry much firepower.

For the moment, the mentality among investors is optimistic that a best-of-all-possible-worlds result will come out of this. Dreams of a late-90s style melt-up are no doubt dancing in the heads of investors as they shovel $14.4 billion into global equity funds this week – the biggest inflow in 15 months. But no two bull markets are alike, and that goes for insurance-style rate cuts as well.

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MV Weekly Market Flash: Risk-Off, With a Side Helping of Large Cap Equities

June 14, 2019

By Masood Vojdani & Katrina Lamb, CFA

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Let’s go back in time exactly one year – to June 14, 2018. Someone from the future visits you and tells you that in the first four months of 2019 – from the beginning of January to the end of April – the S&P 500 will rise by 17.5 percent. The future-visitor then beams out, leaving you with just that one piece of information and a portfolio strategy to plan. What would you assume about the world at large? That gain in US large cap equities is one of the strongest on record, so you would probably be inclined to imagine “risk-on” as the dominant sentiment in global markets. A healthy allocation to core equities and higher-risk satellite classes like small cap and non-US emerging markets would be a plausible strategy, while perhaps reducing core fixed income weights to the lower end of your approved range.

No Reward for Risk

Of course, being in possession of just that one snippet of information about the future means that you wouldn’t have known that stocks came within a whisper of ending their decade-long bull market in December 2018, or that the Fed would make a sudden and radical U-turn in January towards a more dovish policy stance. Even so, one of the noteworthy things about the 2019 incarnation of the equity bull is how confined it is to US large caps, while riskier asset classes have sputtered. The chart below illustrates this divergence between bonds and large cap stocks on the one hand and everything else on the other.

From that point in time one year ago both US small caps and non-US emerging markets are down around 10 percent – still in or close to a technical correction. Non-US developed markets haven’t fared much better, in part due to the translation effect of a strong dollar on foreign currency assets. So a broad-based risk-on mindset has never really set in. The star asset class for this period, particularly when looked at on a risk-adjusted basis, is fixed income. The US Aggregate Bond index is up low-mid single digits for this period, performing a little better than large cap value equities and just a bit behind large cap growth stocks but with much less volatility, as clearly seen in the chart.

Divergence Ahead?

Bonds are in favor largely because the market has talked itself into believing that a forthcoming economic downturn will necessitate aggressive action by the Fed and other central banks (the presumed downturn being global in nature and in fact catalyzed more by flagging economies outside the US than here at home, at least for now). But there is a twist here within the friendly confines of the fixed income space. If economic conditions really are set to turn down, then a logical assumption would be that credit risk spreads start to widen. But that has not happened. Investment grade corporates and high yield issues alike are holding up just fine. The iShares iBoxx High Yield Corporate Bond ETF is up around 6.4 percent in total return for the year to date.

So here’s the picture: while the market is definitely not in a “risk-on” mindset, as evidenced by the poor performance of many higher-risk asset classes, neither is it completely “risk-off” as shown by those healthy returns for large cap stocks and the absence of credit risk spread widening. It’s as if there is some arbitrary line, on the one side of which are assets thought to be protected by a dovish Fed, with the other side being for assets vulnerable to the full-on effects of a worsening economy.

In recent commentaries we have argued that this odd arrangement is not sustainable. At some point either we realize that the economy actually is stronger than expected – in which case asset classes should revert to a more traditional risk frontier (higher return for higher risk) – or that a global recession is indeed imminent, in which case the market goes full risk-off, credit spreads widen and large cap equities get their comeuppance.

But there is an alternative view, which appears to be the one embodied by today’s conventional wisdom. This view holds that the magic of central banks will continue to work well enough to keep the worst of a downturn at bay. In this world, holding a handful of traditionally higher-risk assets like large cap US equities and low investment grade / high yield bonds makes sense, but taking on additional risk from other asset classes doesn’t pay (since the source of market return is permissive monetary policy, not organic economic growth). To be perfectly honest we think this is a risky view with the potential for serious mispricing of certain asset types. But it’s 2019, folks, and strange is the new normal.

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MV Weekly Market Flash: Something’s Gotta Give

March 22, 2019

By Masood Vojdani & Katrina Lamb, CFA

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Well, the first quarter of 2019 is about to enter the history books, and it’s been an odd one. On so very many levels, only a couple of which will be the subjects of this commentary. To be specific: stocks and bonds. Here’s a little snapshot to get the discussion started – the performance of the S&P 500 against the 10-year Treasury yield since the start of the year. 

Livin’ La Vida Loca

For an intermediate-term bond investor these are good times (bond prices go up when yields go down). For an equity investor these are very good times – the 2019 bull run by the S&P 500 is that index’s best calendar year start in 20 years. There are plenty of reasons, though, to doubt that the good times will continue indefinitely. Something’s going to give. The bond market suggests the economic slowdown that started in the second half of last year (mostly, to date, outside the US) is going to intensify both abroad and at home. The stock market’s take is that any slowdown will be one of those fabled “soft landings” that are a perennial balm to jittery nerves, and will be more than compensated by a dovish Fed willing to use any means available to avoid a repeat of last fall’s brief debacle in risk asset markets (on this point there is some interesting chatter circulating around financial circles to the effect that the equity market has become “too big to fail,” a piquant topic we will consider in closer detail in upcoming commentaries).

Flatliners

We have been staring at a flattening yield curve for many months already, but we can now dispense with the gerundive form of the adjective: “flattening” it was, “flat” it now is. The chart below shows the spread between the 10-year yield and the 1-year yield; these two maturities are separated by nine years and, now, about five basis points of yield.

Short term fixed rate bonds benefitted from the radical pivot the Fed made back in January when it took further rate hikes off the table (which pivot was formally ratified this past Wednesday when the infamous “dot plot” of FOMC members’ Fed funds rate projections confirmed a base case of no more hikes in 2019). But movement in the 10-year yield was more pronounced; remember that the 10-year was flirting with 3.25 percent last fall, a rate many observers felt would trigger major institutional moves (e.g. by pension funds and insurance companies) out of equities and back into fixed income). Now the 10-year is just above 2.5 percent. Treasuries are the safest of all safe havens, and there appears to be plenty of safe-seeking sentiment out there. The yield curve is ever so close to inverting. If it does, expect the prognostications about recession to go into overdrive (though we will restate what we have said many times on these pages, that evidential data in support of an imminent recession are not apparent to the naked eye).

Max Headroom

What about equities? The simple price gain (excluding dividends) for the S&P 500 is more than 13 percent since the beginning of the year, within relatively easy striking distance of the 9/20/18 record high and more or less done with every major technical barrier left over from the October-December meltdown. “Pain trade” activity has been particularly helpful in extending the relief rally, as money that fled to the sidelines after December tries to play catch-up (sell low, buy high, the eternal plight of the investor unable to escape the pull of fear and greed).

The easy explanation for the stock market’s tailwind, the one that invariably is deployed to sum up any given day’s trading activity, is the aforementioned Fed pivot plus relaxed tensions in the US-China trade war. That may have been a sufficient way to characterize the relief rally back from last year’s losses, but we question how much more upside either of those factors alone can generate.

The Fed itself suggested, during Wednesday’s post-FOMC meeting data dump and press conference, that the economic situation seems more negative than thought in the wake of the December meeting. The central bank still appears to have little understanding of why inflation has remained so persistently low throughout the recovery, but finally seems to be tipping its hat towards the notion that secular stagnation (the phenomenon of lower growth at a more systemic, less cyclical level) may be at hand. This view would seem to be more in line with the view of the bond market than with that of equities.

As we said above – something’s gotta give. Will that “something” be a flat yield curve that tips into inversion? If so, what else gives? That will be something to watch as the second quarter gets underway.

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MV Weekly Market Flash: The Value Investor’s Lament

March 1, 2019

By Masood Vojdani & Katrina Lamb, CFA

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Happy meteorological spring! Not that the calendar’s third month is bringing much in the way of springlike conditions to many parts of the US, including our own Chesapeake Drainage Basin Region. There’s not a whole lot of warmth in the world of value investing either – and there has not been for a very long time. Why exactly has one of the most time-tested old chestnuts of investing – the value effect – gone so completely pear shaped? We ponder this question in today’s missive.

Another Rotation Forestalled

For awhile it seemed that the tide had turned for the beleaguered legions who continue to swear by the Graham & Dodd value formula. Last fall’s comeuppance in equity markets dealt particularly harshly with the high-flying tech stocks and other growth sectors that had led performance for much of the recent phase of the bull market. But a snapshot of the last three months reveals how fleeting that value rotation was. As shown in the chart below, all four S&P 500 industry sectors trailing the overall index on a three month trailing basis are traditional value sectors: consumer staples, health care, financials and energy.

The dichotomy is not perfect: the utilities sector, generally considered a dividend/value play, continues to outperform the overall index. And the top-performing sector over this period is industrials (the purple trend line on the chart), which is cyclical but typically not an overweight component of growth stock indexes. Otherwise, though, the traditional growth cohorts of technology, communications services and consumer discretionary have been at the leading edge of the extended relief rally we have witnessed since late December last year (along with materials, which is a sort of growth-y cyclical sector).

The Long View Looks Even Worse

Now, the traditional value investor’s response to any short-term snapshot like the one we provided above goes thus: “sure, there are those irrational periods where starry-eyed investors flock to pricey growth stocks. But in the long run, value always wins. That’s why there is such a thing as a value effect enshrined in the scriptures of modern portfolio theory.”

Er, not so much. Consider the chart below, which shows the relative performance of the S&P 500 Growth Index versus the S&P 500 Value Index over the last quarter century going back to 1994. A quarter century that encompasses bubbles, crashes, growth cycles and bear cycles – a veritable kitchen sink of equity market conditions. A quarter century in which growth – the blue trend line – outperformed value (the green line) by nearly double.

You can call a quarter century a lot of things, but you can’t really call it “short term.” To say that “value outperforms growth in the long run” is simply to ignore the glaring evidence supplied by the data that there is actually no such thing as a value effect any more. It is dead, requiescat in pace. But why?

Nothing Stays the Same Forever

There probably will not be a settled conclusion about the demise of the value effect for some time to come. For one thing, there will continue to be value stock fund managers whose livelihood depends in some part on there being a value effect, just like there will always be fossil fuels company executives whose compensation structure benefits from a belief that there is no such thing as climate change. We might posit an idea or two about what has caused the long term malaise in value, though.

If you think about our economy in the sweeping scale of the last quarter century there are two trends we would argue rise to the level of tectonic shifts. The first is the downfall of the financial services industry as the lead engine of economic growth. From the early 1980s through the middle of the 2000s, the share of total S&P 500 corporate profits claimed by the financial sector more than doubled, from around 20 percent to 44 percent just before the crash of 2008. Financial services, in a variety of consumer and commercial guises, powered the economy out of the doldrums of the 1970s and into the halcyon days of the Great Moderation.

The second trend, which started roughly in the mid-1990s but really gained traction in the 2010s, was the encroaching by the technology sector into just about every other facet of commerce – and of life itself, if one wants to extend the argument to the rise of social media and the like. Not a single industry sector exists wherein competitive advantage does not derive in some meaningful part from technology. In this environment those who sit closest to the servers – i.e. the megacap tech firms who own the platforms and the attendant network effects – reap the lion’s share of the rewards.

Now, it just so happens that financial services companies typically have the characteristics of value stocks (low price to book ratios and similar metrics) while enterprises in the technology sector are more likely to sport the sales & earnings growth traits that screen into growth stock indexes. At the same time, the economic growth cycle of 2009 to the present has been dominated by one gaping anomaly when compared to any other growth cycle – near-zero interest rates for a large percentage of the time. Low rates have been particularly harmful to financial firms that make money based on profiting from the spread between their financial assets and their financial liabilities. They have been a boon for companies looking to leverage their growth prospects through cheap external financing.

This is by no means a complete and comprehensive explanation for the vanishing of the value effect. And from a portfolio management standpoint there should always be a rationale to include value as an asset class for diversification purposes. But the traditional interpretation of the “value effect” as being a sure-fire winning proposition in the long run is not a valid proposition. Financial markets are complex, and complex systems produce emergent properties that only become apparent after they emerge. Change happens. No doubt there will be a few emergent surprises for us in the weeks and months ahead.

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MV Weekly Market Flash: Return of the Corridor Trade?

February 15, 2019

By Masood Vojdani & Katrina Lamb, CFA

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As we wind our way through the random twists and turns of the first quarter, a couple things seem to be taking on a higher degree of likelihood and importance than others: (a) the Fed is back in the game as the dice-roller’s best friend, and (b) corporate earnings are starting to look decidedly unfriendly for fiscal quarters ahead. And we got to thinking…have we seen this movie before? Why, yes we have! It’s called the Corridor Trade, and it was a feature of stock market performance for quite a long time in the middle of this decade. Consider the chart below, which shows the performance path of the S&P 500 throughout calendar years 2015 and 2016.

What the chart above shows is that from about February 2015 to July 2016, the S&P 500 mostly traded in a corridor range bounded roughly by a fairly narrow 100 points of difference: about 2130 on the upside, and 2030 or so on the downside. There were two major pullbacks of relatively brief duration during this period, both related to various concerns about growth and financial stability in China, but otherwise the corridor was the dominant trading pattern for this year and a half. Prices finally broke out on the upside, paradoxically enough, a few days after the UK’s Brexit vote in late June 2016. An overnight panic on the night of the Brexit vote promptly turned into a decisive relief rally because the world hadn’t actually ended, or something. A second relief rally followed the US 2016 elections when collective “wisdom” gelled around the whimsical “infrastructure-reflation” trade that in the end produced neither.

So what was this corridor all about? There are two parts: a valuation ceiling and a Fed floor.

Corridor Part 1: Valuation Ceiling

In 2015 concerns grew among investors about stretched asset valuations. Earnings and sales multiples on S&P 500 companies were at much higher levels than they had been during the peak years of the previous economic growth cycle in the mid-2000s. The chart below shows the price to earnings (P/E) and price to sales (P/S) ratios for the S&P 500 during this period.

Those valuation ratios were as high as they were during this time mostly because sales and earnings growth had not been keeping up with the fast pace of stock price growth in 2013 and 2014. While still not close to the stratospheric levels of the late-1990s, the stretched valuations were a cause of concern. In essence, the price of a stock is fundamentally nothing more and nothing less than a net present value summation of future potential free cash flows. Prices may rise in the short term for myriad other reasons, causing P/E and P/S ratios to trade above what the fundamentals might suggest, but at some point gravity reasserts itself. That was the valuation ceiling.

Corridor Part 2: The Fed Floor

The floor part of the corridor is just a different expression for our old friend, the “Fed put” begat by Alan Greenspan and bequeathed to Ben Bernanke, Janet Yellen and now Jerome Powell. Notice, in that earlier price chart, how prices recovered after both troughs of the double-dip China pullback to trade again just above that corridor floor level. The same thing seems to be happening now, with the extended relief rally that bounced off the Christmas Eve sell-off. The floor is a sign of confidence among market participants that the Fed won’t let them suffer unduly (which confidence seems quite deserved after Chair Powell’s capitulation at the end of last month). It is not clear yet where the floor might establish itself. Or the ceiling, for that matter. Might the S&P 500 reclaim its September 20 record close before hitting a valuation ceiling? Maybe, and then again maybe not.

What we do know is that bottom line earnings per share are expected to show negative growth for the first quarter (we won’t find out whether this is the case or not until companies start reporting first quarter earnings in April). Sales growth still looks a bit better, in mid-single digits, but we are already seeing corporate management teams guiding expectations lower on the assumption that global growth, particularly in Europe and China, will continue to slow. Meanwhile price growth for the S&P 500 is already in double digits for the year to date. That would appear to be a set-up for the valuation ceiling to kick in sooner rather than later.

Could stock prices soar another ten percent or even more? Sure they could. The stock market is no stranger to irrationality. A giddy melt-up is also not unknown as a last coda before a more far-reaching turning of the trend. But both elements are pretty solidly in place for a valuation ceiling and a Fed floor. A 2015-style Corridor Trade will not come as any surprise should one materialize in the near future.

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