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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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MV Weekly Market Flash: Troubled Technicals and Hyper Headlines

February 8, 2019

By Masood Vojdani & Katrina Lamb, CFA

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Every time the topic of “technical analysis” comes up in our weekly commentary, we need to begin with the customary disclaimer. There is nothing magical about the tools of the technical trade. 200 day moving averages, round numbers, head-and-shoulders formations – these are all silly things with no inherent meaning. BUT, they do affect short term trading patterns. Why? Because the 70-odd percent of daily market volume driven by algorithm-based trader-bots turns these whimsical flights of fancy into meaningful pivots around which markets go up and down. As per Arthur Miller’s “Death of a Salesman” – attention must be paid! We are paying attention this week because a trend is coming into view with potentially bearish overtones. Which may mean something or nothing at all, but it’s worth a look.

When Support Becomes Resistance

The long term moving average is a staple of technical analysis, with 200 days being a particularly popular representative of the species. In bullish times the 200 day average acts as a support level, while in a bear market it becomes a ceiling of resistance. We will illustrate this phenomenon with the chart below, showing a comparison of the last twelve months price performance on the S&P 500 as compared to the period from January to December in 2000 (the first year in the 2000-03 bear market). 

That reddish line coursing across each chart is the 200 day moving average. In both time periods (2000 and today) you can see the specific instances when the index bounces off the moving average and resumes an upward trend (for example, May and July 2000, and April and May 2018). You can also see where the moving average becomes a resistance ceiling (October-November 2000 and November-December 2018).

This past week, the 200 day moving average seemed to work with surgical precision. On the back of an impressive six week rally starting just after Christmas, the S&P 500 closed Wednesday just 0.15 percent below the moving average. It then promptly fell back in Thursday and early Friday morning trading. Again – this may or may not mean anything significant. Perhaps it even rallies back up after we go to print with this piece – who knows? But the technical pattern of the market since last October is thus far looking less like a bullish resumption and more like settling into a more negative cadence. Short term traders will be inclined to read it as such and then the Copenhagen theory of markets comes back into focus: the observation affects the outcome. Negative feeds on more negative.

What Say the Fundamentals?

As much as technical indicators impact short-term market movements, though, it takes more than that to produce a full-on chronic bear. Fundamentals matter. Here, the current contextual environment allows one to take a glass half full or half empty approach. The half full contingent will point to the more or less unchanging stream of good headline macro data here in the US: a robust jobs market with inflation right around the Fed’s two percent target, and still-healthy levels of consumer and business sentiment if not quite as optimistic as a year ago. Based on the data at hand, the likelihood of a near-term recession in the US is quite low. That’s good news.

But wait, says the half empty crowd. Look at where the consensus is going for Q1 2019 corporate earnings. Back in September last year the consensus forecast for first quarter earnings growth was 6.5 percent according to FactSet. That same forecast today, a bit more than seven weeks away from the end of Q1, is negative 1.9 percent. Even if the usual “estimates Kabuki” games are at play, that is a big delta. The lowered estimates come from corporations lowering their guidance for expected earnings.

What is notable is that the consensus outlook on sales has not come down as much as earnings. This means is that companies are not yet too concerned about structural demand – sales are expected to grow around 5 percent in Q1, which is a healthy number. But it implies that profit margins are going to be squeezed by a combination of factors such as higher wages, higher interest rates and other factors giving less profit bang for each incremental buck of sales. That feeds back into one of the main “glass half empty” talking points of recent months, namely peak profit margins.

Tilting at Headlines

While the fundamentals are confusing and the short term technical indicators giving cause for concern, the market has reverted to grasping at daily headlines for directional guidance. For most of this year there has been enough meat on the positive headlines – the Fed put being back in play (as we wrote about last week), nothing particularly negative on the trade war front, no other sudden surprises – to keep the direction positive.

But a headline-driven market is inherently skittish. There’s not much more room in the Fed punch bowl for positive surprises – even if the Fed were to start actively signaling towards a near-term rate cut it would leave the market wondering just how bad the underlying situation is. Europe’s problems are coming back into focus – spreads between Italian and German debt, for instance, are resuming a notable widening trend. British government leaders seem to be trying their hardest to convince the rest of the world that they are the most inept bunch of chummy toffs ever to claim the mantle of governance anywhere (these days, a decidedly low bar). Where the market winds up at the end of this year is anybody’s guess – but we expect to see plenty more ups and downs along the way, with downside risks that are not going away.

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MV Weekly Market Flash: Breadknives and the Algos That Make Them

January 18, 2019

By Masood Vojdani & Katrina Lamb, CFA

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What do global capital markets and the Warrumbungle National Park in New South Wales, Australia have in common? Topology, for one. In the chart below we have juxtaposed an image of one of the best-known features of Warrumbungle, known affectionately as the Breadknife, with yesterday’s price trend graph for the S&P 500. The similarity, we think you will appreciate, is remarkable. 

The Topology of the Twitterverse

What exactly was it, shortly after 2:30 pm on Thursday, that sent the broad-based US stock index into its best imitation of an eastern Australian rock formation? Something on Twitter, of course, because that is where most news headlines land a few microseconds before they make it into the pixelated pages of mainstream news outlets. The little item in question was a report from Steve Mnuchin’s Treasury Department suggesting that sanctions on China should be lifted in order to encourage a settling of the trade dispute between the US and China. The chronology goes thus: a snippet of the Treasury report made its way onto Twitter, where it was gobbled up by a vast gaggle of tradebots that feed solely off the effluvia and attendant waste products of social media. Stock prices jumped by some three quarters of a percent from where they had hitherto been ambling along.

Almost immediately afterwards came a countervailing comment from Robert Lighthizer, the US Trade Representative, throwing cold water on the idea that sanctions should be lifted. The White House, for what it’s worth, chimed in to quash the idea that lifting sanctions was a possibility in the immediate future (it’s worth noting that the only other meaningful piece of trade-related news earlier in the day was a report that the US, in trying to pressure the EU to buy more agricultural products to offset declining exports to China, was thinking of slapping some new tariffs on automobile imports). The Breadknife crested and shaped the contours of its downward slope back close to where it had begun. Trading ended on a reasonably optimistic note because, apparently, the winning theme was “if someone’s even talking about sanctions at all it must mean the atmospherics are a bit better than they were.” Or something to that effect. Win!

Life In Volatile Times

To be clear: there was technically no news – nothing of any substantial meaning – that transpired between 2:30 pm and the banging of the antique gavel on the floor of the New York Stock Exchange at 4 pm with whatever invitees of the day slow-clapping the close of another trading session. Nothing to merit that Breadknife of 75 basis points up and down. So it goes in a jittery market where rumors, counter-rumors and the sudden catalyzing of vague sentiments one way or the other drive share volumes on any given day. For most of the year thus far (all two weeks and change of it) the prevailing sentiment has been mostly of the glass half full variety. Last month was quite the opposite, where every little X-factor that bubbled to the surface on any given day was a raven foretelling the imminent arrival of the Four Horsemen of the Apocalypse. Expect more of these back-and-forth reels as the year goes on.

Early next week we will be releasing our 2019 Annual Outlook, the main theme of which is that the principal characteristic of risk assets this year is likely to be volatility. Volatility goes up and volatility goes down – just like the Breadknife in Warrumbungle National Park. When markets gyrate excessively in response to the continuous stream of drivel that courses through the Twitterverse, what matters most is staying disciplined and focused on the things that do matter.

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