As it’s the beginning of May, I thought I’d update readers on my crystal ball gazing exercise from the beginning of the year. At the time, we were all recovering from a market panic but now the S&P 500 has rallied more than 25% since the Christmas Eve trough, led by growth stocks.
Back at the beginning of the year, I thought that there was a 40% chance of a bump along, range bound but volatile environment, 35% of a melt up (a return to euphoric markets) and a 20% probability for a hell in a hand cart scenario.
May is a good time to update these probabilities because the old investing lore is to sell in May and come back again in the late autumn or early winter (variously September through to November).
Now truth be told, this old investing adage has been looking a bit tired for years now and as Interactive Investor recently pointed out, the adage doesn’t seem to have been true for quite a few years now.
According to their reckoning, if we go back to 1986, between 30 April to 15 September (typically the date closest to St Leger Day), the FTSE All-Share and the FTSE 100 have fallen 15 out of 33 times (45% of cases). I’m not sure that we should base too much on any seasonality effects in the age of quantitative easing.
I think I’d now bet that there’s a between 40% and 50% chance of a melt up, whereas the range bound scenario has dropped down to 35%. I see no reason to change my hell in a handcart scenario as I see nothing that’s happened recently to think we are on the brink of a systemic collapse, bar perhaps the heavy central bank gold buying which is running at record levels.
But that might just be explained by central banks wanting to diversify away from the dollar as a reserve holding – and I hear that our communist chums in Venezuela are also selling a fair few tonnes of the shiny stuff.
So why my slightly more optimistic outlook? I do think we’ve re-engaged with a powerful momentum driven equity system which is feeding lots of cash into large cap US equities.
Michael Horan, head of trading for Europe, the Middle East and Africa at BNY Mellon’s Pershing, thinks exchange-traded funds (ETFs) are responsible for this massive momentum trade. He argues these have driven ‘unprecedented levels of capital flow into liquid large-cap stocks’.
‘At the same time, the soaring demand for ETF products is triggering lower liquidity in smaller stocks that do not benefit from inclusion,’ he says.
‘This is concentrating investor allocation into a comparatively small number of stocks, reducing liquidity across the rest of the market and causing artificial highs in major indices.’
I’m not sure I entirely agree with all of this analysis, not least because Michael seems to have missed the fact that most really big institutional investors don’t use ETFs. But what Michael is right to draw attention to is that quant-driven strategies are becoming more powerful, some of them passively implemented, others using a much more active framework.
What these combine to produce is a strong push into the most deeply liquid, momentum-driven stocks – notably in technology. I’d also agree with Michael that liquidity amongst smaller cap stocks has declined markedly, creating huge pricing anomalies.
Another way of looking at this is to think of markets as moving in cycles – where are we at the moment? Boom or bust? Analysts at Fidante have a nice and simple way of divining where we are in the stock market cycle – see the diagram below. By their reckoning, we are in the middle of the boom. Most assets should do well in this scenario, bar one: gold. Maybe those central banks aren’t sharp buyers after all.
Source: Fidante Partners
Anyway, if we are in this stage of the cycle, and I would argue we are, and at the very late stage of it, we should expect valuations to be stratospheric.
Not so. Asset manager DWS has worked the numbers on US equities and come to some interesting conclusions. The first is that current S&P 500 price-earnings (PE) multiples ‘are still lower than the highs reached in January 2018: S&P 500 aggregate trailing PE is 18 now versus 21.2’.
That latter PE multiple, however, was largely based on strong 2018 earnings-per-share growth expectations from the US corporate tax rate cut.
David Bianco, Americas chief investment officer at DWS, uses another measure which is a combination ‘of the observed trailing S&P 500 PE and options-market-implied near-term volatility index (CBOE Vix Index) expectations to gauge equity investor sentiment’.
‘This "Panic-Euphoria Indicator" went all the way from panic territory into a state of complacency, if not euphoria, within four months. Depending on macro risks, we think that a 17 to 18 trailing S&P 500 PE valuation is reasonable,’ he says.
But Mr Bianco does issue one caution: ‘further S&P 500 upside will require higher earnings estimates’.
Source: Bloomberg, DWS
But even here there’s a hint of relatively good news.
Deutsche Bank has been tracking the current earnings season and at the last count we were 230 companies in to the season (representing 55% of market cap) and so far 77% have ‘reported better-than-expected first quarter earnings, a sharp recovery from the fourth quarter when the beat rate (68%) dipped to its lowest level in seven years’.
Earnings beats are running at 6.4% (4.7% median), versus 3.4% historical numbers while overall earnings look to have grown 2.4% in the aggregate (4.6% median). At this point the cynic would shrug their shoulders, remind us that earnings estimates are only being revised up over the course of reporting, because they’ve been cut in the run-up. Even with this proviso though, I’d observe that earnings aren’t in a horrible place – they just need to pick up steam in the second half of the year.
Global growth tailwind
And what might provide this second half tailwind? Again, optimistic equity investors might find another set of positive numbers coming from the global economy which looks like it has stabilised it’s ‘pause in growth’ phase and could be about to have a stronger second half to 2019.
As economists at Barclays put it: ‘In the US, our outlook is that economic activity and labour market conditions are healthy enough to buy time for transitory factors holding down inflation to subside.
‘Global growth has stabilized following the (net) positive surprises in 2019’s first quarter. Overall, the relatively benign global outlook for growth is likely to continue into the second quarter.’
So, I think a reasonable case can be built for a more optimistic view, which might provide a tailwind for my lesser spotted melt up.
But there’s one last bunch of data points that tell a slightly curious tale: fund flows. It’s worth watching what institutional investors and retail ETF investors are buying. Topping the sales charts, by a long chalk according to Deutsche Bank, are bond funds.
Since the turn of the year, bond funds have taken in almost $150 billion while equity funds have seen $50 billion leave the door. ‘Persistent outflows despite the strong equity rally are unusual but have been driven by investors chasing falling yields,’ says Deutsche. ‘The pace of bond inflows and equity outflows, in turn, should eventually abate if yields stabilise.’
This I think is an important point. The US markets have rallied because we now, in effect, have a ‘Powell put’ in play. The chair of the US Federal Reserve has president Trump on his tail and is mindful that many think that the central banks have been collectively too aggressive in tightening their balance sheets and increasing interest rates.
In effect I think we’ve seen a vindication of the ‘low rates for longer’ thesis, which simply states that the central banks won’t be able to increase interest rates to ‘normal’ historical levels because of the huge mountain of debt.
My hunch is that the Fed have reached peak interest rates and the next move might be downwards. If that is the case, this is hugely supportive of a two-step process that helps explain those fund flows I mentioned earlier.
The first is that institutional investors pump money into longer duration bond funds as they chase the yield down and then take profits and switch back into equities as the global economy slows picks up speed again, after a possible trade deal between China and the US at some point this summer.
But watch the oil price
Taking all these factors in the round, I’ve upped my probability of a melt up to between 40% and 50% for the remainder of 2019. But there are some obvious potential risks.
The first is inflation – not from increasing wages but from oil. The week before last I received an email to investors from a gentleman called Jean Louis Le Mee, a specialist energy investor at Westbeck Capital.
Westbeck runs a fund that invests in this space so of course they’ll talk up their book but what struck me was the sheer conviction of this note. The big catalyst for a more bullish position is the sanctions on Iran which they reckon is as hawkish a surprise as possible. They also point to possible supply losses in Venezuela, Libya, Nigeria and Algeria and recovering oil demand.
Their bottom line? ‘We believe the risks for an oil price spike to $100-plus this summer are increasing.’
One thing that could precipitate this horrible scenario is if the current US Iran showdown resulted in the Iranian navy closing the Gulf to tanker traffic. If I were the Iranians, I would be giving this serious thought as it’s not clear that they’ll gain anything by diplomatic means with an increasingly belligerent US administration. I heartily dislike the theocratic regime in place in Iran, but I struggle to see the logic behind the current strategic planning dealing with Iran, which could so easily trip into a military stand-off.
I’d also suggest that there is one last factor to watch out for – global manufacturing growth which is looking very weak as of late. Morgan Stanley analysts put out a note a few weeks back which showed how US manufacturing confidence had fallen noticeably in recent weeks. Analysts at Barclays are also worried that this weakness could continue into the second half of next year, especially if the US trade talks with China don’t go to plan.
My take on all of this? Watch the oil price and keep a beady eye on manufacturing numbers but on balance stay optimistic about equities.
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