14 Aug 2014

Macro Strategy Update

Climbing The Wall Of Worry

Almost four years ago, we wrote about the issues that caused investors to worry when equity markets were rising. That was September 2009, when the S&P 500 rebounded 53% after a devastating 40% loss in the preceding year. Today, with markets having made additional gains, investors continue to fret. Fears of liquidity withdrawal, economic slowdown in emerging markets, and high valuation are some of the issues investors need to overcome to remain buyers of today’s equity markets.

Wall Street is a worried bull as seen from how they have been revising their forecast upwards for the S&P500 higher each time the level is breached1. The underestimation of how high equity markets can go is not surprising, given that after the global financial crisis of 2008, followed by the European sovereign debt crisis, investors have grown more cautious and adopted the glass is half empty view when it comes to predicting the future. The reliance on history is probably why investors fear the likely adjustment to the Federal Reserve’s quantitative easing (QE) program.

When QE1 and QE2 ended, stock markets fell (Figure 1). This method of forecasting market action has a 100% accuracy track record. Yet because it has only occurred twice in the entire history of the S&P 500, its extremely small sample size makes it useless from a statistical point of view. Nonetheless, investors’ preference for narratives (where the media trumpets the end of QE as the reason for the sell off in equities) makes the end of QE a good reason to dump stocks.

Figure 1: QE and its effect on the S&P

Unlike in 2010 or 2011, the current concerns are over the adjustments to the QE program, not the termination of QE. Federal Reserve officials have talked about lowering the monthly purchase of bonds from the current US$85 billion, not ending QE totally. Although this is pretty obvious, the reaction from investors and the media appears to suggest that QE is ending. So if we were to apply the same methodology, slowing bond purchase by the Federal Reserve means stocks will rise at a slower pace and not fall, as feared by investors.

Importantly, and the reason why we remain bullish on US equities, the economic and financial conditions today are quite different from 2010 or 2011. Economic growth in the US has proved to be more resilient and housing has finally made a difference since 2011, as seen from private residential investment (Figure 2). Leading indicators are also on a stronger footing this year, compared to 2010 or 2011. The latest OECD Composite leading indicator for the US shows that growth is firming (Figure 3). Better economic conditions, the reason why the Federal Reserve is confident of adjusting its QE program, should be seen as a conducive environment for equities.

Figure 2: Housing investment has risen significantly since 2011

Image courtesy of Stockcharts.com

Figure 3: OECD US leading indicates better growth ahead

Market signals that we track also show a key difference between now and 2010 or 2011. Financial stocks were underperforming the stock market back then (Figure 4). Today, they are outperforming. Being the lifeblood of the economy, it is key that financials, especially banks, are doing well. The index is not only outperforming the market by double digits on a one-year basis (Figure 5), it is also at a four-year high on an absolute basis. The market is discounting better economic conditions in the months and quarters ahead and this is generally good news for equities. Even the bond market confirms this with CCC-rated bonds outperforming BB-rated bonds for the year (Figure 6). Conditions are just not in place to raise the risk of defaults by companies issuing high yielding bonds. Lowering the amount of bond buying is unlikely to derail the rally in US equities given growth in the economy is likely to be sustainable.

Image courtesy of Stockcharts.com

Figure 4: Financial stocks underperformed the market in 2010 and 2011

Image courtesy of Stockcharts.com

Figure 5: Financial stocks currently outperforms the market

Figure 6: Spreads between CCC-rated and BB-rated bonds have been narrowing

The slowdown in China and the emerging world is also another reason to worry. While it is a valid reason if one’s investment options are limited to only this region, the slowdown in the emerging world is not sufficient to trip the developed world into a recession. For starters, the emerging world is slowing, not contracting. China’s growth has slowed but policy makers are acutely aware of the dangers of slowing the economy too aggressively. That is why fine tuning measures to help SMEs and exporters2 and the on-off pumping of liquidity into the banking system by the central bank are reminders that the Chinese leadership is not taking a bold and decisive approach to restructure the economy, for fear of tipping the economy into a recession.

Europe’s stabilising economy also acts as a counter balance to the slowdown in the developing world. The latest PMI surveys show broad improvement in Europe3. The recovery in Germany is accelerating while the downturn in France, Italy and Spain are easing. This is also why European financials have been leading the market (Figure 7). Markets are discounting better economic conditions, in the sense that a fragile recovery is likely to take place in the eurozone. A recovery in the European economy is positive for financials companies as it boost asset values, reduce loan losses and spur credit demand. This is why bank earnings have been rather impressive this season4 . The OECD Composite leading indicator is also projecting better economic prospects for Europe as more signs confirm a recovery (Figure 8). As the largest economic bloc, a mild recovery in Europe can make an impact on the global economy, allaying fears that a Chinese slowdown will drag global equity markets down.

Image courtesy of Stockcharts.com

Figure 7: Financial stocks currently outperforms the market

Image courtesy of Stockcharts.com

Figure 8: OECD Euro area leading indicator

The third issue investors struggle with is valuation. It is a fact that equities today are not cheap, especially compared to March 2009. The S&P 500 is trading at 18.62x on a 12-month trailing basis. A year ago, the PE ratio was 15.89x. Purely from a valuation point of view, earnings have failed to catch up with stock prices. So far, the second quarter earnings season is not exceptional when we exclude financials, according to Zacks Investment Research5. Earnings actually dropped 2.8% in Q2 when financials are excluded. Normally, this sets up a cautionary signal, especially when the S&P 500 is up 18% year-to-date. But a key difference is the equity risk premium, which has fallen and is likely to decline further as economic conditions improve and investors’ preference for equities over bonds grows. Mutual fund flows into US equities amount to US$40.3 billion last month, while bonds continue to suffer a second month of outflows (US$69.1 billion in June and US$21.1 billion in July)6. The risk of owning equities appears to be falling while the danger of holding on to bonds, in light of rising interest rates, appears to be rising. In such an environment, valuations do rise as the bull market matures. The cyclically adjusted price earning ratio, which smooths out earnings over ten years, clearly indicates periods of rising and falling valuations (Figure 9). Since the bull market begun in March 2009, valuations have risen, and if economic conditions stay positive, it is likely to rise further.

Figure 9: Long term trend of price-earning ratio of the S&P Composite (cyclically adjusted)

Technically, developed markets are overbought and are vulnerable to a correction (Figure 10). Emerging markets remain entrenched in a downtrend despite offering a 10% discount compared to the beginning of the year. Investors are probably digesting the current earnings reports and assessing how strong economic growth will be and hence what to expect of the Federal Reserve’s QE policy. Equity markets are likely to tread water with some downside bias for the time being.

Figure 10: Developed equity markets are overbought and susceptible to a correction

Figure 11: Emerging markets stuck in a downtrend


While we are mindful of a potential correction, given the overbought situation in markets, we see no reason to worry over the Federal Reserve’s policy. Global economic growth is also not a worry as an improving Europe balances out weakened emerging markets. The theme of outperformance by developed markets is likely to continue and investors should remain invested in developed equities.

Portfolio Positions

We have previously aligned our portfolios to be overweight developed market equities. Please approve our earlier online recommendation if you have not yet done so and contact your advisers if you have any questions.

1. More strategists join the growing '1700 Club'. 8 August 2013. USA Today.
2. China offers further pro-growth policy fine-tuning. 24 July 2013. CNBC.
3. Euro zone business expands for first time in 18 months. 5 August 2013. Reuters.
4. Bumper European bank earnings boost stocks. 1 August 2013. CNBC.
5. Q2 Earnings Season in the Final Stretch. 9 August 2013. Zacks.
6. US equity funds see highest-ever inflows in July. 4 August 2013. CNBC.

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