21 November 2013

Macro Strategy Update

Bubbles, Corrections and Crashes

For the whole of 2013, we have been bullish on equity markets, particularly developed market equities. So far, it has been a very rewarding year for US and European equities. Still, the stock market rally does not get much respect since multiple expansion has been doing the heavy lifting so far, with earnings growing in the low single digits. Throw in the fact that developed economies continue to be supported by unconventional monetary policy, it is not surprising to find talk of “bubble” in financial media. With bubbles come crashes. This report attempts to put some perspective into these issues.

The S&P500 is up 26% so far despite earnings rising only 3.5%, according to Factset. By paying more for earnings, investors have sent the cyclically adjusted price earnings ratio of the S&P500 to 25x, up from 13x when the bull market began in March 2003. By this metric alone, it does not qualify as a bubble yet. The market has traded at higher multiples before. However, there are other signs that indicate a higher tolerance for risk taking - a prerequisite for bubble formation.

The IPO market is heating up, especially for the Internet sector. Twitter is probably the most recognisable company that saw its IPO pop on the first day of trading, with its shares doubling at the highest point. A string of companies have gone or are in the process of taping favourable market conditions for selling shares to the public. As a result of the bullishness on the Internet sector, the S&P North American Internet Technology index is up 57% since the start of the year, massively outperforming the S&P 500, and even the tech- heavy Nasdaq (up 31% YTD). The appetite for technology stocks brings back memories of the internet stock bubble of 1999, which incidentally was a peak for global stock markets.

The high level of borrowing to invest is also a potential sign that stock markets are in a bubble. The current amount of margin debt climbed to a record $401 billion, surpassing the previous peak of $381 billion in July 2007. Again this shows that investors are getting bolder even as stock prices soar higher.

The VIX index (shown below), commonly known as the fear index, is currently trading near 5-year lows. A measure of future volatility, this index shows the level of comfort investors have with the market, a sign of complacency.


So while it looks dangerous on the surface, it is our opinion that we currently do not have a stock market bubble. Specific sectors or companies may be in a bubble, but not the entire market. By valuation, it is only reasonable to conclude that US equities today are expensive, but not insanely exorbitant and hence not in bubble territory. From the chart below, today’s cyclical adjusted price earnings ratio is nowhere near the levels seen in 1999.


At the company level, investors are also quick to punish corporates that disappoint on results, rather than buy on the hope that the future will be brighter. Take Tesla, a maker of electric cars, as an example. After an astounding 470% year-to-date gains, the shares are now down 34% from its peak, after a disappointing earnings report. Investors still expect results despite paying a hefty sum for future earnings. Investor rationality is not totally out of the window. The case for a bubble in stock markets is not convincing.

As such, we rule out a crash in markets. Monetary policy remains loose and is expected to be favourable for equities for a while longer. With the US consumer price index still hovering below 2%, inflationary concerns are off the radar, giving the Fed an excuse to continue its unconventional policies. A confirmation of Janet Yellen as the new Fed chair will provide continuity in Fed policy, which will most likely indicate that any change in policy will be gradual. The support that the Fed gives to equity markets may lessen but it is unlikely to suddenly vanish, and hence a dislocation to markets is unlikely. In any case, tapering by the Fed has been discounted by markets, with bond yields higher than six months ago.

That said, a change to the bond buying program could be a trigger for a correction in equity markets. The current rally in the S&P500 has not seen a meaningful correction of more than 10% since August 2011. Even when Bernanke first broached the subject of tapering back in May 2013, US equities fell by 5.8% only. However, we cannot ignore the fact that bank stocks have been under performing since August (shown below), a sign that financial conditions in the real economy have already tightened. This is also confirmed by how spreads between CCC- and BB-rated bonds remain elevated since September. The odds of investors booking profits on slight modification to monetary policy, especially when Congress is due for another round of battle on the debt ceiling and budget next February are high.

Conclusion

Our positive outlook on developed markets remains unchanged in the medium term. The fact that cyclical stocks continue to outperform the market suggests that economic growth remains intact and could surprise to the upside. Ironically, it is this strength in the economy that may momentarily weaken equity markets. Adopting a cautious approach to risk assets and taking some risk of the table as we start the new year may be a reasonable course of action.

Portfolio Positions

In view of the above, we are looking to sell some equity funds soon and place in short duration bonds. This will give us a bit of a war-chest to buy equities on the cheap if our anticipated correction happens in the 1st quarter. We expect to send out our recommendation for switching sometime in the next few weeks.



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