6 November 2015

Time Dilation and All Things Relative

Executive Summary

We have just exited the most volatile period of 2015. When our risk matrix signalled an elevated risk environment since August, we were on the look-out for economic deterioration and signs that a larger bear market was on the cards. We reduced equity exposure as a pre-cautionary measure. Now, risk is abating and we have been slowly allocating back into the market. Weighing both bullish and bearish evidence and looking at our risk matrix, we are positive in the short term but are more cautious further out. We will not hesitate to sell any risky assets if our risk matrix says so and will prioritise preservation of capital above everything else.


Time does heal. We are barely two months out of the most volatile period in 2015 and the financial media and investors have practically forgotten their worries which dominated nearly every discussion in September and October. So what has changed since then? Nothing at all. Chinas industries are still slowing, commodities are still in a downtrend, some parts of the world are overvalued, and some parts are cheap. The Fed still wants to raise rates at some point this year, the ECB and BOJ both want to print more money and Greece is still technically bankrupt. Whilst things are not nearly back to normal, our indicators show fundamental and technical risks slowly abating from markets. Perhaps we have experienced a time dilation1, where the world sped through time compared to us, whilst our clocks barely moved.

Global Economy

We had been on the watch for slowing growth which could imply a global recession in recent months. We wrote last month that whilst the economy was weak, we saw mixed signals where there was a clear desync between the services sector and manufacturing sector (Fig 1). We hold on to our view that global growth is still in a soft patch and much of that fear had already been priced into the markets. It now appears that the world is slowing, but the US is on a much stronger footing, so market corrections in such a scenario are always much more muted (Fig 2).

Fig 1: PMI numbers show that whilst manufacturing lagged, services (non-manufacturing) have propped up many economies across the world

Fig 2: Corrections Outside An Economic Recession Are Always More Benign.

Reasons to be Bullish - Flushed With Cash

There have been concerns that asset prices which were previously propped up by the excess liquidity in the financial system would suddenly come tumbling down. First, we do not see a bubble in most assets except in the bond market. Second, whilst the Fed has scaled back on its easing program, other central banks have stepped up as providers of easy money (Fig 3). We do not know whether these easing programs will end badly, but as long as there is a concerted effort to drive down currencies and interest rates, then equities or other risky assets provide the best risk/return attributes for investing.

Fig 3: Bank of Japan and European Central Bank Are Now Providing Liquidity To The Financial System in Place of the Fed

Reasons to be Bullish - Earnings Season and Buybacks

This quarter, 75% of the S&P500 companies which have reported earnings have beaten estimates. This is positive as it shows that pessimism had been slightly excessive going into the earnings season where many analysts downgraded the profitability of these companies. We are also entering the period of the year where historically the bulk of the share buybacks occur. This not only props up equity prices, it also helps to boost EPS numbers for the following reporting quarter. (Fig 4)

Fig 4: We Are Entering The Seasonally Strong Period - Big Share Repurchases Occur In the Nov-Dec Months

Reasons to be Bullish Slow Rate Hikes Do Not Derail the Market

The concern about rising interest rates is sure to appear on everyones minds again. Looking purely at the US stock market, data shows positive returns for US equities in the first year following the start of a Fed tightening cycle (Fig 5). Our view is that whilst the rate hike will introduce more volatility as investors rebalance, the fact that the Fed wants to normalise shows that the US economy is strong which is positive for risk assets and the US dollar. Couple this with the fact that nowadays the Fed is much more transparent and constantly puts out communiques to message their intentions to the market.

Fig 5: The Rate Hike Will Not Derail The Equity Market

Reasons to be Bearish Fully Allocated Investors

Data shows that households are quite fully invested in the stock market (Fig 6) with the allocation in-line with previous peaks (except for the 2000 tech bubble). Whilst this allocation could go up further, this means that investors are unlikely to bid up prices for stocks much further as they do not have the need to increase their present allocation. This implies a more subdued rate of return going forward for the equity market.

Fig 6: Stock Allocation as a Percentage of Assets Appears Quite Fully Allocated

Reasons to be Bearish Stretched Valuations

When you look at whether stocks are cheap relative to cash or bonds, then it is clear that stocks are the asset class of choice. The Feds Cash is Trash policy of keeping rates at zero helps us make this comparison easy. However, when you look at average price to earnings ratios, or the dividend yield on US stocks, it then shows that stocks are really not the bargain bin offerings we thought they were. In fact, valuations are approaching one standard deviation too expensive relative to history. (Fig 7)

Fig 7: US S&P 500 Equity Valuations Approaching Overvalued Levels

Review of Recent Events

With so many conflicting signals in the world and negative news at every turn, perhaps it would be better to stay out of the markets. If we were to weigh all the data available to us, our outlook would be neutral to mildly bullish. For us to take on some risk, we need to turn to what the market is telling us through our risk models. It only very recently turned back to green so we have begun phasing in our cash holdings which we raised during the recent market turmoil (Fig 8). For now, it appears that the volatile events of Aug and Sep are behind us and the market appears stable in the short term. The potentially large bear market scenario which we were concerned, with did not materialise for the time being and we did not have the chance to vastly outperform the market. As we approach possibly tougher markets in 2016, we are confident that our risk matrix will continue to provide guidance and let us know when to exit markets so as to preserve capital.

Fig 8: Risk Matrix Signalled Elevated Risk in Aug-Sep But It Was Short Lived and The Bigger Bear Scenario Did Not Pan Out.

1 Einsteins Theory of General Relativity and Time Dilation time itself will bend due to differences in either gravity or velocity; those stationary are living "faster", whilst their counterparts in a relatively accelerated motion live "slower" at any given moment.

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