With sentiment towards equities having taken a turn for the worse in recent weeks, Giles Parkinson considers where markets may be heading and what action, if any, investors should take.
6 minute read
2017 was a remarkable year for equities as markets reached a series of record highs month after month. This year started strongly too, with some respected investors calling for a ‘melt up’.1 In the words of one: “if you’re holding cash, you’re going to feel pretty stupid”, a sentiment that was pervasive.2
However, the euphoria has dissipated in recent weeks. Having hit a record high just shy of 2,873 on 26 January, the S&P 500 index plunged 12 per cent in a matter of days, before recovering somewhat to stand seven per cent lower by March 26. Equity volatility like this has not been seen for some time. With stocks suddenly struggling, are markets pointing to a deeper, more lasting malaise?
The stock market is not the economy, but the economy matters; firstly because in the short run stronger or weaker data can influence the valuations investors are prepared to attach to shares and, secondly, long-run stock returns are dictated by corporate profits, which are in turn underpinned by economic activity. Unfortunately, although the stock market can usually be seen in retrospect to have been a good predictor of the economy, it’s hard to know what it is signalling ahead of time. The old joke that the stock market has predicted nine out of the last five recessions contains more than a grain of truth.3
While the US economy, the world’s biggest, appears to be performing well for the time being, equity investors can find clues elsewhere about where it might be heading. The bond market is among the best lead indicators. In a normal environment government bond yield curves slope upwards, reflecting investors’ preference for more liquid, shorter-maturity investments. But when animal spirits subside, they can often ‘invert’ as investors start to anticipate cuts in interest rates. Economists debate the exact mechanism by which an inverted yield curve feeds back into the real economy. But history shows an inverted yield curve has preceded every US recession in the last sixty years, with only one false signal.4
Today, while the US yield curve has not inverted it is the flattest it has been since 2007. And with the Federal Reserve seemingly intent on raising interest rates throughout this year and next, and possibly at a faster rate than until recently expected, it could get flatter still. Arguably, this time is different, and in an environment where global central banks are still intervening in markets the yield curve doesn’t ‘work’ in the same way as it has done in the past. Nevertheless, this US recession indicator is flashing amber.
Looking elsewhere, China’s economy, the world’s second largest, is managed very differently. The bond market is much younger and so far the yield curve hasn’t proven to be anything like the reliable guide that it has been elsewhere. Official statistics are also treated with considerable scepticism by independent observers.
While China has a long-standing objective to rebalance its economy away from manufacturing exports and investment in favour of domestic consumption, progress has been slow. For the time being the economy remains dominated by the vagaries of manufacturing and construction. China still consumes around half of the world’s supply of base metals; the most important being iron ore, copper, tin, zinc, lead, nickel and aluminium. Base metal prices arguably provide a useful method of gauging the state of China’s economy since they have the advantage of being set by the market and are at little risk of being subject to government manipulation.
Since each of these metals has its own idiosyncratic supply and demand dynamics, particular significance shouldn’t be attached to the price of any one. But over the years, movements in a broad basket of these base metal prices have tended to chime with comments from the management teams of Western companies as to the fortunes of their Chinese operations. As such, they are a decent coincident or slightly leading indicator of fluctuations in the Chinese economy. Today prices are down by between five and 20 per cent from their peaks set in the second half of last year..5 While that might not be overly concerning given they remain up on where they stood two years ago, it could be an early sign of softer growth.
As for the euro zone, all countries, even Greece, are enjoying a period of solid economic growth. However, while this may have put longstanding questions over the future of the single currency into abeyance, the bloc’s fortunes over the longer term remain a concern, particularly given the ongoing troubles facing Italy.
Italian politics remains in flux following inconclusive elections early in March. Although a tilt towards populism was clear, the risk of Italy catalysing an existential crisis in Europe in the near term is small since the two main radical parties have backtracked from prior demands for a referendum on the euro.
However, while Italy’s economy is at long last growing again, the rate of expansion remains feeble. Amazingly, real income per head is lower than it was when the euro was created in 1999.6 After the UK, Italy has consistently polled as the country most disaffected with the European Union. As and when the next downturn arrives, as it surely will, Italians’ disaffection with the EU seems likely to rise.7
Where’s the value?
As for the valuations investors are prepared to attach to corporate profits, they are extreme on almost any measure. Whichever yardstick you choose to look at, valuations have travelled past the previous market peak in 2007 and are approaching levels last seen in the dot.com era.
Today, global equities are offered at a free cash flow yield of 4.1 per cent. 8 Although that compares favourably with the yield available on government bonds, with the 30-year Treasury bond for example yielding around three per cent, 9 it is expensive versus history. Since the worth of any asset is the present value of the cash it produces in future, interest rates act as financial ‘gravity’. All else equal, higher bond yields will mean that equities – which represent a claim on a long-dated stream of cash flows – are worth less.
The impact of low interest rates can be seen in other asset markets. Consider the auction records recently set for a $2.9 million camera, an $18 million watch, a $450 million painting, and a meteorite10; unquoted start-ups attracting multi-billion dollar valuations11 and companies being paid to borrow money when issuing corporate bonds.12
With bond yields having risen since January, making shares relatively less attractive, equity markets may struggle to recapture their previous sky high valuations quickly, even without evidence that leading economies have begun to weaken. It is impossible to say definitively at what level rising interest rates make equities unattractive on a longer-term view. My personal view is that stocks are still cheap so long as the yield on 30-year US Treasuries remains below four per cent, four or five years from now.
One feature of equity markets in the process of topping out is that investors tend to crowd into an ever smaller basket of stocks that have led the market up to that point. We saw this in the last downturn when natural resources stocks peaked in May 2008, seven months after global equities. The same phenomenon was seen in 2000. Then, although world stocks reached their zenith in March, it wasn’t until the following autumn the likes of Nokia, Nortel, Enron, Oracle, and Broadcom followed.
It would not be surprising to see something similar happening when the market next peaks, assuming it hasn’t already. Technology stocks, broadly defined, have clearly led the market so far this cycle, with investors coining acronyms such as ‘FAANG’ or ‘FAANG-MAN’ to capture the phenomenon. The New York Stock Exchange even launched a futures contract, labelled FANG+, in November.13 Looking at 11 leading technology shares - Facebook, Amazon, Netflix, Google (now Alphabet), Microsoft, Apple, Nvidia, Alibaba, Baidu, Tesla and Twitter – most have outperformed the S&P 500 since that index peaked on January 26, with flat performance for the group compared to a -7.0 per cent return for the S&P 500.14This is not a healthy sign.
Since these companies all offer the prospect of superior revenue growth, it is understandable why the stock market is enamoured with them. However, the investment debate hinges on whether the rosy expectations embedded in their stock prices are justified. Yet arguably an even bigger concern is with another subset of businesses: financially and operationally geared companies whose valuations are closer to those seen in more stable and unleveraged businesses. While such companies are found in many sectors, manufacturing and restaurant businesses make up an undue proportion, as do businesses either recently or currently owned by private equity firms.
Is the tide going out?
Today, we find that many stocks have performed well because of characteristics in the company that have been perceived as merits but could just as easily flip back to being viewed as weaknesses. As Warren Buffet famously remarked, “it's only when the tide goes out that you learn who's been swimming naked”.15
Low margins can surge with just a small amount of economic growth, but can just as easily collapse during a downturn. Moreover, under a recessionary scenario interest costs can be expected to increase as credit spreads widen. Leverage magnifies returns to shareholders on the way up but cuts into equity values on the way down. Should a relatively highly-indebted, cyclical business see its cost of debt rise, what might today appear to be a ‘value’ stock could tomorrow be trading on a far less appealing P/E ratio.
History doesn’t repeat but it does rhyme. Whilst indicators such as the shape of the Treasury yield curve, base metal prices or stock market leadership would have given some warning in past cycles, they will never point to an unambiguous course of action. The shares of larger companies with sound balance sheets, high margins, more muted economic sensitivity, and a measure of pricing power have been out of favour for several years now. They are starting to look increasingly attractive.
1 'GMO’s Jeremy Grantham Says Stocks Could Be Heading for a ‘Melt-Up’', Bloomberg.com, 03 May 2018
3 'Paul Samuelson', Wikipedia
4 'FRBSF Economic Letter', FRBSF, 05 March 2018
5 Source: Bloomberg
6 IMF World Economic Outlook, October 2017
7 'The Italians and Europe, Chronicle of Disenchantement', Institute Delors, 16 February 2018
9 Source: Bloomberg
10 'Record $2.9M paid for camera at Vienna acution', New York Post, 11 March 2018
'Paul Newman's Rolex Daytona just became the most expensive watch ever sold at auction', UK Business Insider, 27 October 2017
'Leonardo da Vinci artwork' sells for record $450m', BBC News, 16 November 2017
'Rare 70 pound meteorite sells for record $237,500 at Christie's', CNBC, 14 February 2018
11 'WeWork's $20 Billion Office Party: The Crazy Bet That Could Change How The World Does Business', Forbes, 24 October 2017
12 'Veolia Successfully Issues a 3-Year Bond with a Negative Yield', Markets Insider, 16 November 2017
13 'One exchange's latest brainstorm: FANG index futures', CNBC, 07 November 2017
14 Source: Aviva Investors and Bloomberg, 26 March 2018
15 'Indecent exposure', The Economist, 05 August 2007
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