Last week, the U.S. equity market climbed to the steepest valuation level in history, based on the valuation measures most highly correlated with actual subsequent S&P 500 10 to 12-year total returns, across a century of market cycles. These measures include the S&P 500 price/revenue ratio, the Margin-Adjusted CAPE (a more reliable variant of Robert Shiller’s cyclically-adjusted P/E in their opinion), and MarketCap/GVA – the ratio of nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues – which is easily the most reliable valuation measure that has been tested, among scores of alternatives.
The chart below shows the ratio of MarketCap/GVA, which now stands beyond even the 2000 market extreme.
From present levels of valuation, the expectation is for the S&P 500 to lose value, on a total return basis, over the coming 12-year horizon. That’s not a worst-case scenario or an outcome that depends on unusual economic outcomes. It’s the standard, run-of-the-mill expectation given current valuation extremes, and it assumes substantial expansion in the U.S. economy over this horizon.
Recognizing that valuations matter profoundly over the long run, yet are nearly useless over the short run, is central to navigating complete market cycles. This does not, for even a moment, change the fact that the most reliable measures of valuation are now an average of three times their historical norms. By the completion of every previous market cycle in history, stock prices have approached or breached those norms. Hussman Fund’s (whose data we have used here) expectation is that the S&P 500 will lose approximately two-thirds of its value over the completion of this market cycle. That may seem extreme but using the same valuation parameters in 2000 and 2007 they called the actual drop to within a few percentage points. The short-run issue is just that nothing prevents the speculative inclinations of investors from driving valuations even higher.
However, as volatility falls, and investors are “encouraged” to increase their risk exposure to “compensate”, we are taking the opposite tack and reducing risk. We prefer to buy near market troughs not peaks! We do not currently hold high cash levels, but are, nevertheless, defensively positioned as market volatility plumbs new lows and uninformed buyers chase increasingly expensive stocks and bonds. There will be bumps along the way, some of them significant, which will allow us to take advantage of better long-term opportunities at a lower valuation.
We are beginning to see some weakness in the markets and the UK is no exception. Brexit concerns have increased the levels of uncertainty and now SocGen has issued warnings about the inability of some UK PLCs to pay their dividends after the Capita profits warning and dividend cut. Their dividend risk screen has 50 current names of which 21 are UK listed. Despite the tabloid headlines this market is still in an uptrend which will not be tested until we reach 7200, but the warning bells are beginning to sound off.
The S&P, the DJI and NASDAQ have again made new highs in January, but are beginning to push back. Small beer at this stage, but three days without a pull back is potentially a change in pattern that needs to be watched closely. As we said earlier the short-run issue is that nothing prevents the speculative inclinations of investors from driving valuations even higher but as with the UK there are some increasing signs of angst not least of all in the bond market where US 10-year Treasuries are approaching the “magical” 3% level. Since last summer rates have doubled from 1.4%. The latest Fed FOMC statement casually mentions that inflation is rising and that there will be further rate rises in 2018. The odds on 4 such events are steadily dropping.
Merkel has managed some sort of coalition deal, but the resolve of all parties is being tested by Trump’s suggested sanctions on EU steel and a quota on automobiles. The special relationship may be on rocky ground, but when it comes to the EU the gloves are off!
The Italian elections are on the 4th March and things look evenly balanced between the centre left, the centre right and Beppe Grillo’s Five Star Movement. Constitutional changes last year have made it harder for Five Star and the return of “Saint” Berlusconi is yet another unknown factor. As with all recent European ballots the outcome could very easily to be a surprise to the established order.
Although the EU commission would like it otherwise it is possible for good fund managers to find significant pockets of difference (aka value) across the market as a whole; there are still worthwhile opportunities here.
Despite its strong showing in 2017 there is still potential for more upside in Japan, which is still a long way from its 1990 peak, let alone coming close to matching the major western markets. We suspect that local rather than global companies are going to benefit most from the reforms that PM Abe has in mind. The very strongly held consensus view is that the US dollar will regain its strength which of course helps Japanese exporters; not something that Mr Trump contemplates with relish before he goes to bed each night. If Japan is to regain its former status the yen may well be the currency to own along with domestic companies.
Asia Pacific and Emerging Markets
Both market sectors are heavily influenced by the moves in the US dollar index and, as we have already alluded to, the consensus is that the US dollar will strengthen. In the short term this may be the case, which will provide an opportunity to add exposure on a market pull back. Long term the demogrphics of this region are the big positive. The Asia Pacific chart shows a very similar pattern being very much overbought in short term.
Commodities and Gold
Gold had a strong year in 2017, also helped by the relative weakness of the dollar. If the consensus view on the green back doesn’t materialise then it could be a very good 2018 too; particularly for mining stocks, which still languish at lows relative to the gold price – the green line on the chart.
Like some equity markets the oil price is becoming very over extended to the upside, but could reach resistance at $70 before a more meaningful correction. The implications for the global economy in the short term are highly inflationary and this is coming through in rising transportation costs, which feel the immediate impact of higher pump prices.
Commodities in general have been out of favour for some time as the chart of the GS Commodity index relative to the S&P 500 clearly shows. A rising line indicates commodities outperforming the S&P and vice-versa. Given our views on the US equity markets and the bullish potential for gold and oil this trend could be about to change. Commodity plays are good providers of portfolio diversification.
The canary in the coal mine is without doubt the bond market. Some of us have been watching the relentless rise for getting on for 40 years starting with yields peaking at 16% in the early 80s. With the Fed in tightening mode and probably four rate rises to come in 2018 on top of more Treasury issuance to fund the Trump tax bill it is no wonder that 10-year yields are on the rise. The perceived wisdom is that if rates reach 3%, and we are very close to that number, then buyers will return to shore up the market. Let us hope that is in fact the case. With so many derivative positions “betting” that 3% is the limit and surge through there would very quickly turn into a rout. Be very careful out there in bond world.
In the short-term any equity market weakness could well induce some risk-off buying of bonds and if the Fed’s rate rises do tip the US into recession, then they have hinted at negative interest rates, which would keep the bond bull market going for a while. However, buying paper with a built in negative real return is the current definition of insanity.
With interest rates on the rise and central bank buying of debt on the wane this is the final curtain call for the bond market and we won’t be waiting around for it.
Central bank rhetoric has changed and options for withdrawing QE are on the table and rate rises in the States are rising apace. As usual they caveat their prognostications and are likely to return with further accommodation if asset markets show any serious weakness. We doubt that such an outcome would be as well received as the central banks anticipate.
- Government bonds are heroically expensive – the trend in rates appears to be on the turn.
- Spreads on corporate bonds are still tight and several European issues are trading on negative redemption yields. On that basis, they are ridiculously expensive and default risk can only rise from here, also making high yield potentially less attractive. Is the yield premium adequate? It would appear not given the increasing level of selling seen in this sector. There is also significant concern over liquidity risk, despite central bank buying (Europe and Japan) and regulatory stress testing.
- Western equity markets are long overdue a correction.
- Property is attractive as a real asset offering a higher spread against most fixed interest markets, but with the gating of many UK bricks and mortar funds in 2016, due to large redemptions, their attractiveness is now questionable. REITs are equities in disguise.
- Elections are coming back to haunt European markets. With the prospect of more to come in Italy in March a degree of caution of caution might be required. Conventional wisdom says that ECB QE should be beneficial for financial assets, but the Greek issue and the recapitalisation of European banks are yet to be fully resolved, plus Draghi has threatened to start removing the QE punch bowl. However, it is unlikely that the ECB would allow things to get out of hand, but how well will any response be taken? The Nikkei index has punched through resistance at 21,000 and looks poised to move higher; domestic issues are preferred. Emerging and Asia Pacific markets are not overly expensive as a long-term position, but will continue to be volatile and affected by dollar machinations and Chinese economic weakness.
- Demand for the physical metal continues to be strong and sentiment is returning with new gold markets opening in Shanghai and Dubai plus the world contemplating the latest North Korean threat. Mining shares are not unattractive
- Commodities have potentially reached a bottom relative to equity markets.
- The central banks have a significant unknown variable to contend with; the US President. Sovereign bond yields are rising on expectations of higher interest rates; not for the first time in recent history. Global economies are still fragile and any shock to the system is likely to be met with further central bank “largesse”. We observe closely for signs of success…or failure.
Clive Hale – 1st February 2018
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