This is the first “What We’re Watching” column which will be due out each Monday. What We’re Watching will consist of a brief review from the prior week, giving a preview of this week and highlight what are keeping an eye on as the week develops.
What We’re Watching July 25, 2016:
- Record highs in the S&P 500
- A deluge of corporate earnings
- Central banks
- Oil Prices
Last week the S&P 500 reached new record highs 4 out of 5 days, ending the week at its high water mark. The market rose 9 consecutive days before taking a breather on Thursday and then finishing the week on another up day Friday.
Strength in markets persisted after Brexit failed to be the end of the world – at least for now. If markets continue higher this week, it could be a signal that the long-awaited correction might require more waiting.
As we and St. James Investment Company touched upon in “Rats, Cats and other Predators” it is our view that markets are reacting less to fundamentals than a lack of fear at the moment. The “risk-on” attitude of investors is carrying markets higher despite what might be wrong with the global economy and financial markets under the surface. The only fear that investors are showing is a fear of missing out on the next small market gains.
The S&P 500 is near the fourth highest cyclically adjusted price to earnings (CAPE) ratio ever. Bond prices are near highs as interest rates continue to hover near all-time lows. Both circumstances are warning signals to fundamental investors.
There is the possibility that the pricing of the stock market is correct and that the bond market is wrong. With interest rates at record lows, it is hard to believe that the global economy is healthy, however, the doomsayers have been wrong a long time now.
The psychology in the markets is difficult to assess. The American Association of Independent Investors (AAII) Sentiment Survey for July 21st showed optimism slightly below average yet, pessimism was also lower than the historical average. The survey’s biggest winners were those with a neutral outlook on the markets at 37.9% against a historical average of 31%.
The Gallup Economic Confidence Index slipped again as people’s economic outlook continued to deteriorate. Gallup’s poll considers people’s feelings of current economic condition, as well as, outlook.
Across the pond, German business sentiment fell less than expected, helping boost European shares on Monday. We wonder how the rest of Europe will feel in coming months as many banks appear set to fall into difficulty.
The only reasonable conclusions about surging equity prices that we can come up with is: because economic and financial sentiment is neutral to not as bad as feared, markets are still able to take advantage of the central bank feeding that has occurred in recent years. People are more afraid to pull out of their investments on fear they might miss some upside, than to position for safety on fears that the equity markets could turn down in a flash on some news or event.
What could turn the markets down?
As we discussed in our quarterly letter, corporate earnings have been headed down for a year now. While earnings so far this quarter have slightly beaten estimates, that is against dramatically lowered earnings expectations, not actual improvements in earnings.
“Of the 125 S&P 500 companies that have reported results so far, 68 percent have beaten earnings expectations. In a typical quarter, 63 percent of companies report above estimates”- Thomson Reuters data. Again, we must remember that earnings estimates were taken down dramatically earlier this year.
According to FactSet, 2nd Quarter blended earnings growth has declined by (3.7%). That decline is “less bad” than the anticipated -5.5% earnings decline. If earnings finish the quarter negative, it will mark the fifth consecutive quarter of earnings declines. The first time that has happened since Q3 2008 through Q3 2009.
There have been some positive surprises in earnings as industrial’s and information technology have led. Tech, ex-Apple, has an earnings growth rate of 2.2%, but with Apple included is -3.9%. This is useful information in building a tactical investment strategy.
The forward 12-month P/E ratio is a generous 17.0 for a slow growth economic outlook. The forecast year-over-year earnings decline is now at a (.1%). The last time there was an annual year-over-year decline in earnings was during the financial crisis. To maintain upward market momentum, earnings will need to rebound. Improvements in the economy or productivity would help improve earnings. Ultimately, stock prices follow earnings; however, that path can be quite volatile and emotional. The timing of a correction or a rally is very tied to perceptions of what the future holds.
What could improve earnings other than economic growth or improvements in productivity?
We saw an uptick in domestic mergers and acquisitions in 2015. This sometimes signals that corporate managers are looking for inorganic ways to grow their businesses. Since earnings have not increased, it is potentially a bad sign that the mergers could result in bad outcomes.
Much of last year’s M&A activity was in the energy space. MergerMarket’s recent EMU Trend Report for the first half of 2016 points out, that while still robust, deal flow will fall approximately $20 billion short of 2015’s numbers which were around $80 billion. This is likely reflective of many weak players in the energy space having been eliminated and the oil market beginning to balance.
Globally, M&A has actually slowed quite a bit in 2016 compared to 2015. Again according to MergerMarket, global deals fell from $372.5 billion a year earlier to $224.5 billion year-over-year through May. This could represent that managers are just not willing to pay the high market valuations for growth that might not exist structurally in the economy.
Central Bank Actions and In-actions
The Bank of Japan and European Central Bank both backed off on the idea of immediate stimulus and the so-called helicopter money (a topic we will explore later this week). In America, speculation is rising again that the recent positive employment numbers would lead the Fed to consider raising interest rates again this year. These factors have led to a strengthening of the dollar for the past two weeks.
Monitoring central banks is always on our “to do list” even though it has become wearisome. Central banks do not believe that the global economy is healthy. The questions than become; 1) how bad is the global economy and 2) how long will it need help?
We can’t speculate on just how bad the global economy is. The various institutions around the world are not disclosing all of the information one needs to do the analysis in full anyway.
In the U.S., if the Fed does raise interest rates, we would expect to tactically rotate some percentage of managed money away from assets that suffer with a stronger dollar. A stronger dollar could also happen if the BOJ or ECB does go through with more monetary stimulus at some point. The wildcard is probably China, which has devalued multiple times in the past year and is likely to do it multiple times by year-end.
The monetary game is a complicated one, one thing to keep in mind, despite all the doom and gloom about the dollar’s future, for now, it’s the “go to” currency for safety.
We won’t dwell too much on oil prices, however, those are sliding again as the dollar firms, the summer drive season isn’t as strong as expected, rig counts have ticked up and refineries prepare for shutdowns which could exasperate oil gluts.
While the correlation between equity markets and oil has dissipated lately, there is still the worry that a weak oil market could lead to deflation concerns. If that happens, then refer to the above monetary reaction possibilities.
Where the biggest concern with oil prices probably lies is in the debt market where high-yield energy bonds are subject to higher risk if oil (and natural gas) prices don’t firm up. So, low oil prices could lead to deflation concerns which lead to monetary stimulus which could lead to inflation concerns. What a tangled web.
The world is more complicated and undergoing change faster than ever. That is our understanding until it isn’t. We suspect we won’t have a different understanding for a long time. With that world view, we choose to invest tactically in order to be able to sidestep as many of the risks as possible in real time.
The long-term trends covered in our quarterly letter, demographics, debt and climate change are among the super-trends that will impact most of our more granular tactical investment decisions. Ultimately, we expect that the combination of demographics and debt will play the major role in structural economic weakness for a decade or more. Climate change will impact the economy both negatively – catastrophe and displacement – and positively – mandated economic activity, i.e. alternative energy.
In the short-run, we remain cautious due to general economic weakness, stretched valuations and extremes in the debt markets. We are opportunistically focused on the assets that appear near the top of our weekly Asset Class Quickview. To talk more about what we’re watching and how it might impact you, contact us to set up a time to talk.