Day Hagen Asset Management Research Update – 4/19/2017

In News by Michelle


As we have noted in our past research publications, the U.S. equity markets remain mired in overvalued territory, as defined by several historical measures. While high valuation multiples are typically not good timing indicators, they are useful for determining areas of resistance in the market. To wit: The current S&P 500 median P/E is 24.1x, which is on par with what we saw prior to the technology bubble bursting (and its aftermath) and well above levels seen before the “Great Recession” of 2007-2009. Based on NDR’s calculations from 1964-present, the S&P 500 would need to decline by nearly 8 percent just to get to the +1 standard deviation level of the historical P/E range (assuming earnings growth is stagnant). In other words, the S&P 500 at 2,176 would still be considered overvalued.

The aforementioned decline scenario is based on the “P” (price) in the P/E ratio—i.e., the price going down. The other side of the P/E equation is for “E” (earnings) to grow. For that to occur, we need broad-based economic growth where a rising tide would lift all (earnings) boats.

Near-term, this may be a tall order. Recently, both the Atlanta and New York Federal Reserve banks downgraded their outlook for U.S. economic growth for the first quarter after disappointing data on retail sales and consumer prices in March. They estimate that first quarter GDP growth will be closer to .5 percent than the .6 percent previously calculated (and down from over 3 percent just a few months ago!). These are the headlines that have many investors worried, including us. If we can’t get economic expansion, sometimes referred to as “escape velocity,” it will be extremely difficult to get multiple expansion.

Much has been written about the difference between hard and soft economic data or, more simply put, actual data versus estimates and surveys. Much like valuation estimates, economic estimates in an expanding economy are often optimistic. Below is a chart showing the Conference Board’s Expectations of Business Conditions (moved forward by eight months) compared to real GDP (inflation adjusted). As shown, the expectations correspond to year-over-year real GDP growth of 4.2 percent. It is our belief that the resilience in the domestic equity market is because growth expectations have increased significantly over the past year. If growth fails to meet expectations, then the overvalued equity market may need to reset itself.


On a weekly basis I like to evaluate the flows into exchange traded products traded on U.S. exchanges. Flows are based on the in-kind redemption/creation process, where ETF shares are typically traded in 50,000-share blocks. Interestingly, up until this past week, there were net outflows from North American equity funds for April (-$9 billion). However, even though most North American markets and ETFs were down last week, there was a net inflow into those funds of nearly $2 billion. In addition to domestic equity ETFs, we have seen steady inflows into European and international (non-U.S.) funds. The bulk of the inflows last week were into large-cap domestic ETFs (below). But as shown, flows still remain negative month-to-date. Negative flows can be used as a sentiment measure, suggesting that investors have become somewhat pessimistic.

Nonetheless, when looking at flows in aggregate, we are not seeing broad-based selling of equity ETFs. What we do see is ETF money rotating within domestic sectors and internationally. Below is a chart showing the flows into international funds. These are funds that hold international equities and U.S. ADRs of international companies. There are no U.S. equity funds counted in this category. As shown, with the exception of September 2016, flows have been positive for the past two years, suggesting that investors are optimistic on international equities.

Within the international ETF category, flows have been strongest into IEFA, the iShares Core MSCI EAFE ETF (below). IEFA is a cap-weighted composite fund where the bulk of the holdings are in Japanese and major European stocks. And the top three sector exposures in this fund are Financials, Industrials, and Consumer Discretionary. For broad international exposure, we remain favorable on EAFE index countries given the current country and sector allocation.

Some further flow observations:

  • Nearly $4 billion has come out of small-cap ETFs thus far in April.
  • Sector flows have been positive this month in Health Care, Real Estate, Utilities, Materials and Consumer Staples.
  • Financial ETFs have seen the largest outflows so far this month ($750 million).
  • German ETFs have taken in over $1 billion in assets this month.
  • U.S. Government bond funds continue to see positive inflows despite the prospects for higher interest rates. They have had eight straight months of inflows.
  • Composite Emerging Market funds have had net inflows of over $2 billion this month, and net inflows since December 2016.

In sum, domestic and international fund flows remain supportive of the markets longer term.

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management


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