Download Market valuation, the Fed`s success, and high stakes in November

Wally’s Monthly Update | August 2016
WALLY’S MONTHLY UPDATE
Market valuation, the Fed’s success, and high stakes in November
In this month’s letter we make the case for why the market can sustain higher valuations amidst an
improving earnings picture and unattractive alternatives to stocks. We assess the Fed’s remarkable
success following eight years of exceptional challenges. Finally, we briefly present the case for why the
Economist Intelligence Unit (EIU), a widely respected think tank affiliated with the Economist magazine,
assesses the potential implications of a Trump victory in November.
Why the market can sustain elevated valuations
The inevitable warnings have been voiced. It’s 1999 or
2007 all over again. Stocks are too expensive. The market
is about to crash. You’ve heard it all before. While there
are indeed some similarities with 1999, the year before
the dotcom bubble began to violently unravel, 2016 is a
very different world.
Let’s start with the similarities. Broadly, there are two. For
the first time since that year, all three US indexes (the
Dow Jones Industrial Average, the S&P 500 and the
Nasdaq Composite Index) are at or near all-time highs.
The second similarity is in the market’s relatively elevated
valuations. Although nowhere near the foolish heights
reached in late 1999 and early 2000, the market is indeed
trading near its highest multiple in years.
First, let us define what we mean by “valuation”.
Although several multiples can be used to value a
market, such as the Price-To-Sales, Price-To-Book, or
Price-To-Cash Flow ratios, the most commonly used
Wally MacDonell
Portfolio Manager
Tel: 1-844-241-9890
[email protected]
valuation multiple is the Price-To-Earnings (PE) ratio.
Even the PE ratio itself can be measured in several ways.
Specifically, we can measure the price relative to lagging
(i.e. last 12 months’) earnings, forward (next 12 months’)
earnings, or the so-called CAPE (Cyclically Adjusted PE)
ratio. The latter was developed by Professor Robert
Schiller of Yale University and is designed to smooth out
earnings volatility by dividing the market price by the
average of the last ten years’ earnings.
The idea of PE ratios is relatively simple. A dollar is a
dollar. Over time investors’ willingness to pay for a dollar
of earnings will fluctuate within a historical range. At the
low end of the range, stocks will look cheap and thus be
more likely to gain in the future, while the opposite will
be the case at the high end of the range. Various studies
have confirmed that the ten-year return following
elevated multiples significantly lags that following cheap
multiples.
So where are we now? When looking at the CAPE and the
lagging PE for the S&P 500, there is no question that
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Wally’s Monthly Update | August 2016
their values are above their respective historical longterm averages (see charts). But the forward PE ratio is
more intriguing. By its very nature, it is forward looking,
which is really what investors care about. But its main
weakness is that it relies on analysts’ forecasts of future
earnings and is therefore subject to analysts’ biases.
That’s where the lagging PE comes in. It uses companies’
reported earnings. Given the volatility of earnings and
the well-documented tendency of firms to manipulate
their earnings in the short-term, the CAPE is a steady
ratio not subject to such volatility or manipulation.
S&P 500 Last 12-mos PE Ratio:
has actually improved to 13.8% from 12.5%. Should this
forecast hold, investors’ optimism would be validated.
Moreover, a significant portion of the decline in earnings
came from the energy sector. Other sectors, such as the
consumer discretionary (14.3), industrials (13.0%), utilities
(11.3%), and health care (6.3%) sectors were the profit
growth leaders in the second quarter. By comparison, the
energy sector is poised for an 86% decline in earnings
growth. The strong earnings by US retailers bode well for
the strength of the US economy and are a reflection of
consumer confidence. The two sectors that have
surprised to the upside the most are industrials and
information technology, leading to an upward revision in
earnings forecasts for both sectors. Strength in cyclical
sectors like these is an encouraging sign for future
earnings growth. In fact, industrial is one of three sectors
(including health care and utilities) with second-quarter
earnings growth that is better than consensus
expectations on Jan. 1.
S&P 500 CAPE Ratio:
Source: www.multpl.com
With the second quarter earnings season now nearly
complete for the S&P 500 Index, earnings growth, while
negative, is more than 3% ahead of initial expectations,
according to S&P Capital IQ. Earnings are expected to
decline by 2.1% from the second quarter of 2015. While
this will be the fourth quarter in a row that the index
posted a decline, the rate of decline has improved
substantially from the –6.8% recorded in the first quarter.
While earnings expectations have been adjusted lower
from where they were at the beginning of the year, the
growth rate for next year has actually increased as
anticipated 2016 earnings have declined more than those
for 2017. Calendar-year 2017 S&P 500 earnings per share
(EPS) expectations have now declined to $132.80 from
$141.26 at year-end 2015, but the 2017 EPS growth rate
Investors clearly continue to display confidence in stocks,
as evidenced by the triple record in the major US indexes
despite the elevated valuation. The forward PE ratio is
interesting at this time because of this improving
earnings picture. The ratio has now declined slightly even
as the market sets new highs. Another booster for
optimism is the Purchasing Managers’ Index (PMI), a key
leading indicator for stocks. There are in fact two PMIs,
one for services and one for manufacturers. Both
continue to perform strongly, even when Europe and
China are included with the US, despite a slight decline in
July following the Brexit vote. This suggests that the
global economy as a whole is healthier than many
suspect and certainly nothing like the gloomy picture
painted by shrill warnings emanating from the political
silly season in the US.
Wally’s Monthly Update | August 2016
fixed income assets) almost two years ago and raised
interest rates for the first time in a decade last
December, its policy stance remains highly
accommodative.
Source: S&P Capital IQ
There is another very good reason why we believe the
market can sustain elevated valuations for the time
being, namely the condition of the bond market. Last
month, we wrote that over $12 trillion worth of bonds
were now offering negative yields. Since then, the figure
has risen to $13.4 trillion, according to the Financial
Times (FT). This is not a discrepancy in data as our source
last month was also the FT. The addition of $1.4 trillion of
bonds whose yields turned negative in 1 month is
remarkable to put it mildly. We did say that we thought
ultra-low bond yields were here to stay. Investors are left
with little choice but to accept higher equity valuations as
bond yields plow new depths.
Wally’s Bottom Line
 Despite four quarters of negative earnings growth,
the earnings picture is steadily improving in the
United States, helping markets sustain higher
valuations and alleviating concerns about an
impending pullback.
 The bond market rally continues unabated,
leaving yields near all-time lows and $13.4 trillion
worth of negative yields.
 Inflation remains subdued in both the United
States and Canada. Although some Fed officials
have made some hawkish noises in recent days,
the market still expects the central bank to stand
pat at its September meeting.
Has the Fed succeeded?
Since the financial crisis of 2008 central banks around
the world have shouldered most of the burden of
stimulating the global economy. As the custodian of
the world’s biggest economy, the US Federal Reserve
has played a particularly critical role in this process.
Even though the Fed completed its three rounds of
quantitative easing (the creation of new money to buy
Markets have therefore been anticipating the Fed’s
next move on the path to interest rate normalization
(i.e. bringing the Fed Policy Rate back towards its
historical average). Fed officials have themselves sent
mixed signals about the timing of the next move
simply because the data upon which the Fed bases its
decisions has itself been mixed. In recent days, no less
than three Fed officials have hinted that a September
rate hike is not off the table, although the consensus is
still for no move in September.
So it begs the question, has the Fed’s policy worked?
The answer is not so straight forward, but on balance
we think it has. The main purpose of accommodative
central bank policy is to stimulate the economy by
encouraging individuals and companies to spend
rather than save. On that front, the Fed has succeeded
in spurring personal consumption and to a lesser
extent corporate spending. While sales at US retailers
stalled in July, June sales were stronger than
previously estimated. This follows a series of record
setting retail sales figures throughout the year.
Consumer confidence remains high according to the
Conference
Board’s
Index,
suggesting
that
consumption growth should continue its strength
through the third quarter. The housing market also
continues to show signs of strength. Commercial and
industrial loans extended by US banks have
consistently grown at double digits since May 2014. In
the meantime, inflation remains subdued, a key factor
that alleviates pressure on the Fed to normalize rates.
Compared to the rest of the world, the US economy
continues to be the most robust, consistently churning
out healthy data and beating estimates. Job creation
has surpassed expectations and wage growth has
finally started to pick up. At the same time, financial
markets have been on a tear. It is rare for both stocks
and bonds to boom at the same time, as they have
recently.
On balance, the Fed can be judged to have succeeded
in a hostile environment that started with the worst
financial crisis since the Great Depression, through the
near-breakup of the Eurozone, increasing geopolitical
turmoil in the Middle East, a belligerent Russia,
widespread terror attacks around the world, a collapse
in oil prices, and now Brexit and Trump. All in all not
Wally’s Monthly Update | August 2016
bad after eight
challenges.
years
of
such
unprecedented
Unusually high stakes for the November election
Notwithstanding the improving earnings picture and
sustained investor optimism, there are risks that could
derail the market. When valuations are elevated,
markets tend to be more sensitive to disruptive
events. One such potentially disruptive event, to put it
mildly, would be a Trump victory in November. The
Economist Intelligence Unit (EIU), a widely respected
think tank affiliated with the Economist magazine,
currently places such an eventuality tied for fifth place
among the biggest risks facing the global economy at
this time. The EIU ranks the risks based on both the
severity and the probability of the risk. A Trump
victory is down to fifth from the second place it held in
June only because the probability has declined. Make
no mistake, a Trump victory would very likely be a
disruptive event for the global economy and financial
markets.
We will let the words of the EIU speak for themselves:
“Trump has given very few details of his policies - and
these tend to be prone to constant revision - but a
few themes have become apparent. First, he has been
exceptionally hostile towards free trade, including
notably NAFTA, and has repeatedly labelled China as a
"currency manipulator". He has also taken an
exceptionally punitive stance on the Middle East and
jihadi terrorism, including, among other things,
advocating the killing of families of terrorists and
launching a land incursion into Syria to wipe out IS
(and acquire its oil). In the event of a Trump victory,
his hostile attitude to free trade, and alienation of
Mexico and China in particular, could escalate rapidly
into a trade war. At the least it would scupper the
Trans-Pacific Partnership between the US and 11 other
American and Asian states signed in February 2016.
His militaristic tendencies towards the Middle East
(and proposed ban on all Muslim travel to the US)
would be a potent recruitment tool for jihadi groups,
increasing their threat both within the region and
beyond, while his vocal scepticism towards NATO
would weaken efforts to contain Russia's expansionist
tendencies. Elsewhere, and arguably even more
alarmingly, his stated indifference towards nuclear
proliferation in Asia raises the prospect of a nuclear
arms race in the world's most heavily populated
continent. Although we do not expect Trump to defeat
Hillary Clinton, there are risks to this forecast,
especially in the event of a terrorist attack on US soil
or a sudden economic downturn”.
Clinton has largely followed the edict that when your
opponent is busy self-destructing, do not get in the
way. Polls show her comfortably ahead both nationally
and in key battleground states. Two and a half months
however is an eternity in politics. Like everyone else,
we will closely follow developments in this unique
election cycle and act as necessary to adjust our
positions.
We obviously do not take a political position on these
pages. In an objective sense, we do view a Clinton
victory as clearing up a lot of uncertainty and
anticipation that currently resides within investors.
Should she in fact win the election, and especially if
the Democrats win back the Senate, we could see
progress on a number of stalled initiatives such as
infrastructure spending, development of renewable
energy,
and
the
ratification
of
the
TPP
(notwithstanding Clinton’s current stated opposition
to the treaty). All of those would be economically
stimulative and should help push financial markets
higher.
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