Equities
Dear Client, I will be visiting clients in Paris, Amsterdam, and London next week. In lieu of our regular report, we will be sending you a Special Report from Matt Gertken, BCA’s Chief Geopolitical Strategist. Matt argues that US politics and the 2020 election represent the greatest source of geopolitical risk over the coming year, and possibly beyond. Best regards, Peter Berezin Highlights Having underperformed for more than ten years, non-US stocks are set to gain the upper hand over their US peers. A reacceleration in global growth, a weaker US dollar, and favorable valuations should all support non-US stocks next year. Meanwhile, one of the greater drivers of US equity outperformance – the stellar returns of tech stocks – is likely to dissipate. Investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. US Stocks: From Leaders To Laggards? US equities have handily outperformed their global peers since 2008. About half of that outperformance was due to faster sales-per-share growth in the US, a third was due to faster growth in US margins, and the rest was due to relative P/E expansion in favor of the US (Chart 1). Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Chart 1Faster Sales Growth, Rising Margins, And Relative PE Expansion Helped Drive US Outperformance Over The Past Decade Improving Global Growth Outlook Global growth should benefit next year from the dovish pivot by most central banks. The share of central banks cutting/raising rates leads global growth by about 6-to-9 months (Chart 2). Chart 2Lower Rates Should Help Spur Growth Chart 3The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The global manufacturing downturn is also coming to end as inventories continue to be run down. The auto sector, which has been at the forefront of the manufacturing slowdown, is finally showing signs of life. US banks stopped tightening lending standards for auto loans in the third quarter. They are also reporting stronger demand for vehicle financing (Chart 3). In Europe, the new orders-to-inventory ratio of the Markit Europe Automobile PMI has moved back to parity for the first time since the autumn of 2018. In China, vehicle production and sales are rebounding on a rate-of-change basis (Chart 4). Both automobile ownership and vehicle sales in China are still a fraction of what they are in most other economies (Chart 5). Chart 4Chinese Auto Sector Is Bottoming Out Chart 5China: Structural Outlook For Autos Is Bright The trade war is a clear and present danger to our bullish outlook on global growth. The good news is that President Trump has a strong incentive to make a deal. A resurgence in the trade war would hurt the economy, which is Trump’s best selling point (Chart 6). As a self-described master negotiator, Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit with China. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will improve only after he is re-elected. Assuming a “Phase 1” agreement is concluded, global business sentiment should improve. Chart 6Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else A détente in the trade war is unlikely to cause China to restart its deleveraging campaign. Credit growth is currently only a few points above trend nominal GDP growth, implying that the ratio of credit-to-GDP is barely increasing (Chart 7). The combined Chinese credit and fiscal impulse is still rising; it reliably leads global growth by about nine months (Chart 8). Chart 7China: The Deleveraging Campaign Has Been Put On The Backburner Chart 8Chinese Stimulus Should Boost Global Growth Faster Global Growth Should Disproportionately Benefit Non-US stocks The sector composition of international stocks is more skewed towards cyclicals than defensives compared to US stocks (Table 1). As a result, non-US stocks generally outperform their US peers when global growth accelerates (Chart 9). Table 1Cyclicals Are More Heavily Weighted Outside The US Stock Market We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin (Chart 10). Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 11). Chart 9Non-US Equities Usually Outperform When Global Growth Improves Chart 10Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields The US Dollar Should Weaken Compared to most other economies, the United States has a large service sector and a small manufacturing base. This makes the US a “low beta” play on global growth. As a result, capital tends to flow from the US to the rest of the world when global growth picks up, putting downward pressure on the US dollar in the process (Chart 12). Chart 11Steeper Yield Curves Will Benefit Financials Chart 12The Dollar Is A Countercyclical Currency Interest-rate differentials have been moving against the dollar for most of this year (Chart 13). This makes the greenback more vulnerable to a correction. Chart 13The Dollar Has Been Diverging From Rate Differentials This Year Chart 14Long Dollar Is A Crowded Trade Bullish sentiment towards the dollar also remains somewhat stretched. Net long speculative positions are near the top of their historic range (Chart 14). Our tactical MacroQuant model, which has an excellent track record of predicting short-to-medium term moves in the dollar, has dropped its bullish bias towards the currency (Chart 15). Chart 15MacroQuant Has Soured On The US Dollar A weaker dollar will help boost commodity prices, which is usually good news for cyclical stocks (Chart 16). A softer dollar will also raise the USD value of overseas shares, thus making international stocks more attractive in common-currency terms. Valuations Favor Non-US Stocks There is an old investment adage which says that valuations are useless as a short-term timing tool. That is only partially true. While valuations by themselves offer little guidance as to where the stock market is going in the short run, combined with a catalyst, valuations can make a big difference. When stocks are cheap, a bullish catalyst can cause prices to surge; whereas when stocks are expensive, a bearish catalyst can cause them to plunge. Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Non-US stocks are currently trading at 13.8-times forward earnings. This represents a significant discount to US stocks, which trade at a forward PE ratio of 17.7. The valuation discount is even greater if one looks at other measures such as the cyclically-adjusted PE, price-to-book, price-to-sales, and the dividend yield (Chart 17). Chart 16A Weaker Dollar Tends To Support Commodity Prices Chart 17US Stocks Are More Expensive... Differences in sector weights account for about a quarter of the valuation gap between the US and the rest of the world (Chart 18). The rest of the gap is due to cheaper valuations within sectors. Financials, utilities, and consumer discretionary stocks, in particular, are quite a bit more expensive in the US than elsewhere (Chart 19). Chart 18…Even When Adjusting For Sector Weights Chart 19AEquity Sector Valuations: US Versus The Rest Of The World (I) Chart 19BEquity Sector Valuations: US Versus The Rest Of The World (II) The valuation gap between the US and the rest of the world is even starker if we compare earnings yields with bond yields. Since bond yields are lower outside the US, the implied equity risk premium is markedly higher for non-US stocks (Chart 20). An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top. Some commentators have argued that the loftier valuations enjoyed by US stocks are warranted due to their superior growth prospects. While there may be some truth to that, it is worth noting that the IMF projects GDP growth (based on MSCI country weights) will be faster outside the US over the next five years (Chart 21). Chart 20Equity Risk Premia Remain Quite High Chart 21Growth Prospects Brighter Outside The US One should also keep in mind that relatively fast US earnings growth is a fairly recent phenomenon. Between 1970 and 2008, European EPS actually grew slightly faster than US EPS (Chart 22). Earnings in emerging markets also increased more rapidly than in the US during the two decades leading up to the Global Financial Crisis. Chart 22US Earnings Have Not Always Outperformed The Role Of US Tech The large weight of the tech sector in the US stock market explains much of the superior performance of US stocks over the past decade. As Chart 23 illustrates, EPS in the I.T. sector has grown a lot more quickly than in other sectors. Chart 23US Earnings: Who Has Been Doing The Heaving Lifting? Chart 24S&P 500: Much Of The Increase In Margins Has Occurred In The I.T. Sector Looking out, there are four reasons why US tech stocks may be due for a breather. First, tech valuations have gotten stretched relative to the broader market. Second, tech margins have risen to unprecedented high levels. We estimate that about half of the increase in S&P 500 profit margins since 2007 has been due to I.T. (Chart 24). Even that understates the role of tech in the expansion of profit margins because Standard & Poor’s no longer classifies some large-cap behemoths such as Google and Facebook as I.T. companies. Third, tech companies may face increased regulatory scrutiny in the years ahead stemming from alleged privacy violations, perceived monopolistic behavior, and worries about the censorship of online speech. This could weigh on sales and earnings growth. Fourth, the growth in private equity funds is likely to limit the number of tech companies that go public at a very early stage. Stock market investors were very lucky that companies such as Microsoft, Cisco, Nvidia, Qualcomm, Oracle, Amazon, and Netflix issued shares to the public at a young stage in their development (Table 2). All seven had market caps below $1 billion when they went public. Such hidden gems are becoming less common: The number of publicly listed companies in the US has fallen by more than half over the past two decades (Chart 25). The median age of tech companies at the time of IPO has risen from around 7 in the 1990s to 12 years today (Chart 26). Table 2Big Gains From Once Small Companies Chart 25The Number Of Publicly Listed Companies Fell Chart 26Tech Companies Entering The Public Arena Are Now More Mature Had Uber gone public as a small, upstart company not long after it was founded in 2009, it probably would have also made public shareholders a lot of money. Instead, it ended up going public this year with a market cap of $75 billion, only to see it shrink to as low as $40 billion in the ensuing six months. We won’t even mention what would have happened if WeWork had gone public. Investment Conclusions An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top: The first during the “Nifty 50” era of the late 1960s, the second during the 1990s dotcom boom, and the third during the recent FAANG craze (Chart 27). It is too early to say whether FAANG stocks have peaked, but it is worth noting that the group has underperformed the S&P 500 since May (Chart 28). Chart 27Putting The Recent FAANG Craze Into Context Chart 28FAANG Stocks And The Market Chart 29Has The Underperformance Of Value Run Its Course? Regardless of whether the secular outperformance of US equities is ending, the cyclical backdrop that we foresee over the next 12-to-18 months – characterized by faster global growth, a weakening dollar, and higher commodity prices – is likely to favor non-US stocks. As such, investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. Consistent with this, we are initiating a new recommendation to go long the MSCI ACWI ex USA index versus the MSCI USA index in dollar terms. Looking across the various stock markets outside the US, we are particularly fond of Europe. Net profit margins among companies in the STOXX Europe 600 index are about three percentage points below the S&P 500. This gives European companies greater scope to boost earnings. European banks are especially attractive, sporting a forward PE of 8.3, a price-to-book ratio of 0.6, and a dividend yield of 6.1%. Lastly, on the question of style investing, we would note that the relative performance of the MSCI value and growth indices closely tracks the performance of global financials versus I.T. (Chart 29). Given our preference for the former over the latter, we suspect that value will outperform growth next year. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Allowing for the distortions from sector skews and currency adjustments, the best way to assess an equity region’s attractiveness is to quantify the prospective return implied by its valuation versus its own history. The method is to regress historic starting…
Highlights The attractiveness of European stocks is relative to European bonds rather than relative to non-European stocks. Despite vastly different stock market valuations in Germany, Japan, and the US, the implied prospective 10-year annualised returns are almost identical – at around 5 percent per annum. Overweight the DAX versus German long-dated bunds. Equities would lose their attractiveness if the global 10-year bond yield were to rise through 2.5 percent, because the required excess return from equities would viciously normalise. Tactically overweight EM versus DM. Fractal trade: short GBP/NOK, as the recent rally in the pound appears technically extended. Feature Chart of the WeekOverweight Europe Vs. World = Overweight Consumer Staples Vs. Technology Stock markets recently broke to new highs, begging the perennial question: how attractive are equities at current valuations? To answer, we need to assess the prospective return that is now ‘baked in the equity valuation cake’. But which valuation metric gives the most credible assessment of prospective returns? Equity valuations based on assets are problematic – because nowadays, assets comprise intellectual capital or intangibles or ‘virtual’ assets, which are extremely difficult to value. Equity valuations based on earnings are problematic. Equity valuations based on earnings (profits) are also problematic – because they take no account of structurally high profit margins (Chart I-2). The problem is that earnings will face a headwind when profit margins normalise, depressing prospective returns. Some people suggest adjusting the earnings to derive a cyclically adjusted price to earnings multiple (CAPE), but by definition this does not correct for the structural rise in profit margins. Chart I-2Structurally High Profit Margins Flatter Earnings Hence, the most credible assessment comes from price to sales – because sales are quantifiable, unambiguous, and undistorted by profit margins. Significantly, while price to earnings missed the high valuation of world equities in 1990 (Japanese bubble) and 2007 (credit bubble), price to sales did not (Chart I-3 and Chart I-4). Chart I-3Price To Earnings Missed The Japanese Bubble And The Credit Bubble... Chart I-4...But Price To Sales ##br##Didn't Are Stocks Attractive? Based on the credible assessment from price to sales, today’s prospective 10-year annualised return from world equities is around 5 percent (Chart I-5). This is not that different to the 4 percent prospective return at the peak of the credit bubble in 2007.1 Which raises an obvious question. Back in 2007, a secular growth boom provided the excuse for the rich absolute valuation, but today, if anything, investors fear a ‘secular stagnation’. What can excuse today’s rich absolute valuation? Chart I-5The Prospective Return From World Equities Is 5 Percent The answer is ultra-low bond yields. In 2007, the global 10-year bond yield stood at 5 percent; today, it stands well below 2 percent (Chart I-6). A lower prospective return on bonds means a lower prospective return on competing long-duration assets, like equities. Chart I-6The Global 10-Year Bond Yield Has Plunged To Below 2 Percent Moreover, as bond yields approach their lower bound, the riskiness of bonds rises because they take on an unattractive ‘lose-lose’ characteristic. As holders of Swiss government bonds discovered this year, prices do not rise much in a rally, but they do plunge in a sell-off. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on competing long-duration assets, like equities. The 5 percent prospective return makes equities look attractive relative to bonds. The upshot is that the 5 percent prospective return from equities is low in absolute terms. But in a world of ultra-low numbers – for both bond yields and equity risk premiums – the 5 percent prospective return makes equities look attractive relative to bonds. At the peak of the credit bubble in 2007, equities were offering a lower prospective return than the 5 percent available from bonds. But today’s equity risk premium over bonds is generous. The caveat is that this would change if the global 10-year bond yield were to rise through 2.5 percent because the required risk premium on equities would viciously normalise. Are European Stocks Attractive? Turning to the relative attractiveness of major stock markets, it is tempting to think that the markets trading on the best head-to-head valuation comparisons are the most attractive. For example, Germany and Japan, both trading on a price to sales multiple of 0.9, appear compelling buys compared to the US, trading on a multiple of 2.1 (Chart I-7). But such a knee-jerk conclusion is wrong, for two reasons. Chart I-7Germany And Japan Trade On Much Lower Multiples Than The US First, stock markets have very different sector compositions. Two sectors with vastly different structural growth prospects – say, technology and banks – must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its ‘sector fingerprint’ is not necessarily the better-valued stock market. Second, major stock markets are dominated by multinational companies with mixed currency sales and profits, while the stock price is quoted in the domestic currency. Hence, if the market expects the mixed currency profits to depreciate in domestic currency terms, the stock will trade at a discount. Put another way, if the domestic currency is cheap the stock market will appear cheap. The best way to see this is to look at the two valuations of dual-listed multinationals like the UK/US cruise operator Carnival. In London, the stock trades on a price to forward earnings at 9.7; in New York it trades at 10.3. But it would be absurd to suggest that Carnival is cheaper in London than in New York! The discrepancy is simply because the market expects the pound to appreciate versus the dollar. A head-to-head comparison of stock market valuations is misleading. Allowing for the distortions from sector skews and currency adjustments, the best way to assess an equity region’s attractiveness is to quantify the prospective return implied by its valuation versus its own history. The method is to regress historic starting price to sales with the (historic) prospective 10-year returns that followed. Then apply this relationship to the current price to sales to predict the (current) prospective 10-year return. The results are amazing. Despite the vastly different price to sales multiple of 0.9 in Germany and Japan, and 2.1 in the US, the implied prospective 10-year annualised returns are almost identical – at around 5 percent from each of the three stock markets (Chart I-8-Chart I-10). Chart I-8Expect Near-Identical Returns From The US... Chart I-9…Germany… Chart I-10...And Japan Still, there is one significant difference: the 10-year bond yield is much lower in Germany and Japan than in the US, equating to a much more attractive equity risk premium of over 5 percent in Germany and Japan. So to answer this week’s title, yes, European stocks are attractive. But the attractiveness is not relative to non-European stocks, the attractiveness of European stocks is relative to European bonds. Bottom Line: maintain a structural overweight to the DAX versus German long-dated bunds. Europe’s ‘Sector Fingerprint’ Is No Longer Pro-Cyclical Over the short term, stock market relative performance is just the result of global sector relative performance combined with the unique sector fingerprint of each stock market. It follows that regional and country equity allocation must always start with a sector view combined with an awareness of the sector fingerprint of the major bourses (Table 1-1). Table I-1EM, DM, And Europe Have Unique ‘Sector Fingerprints’ In this regard, there is an important change. Market action plus index composition changes are making the European index less cyclical. Specifically, the European index is no longer over-weighted to Financials relative to the world index. Instead, the European sector fingerprint is now: ‘Overweight Consumer Staples, Underweight Technology’ (Chart of the Week). With the overweight skew being to defensive staples and the underweight skew to partly-cyclical tech, the cyclicality of the European index has become ambiguous. By contrast, emerging market (EM) equities remain ultra-cyclical with a sector fingerprint that is: ‘Overweight Banks, Underweight Healthcare’ (Chart I-11). Suffice to say, this is ultra-cyclical because the 10 percent overweight is to an unambiguously cyclical sector, while the symmetrical 10 percent underweight is to an unambiguously defensive sector. Chart I-11Overweight EM Vs. DM = Overweight Banks Vs. Healthcare The upshot is that a pro-cyclical sector tilt no longer implies an overweight to European equities versus other regions, but it does strongly imply an overweight to EM equities. This is our recommended stance, albeit only on a tactical horizon until our leading indicators show that the current growth rebound can be sustained well into 2020. Stay tuned. Fractal Trading System* The broken 65-day fractal structure of GBP/NOK suggests that its recent rally is susceptible to a countertrend sell-off, albeit UK election campaign developments are likely to be the near-term sentiment drivers. Go short GBP/NOK, setting a profit target at 2.5 percent with a symmetrical stop-loss. In other trades, short Italian 10-year BTP achieved its 3 percent profit target and is now closed, while long gold / short nickel is very close to its 11 percent profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Total (capital plus income) nominal annualised returns Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations
Recently, the parallels drawn with the mid-to-late 1990s and the current market backdrop have mushroomed, but our view is that the differences could not be wider. Since the history of our reconstructed SPX data going back to the late-1920s, there has never been a five-year period when the S&P 500 rose by at least 20% every year except for the 1995-1999 era. In that five-year period the SPX soared more than threefold, increasing annually by 34%, 20%, 31%, 27% and 20%, respectively. Investors forget that those were manic markets and despite a high and rising fed funds rate that peaked at 6.5% in early 2000 (real rates were over 4%), the forward P/E multiple went to the stratosphere ignoring theory and defying logic (Chart 1, next page). Putting the late-1990s exuberance into perspective is instructive: if 1995 is similar to 2016 (and 1998 is similar to 2019) then the SPX should spike to over 6000 by the end of next year (Chart 2, next page)! Bottom Line: Caution is still warranted on the prospects of the broad equity market. Chart 1 Chart 2
To test the S&P 500’s sensitivity to earnings surprises, we dug through weekly earnings updates going back to the beginning of 2012 (4Q11 earnings season) to compare expected index earnings per share (EPS) with reported index EPS. We track S&P 500…
Highlights Portfolio Strategy Depressed technicals, compelling valuations, macro tailwinds, improving operating fundamentals and the messages from our relative profit growth models and relative Cyclical Macro Indicators all signal that the time is ripe to initiate a long energy/short utilities pair trade. Pricey valuations, overbought technicals, the sell-off in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. Recent Changes Initiate a long S&P Energy/short S&P Utilities pair trade today. Table 1 Feature Equities propelled to uncharted territory, celebrating an easy Fed and the US/China détente with a hint of a tariff rollback, overcoming the seasonally difficult months of September and October. Historically, investors chase performance during the end of the year and seasonality will likely favor further flows into equities in the last two months of the year. On the economic front, while manufacturing remains in recession, a resilient labor market is providing a significant offset allaying fears of recession gripping the broad economy. Drilling deeper on the labor front is revealing. The unemployment rate ticked higher to 3.6% last month based on the household survey as the participation rate increased. However, according to the Sahm Rule Recession Indicator (SRRI), courtesy of Fed economist Claudia R. Sahm,1 were the unemployment rate to average 4% for three consecutive months by September 2020, the US economy will enter recession. In other words, based on empirical evidence the SRRI shows that when the three-month average unemployment rate has jumped by 50bps compared with previous twelve month low, the US has entered recession 100% of the time since the end of WWII (Chart 1). Chart 1Watch The Sahm Rule Recession Indicator Meanwhile, the parallels drawn with the mid-to-late 1990s and the current market backdrop have mushroomed, but our view is that the differences could not be wider. Since the history of our reconstructed SPX data going back to the late-1920s, there has never been a five-year period when the S&P 500 rose by at least 20% every year except for the 1995-1999 era. In that five-year period the SPX soared more than threefold, increasing annually by 34%, 20%, 31%, 27% and 20%, respectively. Investors forget that those were manic markets and despite a high and rising fed funds rate that peaked at 6.5% in early 2000 (real rates were over 4%), the forward P/E multiple went to the stratosphere ignoring theory and defying logic (Chart 2). Putting the late-1990s exuberance into perspective is instructive: if 1995 is similar to 2016 (and 1998 is similar to 2019) then the SPX should spike to over 6000 by the end of next year! Moving over to economic green shoots, we turn our attention to the signal the emerging markets are emitting. While both the EM and the Chinese manufacturing PMIs are expanding smartly, leading indicators suggest that the recovery may be running on empty. Chart 2One Of A Kind Chart 3Mixed Signals Chart 3 shows that the Chinese credit impulse is contracting, weighing on EM FX momentum and also signaling that the CAIXIN China manufacturing PMI, that has opened the widest gap with the official China NBS manufacturing PMI since the history of the data, will likely suffer a setback in the coming quarters. In the transportation sector, the Baltic Dry Index is down 33% since the early-September peak and is also losing steam on year-over-year basis, warning that a global trade recovery is skating on thin ice. Moreover, EM sentiment is downbeat. Investor flows into EM equities, according to the most liquid iShares MSCI EM ETF, have been drifting lower since the 2018 peak and have more recently gapped down (bottom panel, Chart 3). Thus, the recent green shoots may prove fleeting. This week we are initiating a new market-neutral pair trade and reiterate our negative view on a niche defensive sector. With regard to US liquidity, that we have been inundated with client requests recently, we highlight our simple liquidity indicator: industrial production (IP) growth versus M2 money supply growth. In other words, we gauge how fast a unit of currency is translated into IP. Chart 4 highlights that IP/M2 is contracting at an accelerating pace, heralding further earnings growth pain for the S&P 500. US dollar based liquidity is also contracting as we showed in last week’s US Equity Strategy Webcast slides. Chart 4Clogged Pipelines Weighing On Profit Growth Other SPX profit indicators we track continue to suggest that the earnings soft patch is not out of the woods yet (we use forward EBITDA estimates to gauge trend growth, which excludes the one time fiscal easing boost to net EPS). Net forward EBITDA revisions are below zero, the ISM manufacturing new orders-to-inventories ratio has fallen 40% from the 2018 peak and is hovering near parity, momentum in the key ISM manufacturing new orders subcomponent is contracting and BCA’s boom/bust indicator continues to deflate. All of this, suggests that a turnaround in profits remains elusive and is a first half of 2020 outcome, at the earliest (Chart 5). Already, Q4/2019 profit growth estimates have now sunk into negative territory according to the latest FactSet data.2 Finally, the Fed released the last Senior Loan Officer Survey of the year in the past week and demand for C&I loans collapsed. This data series has broken below the 2016 trough and warns that C&I credit origination will continue to contract. Chart 5No Pulse Chart 6Capex Contraction Dampens Need For Credit Such a souring backdrop makes intuitive sense as animal spirits have died down courtesy of the Sino-American trade war. CEO’s are still voting with their feet and are canceling/postponing capital outlays. Absent capex, C&I credit demand runs aground (Chart 6). It remains unclear if a US/China “phase one” trade deal including tariff rollbacks can reverse the ongoing global trade contraction, signaling that caution is still warranted on the prospects of the broad equity market for the next 9-12 months. This week we are initiating a new market-neutral pair trade and reiterate our negative view on a niche defensive sector. Long/Short Idea: Buy Energy/Sell Utilities There is an exploitable opportunity in going long the S&P energy sector/short the S&P utilities sector and we recommend initiating this market-neutral trade today. The top panel of Chart 7 shows that energy stocks have come full circle and are trading at levels last seen two decades ago when WTI oil was fetching less than half of today’s $55/bbl price. Encouragingly, there seems to be long-term support for relative share prices at the current overly depressed level. While utilities have been making headlines all year long given their outperformance, when put in proper perspective this niche defensive sector with a mere 3% weight in the SPX looks like a shipwreck (bottom panel, Chart 7). Taken together, this battle between two diminishing sectors presents a tradable opportunity by favoring energy stocks at the expense of utilities. In fact, this ratio trades at more than two standard deviations below the historical uptrend, and thus offers a lucrative risk/reward profile (Chart 8). Chart 7Buy Energy… Chart 8…At The Expense Of Utilities Beyond depressed technicals and compelling overall valuations with an alluring relative dividend yield (investors are paid an unprecedented 100bps in dividend yield carry to put on this trade, Chart 9), macro tailwinds, improving operating fundamentals, and the messages from our relative profit growth models and relative Cyclical Macro Indicators (CMI), all signal that the time is ripe to initiate a long energy/short utilities pair trade. On the macro front, inflation expectations have tentatively troughed and if oil rebounds further, as our Commodity & Energy Strategy service expects, then given their tight positive correlation with oil prices, rising inflation expectations should put a definitive floor under the relative share price ratio (Chart 10). Chart 9Unloved And Oversold Chart 10Return Of Inflation… However, the real interest rate component (i.e. growth) also explains roughly half of the selloff in the 10-year Treasury yield since early September, which also moves in lockstep with relative share price momentum (bottom panel, Chart 10). Were this budding global growth recovery to gain steam into the first half of 2020, then energy profits would outshine utility sector profits. As a reminder, oil is a global growth barometer and rises with increasing global growth while defensive utilities flourish when growth sputters (Chart 11). The US dollar’s recent appreciation has also dealt a blow to this trade and a grinding lower currency which is synonymous with a modest global growth recovery would also reverse this pair trade’s fortunes (top two panels, Chart 12). Chart 11…And Green Shoots Beneficiary Chart 12Operating Metrics Also… Zooming into the relative operating outlook, the bottom panel of Chart 12 shows that oil price inflation is outpacing natural gas selling prices. This relative underlying commodity backdrop is important as energy stocks move with the ebbs and flows of the oil market, whereas the marginal price setter for utility services is natural gas prices. The upshot is that heading into 2020, bombed out relative share prices should play catch up to the firming relative commodity backdrop. Capital spending outlays also favor energy shares over utilities stocks (top two panels, Chart 13). Surprisingly, the utilities sector net debt-to-EBITDA ratio is above 5x, waving a red flag, but energy indebtedness is coming down fast in the aftermath of the early 2016 oil price collapse and the energy sector’s net debt-to-EBITDA ratio is close to 2x (bottom panel, Chart 13). Our relative CMIs and relative profit growth models do an excellent job capturing all these moving parts and are unanimously sending a bullish message that an earnings-led recovery is in store for the relative share price ratio (Chart 14). Chart 13…Favor Energy Over Utilities Chart 14Green Light From US Equity Strategy Models Bottom Line: Initiate a long S&P energy/short S&P utilities pair trade today. Out Of Power Warning Utilities stocks have been all the rave this year, but given their small weighting in the SPX they only explain a very small part of the broad market’s run (in contrast, the heavyweight tech sector explains most of the S&P 500’s rise as we highlighted in recent research).3 We reiterate our underweight stance in this small defensive sector that has run way ahead of soft profit fundamentals. Worrisomely, utilities trade with a 20 forward P/E handle and command a 20% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 350bps (not shown). Chart 15 shows that our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession. Technicals are also extended (bottom panel, Chart 15), warning that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam. Chart 15Overbought And Overvalued In sum, pricey valuations, overbought technicals, the selloff in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. The top panel of Chart 16 shows that relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. Similarly, the recent selloff in the total return bond-to-stock ratio also warns that buying up expensive utilities at the current juncture is fraught with danger (second panel, Chart 16). The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (new export orders shown inverted, bottom panel, Chart 16). Chart 16Budding Recovery Weighing On Utilities Chart 17Sell The Strength Turning over to the sector’s operating metrics reveals that investors piling into utilities is unwarranted. Natural gas prices are contracting at the steepest pace of the past four years (middle panel, Chart 17) and signal that the path of least resistance is lower for relative share price momentum. Meanwhile, electricity capacity utilization is in a multi decade downtrend, warning that the relative profitability will remain under pressure in the coming quarters (bottom panel, Chart 17). In sum, pricey valuations, overbought technicals, the sell-off in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. Bottom Line: Shy away from the expensive S&P utilities sector. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/econres/claudia-r-sahm.htm 2 https://insight.factset.com/sp-500-now-projected-to-report-a-year-over-year-decline-in-earnings-in-q4-2019 3 Please see BCA US Equity Strategy Insight Report, “Deciphering Sector Returns” dated August 30, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights All the steps in the earnings dance are well known: Company management teams guide Wall Street analysts to lower their expectations in the weeks leading up to the beginning of earnings season, and their companies’ results then comfortably clear the lowered bar. Given the lack of true suspense, the S&P 500 largely ignores quarterly results: In the near term, moves in the S&P 500 have little to no relationship with either earnings growth or the magnitude of earnings beats. Over time, however, index prices and earnings move together: If earnings multiples mean-revert, earnings and prices have to converge over the long run. The equity bull market isn’t finished yet: The monetary policy backdrop will support earnings growth well into 2021, though it will not promote multiple expansion for much more than a year. Feature Chart 1We've Seen This Movie Before Taking a turn chairing BCA’s daily meeting last week, we duly updated our colleagues on the progress of earnings season. At the time, over 75% of the S&P 500’s constituents had reported, and the index was on its way to surpassing consensus analyst expectations by a few percentage points. We then showed charts tracking the course of expectations across each of this year’s three quarters to show that the “surprise” wasn’t actually very surprising (Chart 1). We included the charts to add a bit of levity, but a fellow strategist asked an incisive question: If earnings season follows the same pattern every quarter, why pay attention to it at all? Earnings season surely has its elements of Kabuki theater, but earnings are the fundamental basis for purchasing an ownership stake in a company. A share of stock is a claim on a company’s aggregate future earnings. To the extent that quarterly earnings reports provide a window into the trajectory of a company’s future earnings path, they contain relevant information about the fair value of its shares. Quarterly earnings offer more insight at the individual stock level than at the index level, as individual stocks are subject to idiosyncratic factors, while index earnings tend to reflect overall economic performance, and we therefore view them as a check on the other real-time indicators we examine to gauge the health of the economy. A review of how S&P 500 prices interact with S&P 500 earnings suggests that earnings have little to no impact on near-term index performance. They do move together in the long term, though, as they must if earnings multiples are a mean-reverting series. In the near term, when multiples are oscillating, anticipating stock market moves is a function of anticipating earnings growth and swings in multiples, which move independently of one another. The fed funds rate cycle has historically provided a good high-level guide to earnings and multiples trends. S&P 500 Performance During Earnings Season To test the S&P 500’s sensitivity to earnings surprises, we dug through weekly earnings updates going back to the beginning of 2012 (4Q11 earnings season) to compare expected index earnings per share (EPS) with reported index EPS.1 I/B/E/S has long been recognized as the earnings-estimates authority, so we use its estimates in conjunction with its compilation of reported earnings to ensure our analysis really is apples-for-apples.2 We track S&P 500 performance in three-month segments, beginning with the Monday following the second Friday of the new quarter, since that is the week that the banks typically get earnings season rolling. Earnings beats are stable and predictable, but the S&P 500's reaction to them is anything but. The empirical record over the last 31 quarters supports our colleague’s intuition. Over the 13 weeks following the major banks’ releases, S&P 500 performance exhibits no consistent link with earnings surprises (Chart 2). The best-fit line through a simple scatterplot shows that the relationship, such as it is, has been inverse and weak (Chart 3). The link with the year-over-year change in S&P 500 earnings is even weaker (Charts 4 and 5). Chart 2Earnings Surprises Don't Move The S&P 500 … Chart 3… Which Is Slightly Negatively Correlated With Them Chart 4Earnings Growth Doesn't Move The S&P 500 … Chart 5… Which Has No Short-Term Relationship With It Earnings data support our colleague’s contention that earnings season, at least as it relates to expectations, is something of a charade. Companies, which heavily influence analyst estimates with their guidance, have beaten expectations every quarter for at least eight years. As Charts 2 and 3 show, earnings beat expectations by an average of 3.7%, nearly the midpoint of the 1-6% range. The S&P 500 shouldn’t be expected to react to “surprises” that are more or less pre-ordained. Bottom Line: Earnings season has no observable impact on the S&P 500. Earnings attract a lot of attention, but they do not influence index-level performance in the near term. The S&P 500 And Earnings Over Longer Periods Anything can happen over short periods, but stock prices have to track earnings over the long term. If the idea that an ownership share represents a proportional stake in company earnings is too abstract, consider the equity equation. Equity prices, P, can be viewed as the product of earnings, E, and the multiple investors are willing to pay for each dollar of earnings, P/E. P = E * (P/E) The market P/E ratio is subject to mean reversion, making changes in earnings the key long-term driver of S&P 500 performance. Since 1966, the S&P 500 index (Chart 6, top panel) has appreciated at the same rate as its trailing four-quarter operating earnings (Chart 6, middle panel), given that its trailing multiple is not far from where it started (Chart 6, bottom panel). Growth in forward earnings expectations (Chart 7, middle panel) has lagged S&P 500 growth (Chart 7, top panel) since expectations data began to be compiled in 1979 because the forward multiple has more than doubled from late ‘70s trough levels (Chart 7, bottom panel). In any extended period not bookended by an outlier multiple, however, one should expect S&P 500 appreciation to track earnings estimate growth. Chart 6S&P 500 Earnings And Prices Will Converge Over Time ... Chart 7... As Long As The Starting Or Ending Multiple Isn't An Outlier Bottom Line: Stock price gains and earnings growth will converge over the long run as long as the earnings multiple mean-reverts. Earnings do matter in the long run. Where Do We Go From Here? There are several earnings growth models within BCA. Like all regression models, they often work well in stretches, but are susceptible to unanticipated inflections and changes in correlations. Since the crisis, the difference between year-over-year growth in industrial production and year-over-year growth in the money supply has aligned closely with earnings growth (Chart 8). If we (and global equity markets) are correct in sniffing out a bottoming in global manufacturing activity, and loan growth is unlikely to accelerate much as banks are pulling in their horns in commercial real estate and selected consumer categories, earnings growth could pull out of its funk. Chart 8Earnings Growth Will Revive Once Global Manufacturing Pressure Abates We have found that earnings growth and multiple re-rating or de-rating is reliably influenced by the monetary policy backdrop. While the level of the fed funds rate goes a long way to explaining overall index moves, earnings growth and multiple expansion/compression are a function of its direction. Broadly, forward estimates grow at a rapid rate when the Fed is hiking rates (the economy is expanding) and slump when it’s cutting them (the economy needs a hand). Forward multiples are the mirror image of earnings estimates, contracting when the Fed is hiking and expanding at a robust clip when the Fed is cutting. Earnings grow at a rapid clip when the Fed is leaning against a too-strong economy, but they slump when the Fed is trying to nurse it back to health. Viewed through the lens of the fed funds rate cycle (Figure 1), policy had been in Phase I from December 2015, when the Fed began hiking rates, until the end of July, when the Fed began cutting, transitioning into Phase IV. Phase IV has been characterized by solid multiple expansion and, ex-2008-9, decent earnings growth. It will remain in force until the Fed returns to hiking rates, which we do not expect until the second half of 2020 at the earliest. Once the Fed does resume hiking, it will likely take some time for it to raise the fed funds rate above its equilibrium level (Phase II). Figure 1The Fed Funds Rate Cycle Our base case is that the Fed will not turn restrictive until 2021. Easy monetary policy is a tailwind for earnings growth, which remains strong in Phase II, so we expect that earnings growth will shake loose of 2019’s doldrums across the next two years. Stocks should benefit from re-rating until the Fed resumes hiking rates (Phase I), cutting off multiple expansion. They will de-rate once monetary policy becomes restrictive (Phase II), as it must once the Fed perceives a need to cool the economy. The bottom line is that the monetary policy backdrop should be earnings-friendly well into 2021, even if multiple expansion isn’t likely to persist beyond the next nine to twelve months. Investment Implications Investors should not look to quarterly earnings reports to inform asset allocation decisions. Quarterly releases may be telling for individual companies’ longer-run profit potential, but they do not shed much light on the S&P 500’s future earnings. The long-run index earnings profile is much more likely to be influenced by broad themes than real-time data points. We devote our focus to the cyclical forces affecting asset-class-level returns, and find that the monetary policy cycle offers useful insight into future moves in earnings and multiples. The Fed's dovish pivot will help keep the expansion going, ... That insight is favorable for equities, and for spread product as well. We are in the latter stages of both the business cycle and the credit cycle, but new injections of monetary accommodation and the postponement of the shift to restrictive monetary policy settings will extend the longevity of the expansion and the period over which credit generates positive excess returns. Investors have different objectives and risk tolerances, but we think all of them should remain at least equal weight equities in balanced portfolios, and overweight spread product (and underweight Treasuries) within fixed-income sleeves. It is too soon to de-risk investment portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 All data cited in this section comes from Refinitiv’s (formerly Thomson Reuters’) This Week in Earnings publication. 2 Earnings estimates compiled by other vendors may differ from I/B/E/S estimates, and other measures of reported earnings, like Standard & Poor’s, regularly diverge from I/B/E/S’.