James Bevan: Equities – where next?
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In conversations with industry and colleagues and investors, it seems that on balance institutional investors remain bullish, though they are hard-pressed to find any bargains in the US stock market.
There were plenty of bargains in the Greek stock market yesterday, but Greek stocks are cheap for lots of good reasons. Other European stocks remain relatively cheap compared to valuations in the US, but the European economy’s performance continues to lag the performance of the US. The same can be said of Japan’s stocks and economy.
China’s economy continues to slow, but its stocks aren’t cheap, especially given the frantic and frenetic attempts by the government to prop up the stock market, including threats to shoot short sellers.
In terms of valuation levels, the current forward P/Es of the major global MSCI stock indexes are as follows: US (17.3), Japan (15.5), UK (15.4), EMU (15.3), and Emerging Markets (11.5).
The stock market returns so far this year mostly reflect inflows into the markets that are relatively undervalued. Here are the year to date gains in the major MSCI indexes in local currencies: Japan (17.0%), EMU (16.2), US (2.6), UK (1.4), and Emerging Markets (-0.6). However, both the US and UK indexes have been weighed down by the big drops in their Energy sectors.
In China, the forward P/E of the MSCI stock index is down from the year’s high of 12.3 during the week of April 30th to 10.0 currently. The comparable valuation multiple of Hong Kong’s Hang Seng China Enterprises index is down from 8.5 to 7.0 over this same period. The fireworks have been in the Shanghai A-Share Index (down from 19.0 on June 11th to 15.3) and the Shenzhen A-Share index (down from 43.4 on June 4 to 31.2).
Nagging
One of the nagging questions we need to address is how long the current bull market last, and which indicators might provide best guidance as to the likely onset of a bear phase. Since bear markets are usually caused by recessions, timing the next significant drop of 20% or more in stock prices depends on forecasting the next recession accurately.
If we focus on normal cycles, spring 2019 is the next due date for onset of the next US recession but this by no means a normal cycle, and there are some leading indicators that might help us anticipate the next bear market.
Ordinarily, we might hope to look at leading indicators but the S&P 500 is one of the 10 components of the Index of Leading Economic Indicators (LEI). In other words, the market is already discounting future economic developments including booms and busts. The yield curve spread and initial unemployment claims are also components of the LEI and all remain in bullish territory.
Industrial commodity prices can be useful, with the CRB raw industrials spot price index providing a daily real-time indicator of the global economy. It’s looking bearish for stocks currently but if we divide it by initial unemployment claims to deliver a sort of boom-bust barometer, the outlook seems relatively upbeat.
We also monitor the so-called Misery Index, which is the sum of the unemployment rate and the PCED inflation rate. This tends to rise during bear markets without providing much warning. In June, it fell to 6.6%, the lowest reading since August 2007, with the unemployment rate at 5.3% and inflation at 1.3%.
Perhaps this is a useful warning: When misery is as low as it is now, the next big move in the index has tended to be in a more miserable direction. However, we need to recall that there is still room for less misery given the 5.3% lows of both February 1966 and August 1999.
Interestingly, that many investors may be on the lookout for the next bear market, is bullish from a contrarian perspective. In effect, investors are climbing the wall of worry.
For the US equity market, the Bull/Bear Ratio (BBR) dropped to 2.47 last week, which was the lowest reading since October 21, 2014. But the percentage of bears, at 17.5%, remained below 20.0%, as it has since last summer.
The recent drop in bullishness was offset by an increase in the percentage in the correction camp – and the recent decline in the BBR may reflect concerns about the implications of the sharp drop in commodity prices. The CRB futures price index fell at the end of July to the lowest level since March 2nd 2009, and the narrower CRB raw industrials spot price index (which excludes petrol, wood, and agricultural commodities) is down to its lowest reading since November 9th 2009.
Mystery
It’s no mystery why this is happening. There is too much supply of, and not enough demand for, commodities. Producers expanded their capacity betting on a secular bull market in commodities led by several decades of rapid growth in China, which joined the World Trade Organization at the end of 2001. They were right for about one decade but wrong since 2011, when China’s growth rate started to slow significantly and Euroland entered recession.
The question is whether a secular bull market in stocks is possible now that commodities are in a severe bear market. As the FT pointed out on 3rd August, in its article Commodity prices fall hits capital expenditure: “The energy, chemicals and mining sector accounted for well over a third of global capital expenditure last year but rating agency Standard & Poor’s predicts that spending will fall more than 10 per cent this year and decline further in 2016.”
Meanwhile, China’s Caixin M-PMI fell to 47.8 in July from 49.4 in June, which was much worse than the official measure of Chinese manufacturing activity, released last Saturday, which came in at 50.0 for July, down from 50.2 in June. The pressure is on China’s government to do more to stimulate growth and it has pledged to make ‘pre-emptive’ policy adjustments in the second half, and there are widespread expectations of more easing moves from the PBoC, with encouragement for banks to increase loan support for the tourism sector.
Despite the weakness in China’s M-PMI, the comparable measures in the US and Euroland are holding up quite well. In the US, the M-PMI ticked down to 52.7, but its orders and production components for July ticked up to 56.5 and 56.0 respectively. In Euroland, the overall index edged down to 52.4 last month, but Italy’s rose to 55.3, the highest since April 2011. Spain remained robust at 53.6, while Germany was solid at 51.8. France was the weak outlier yet again with a reading of 49.6.
We can also point to the risk of more exuberance. FRB St. Louis President James Bullard said last Friday that recent economic data are bolstering the case for raising short-term rates when the FOMC meets in September. He said: “We are in a good position to make the first normalization move… My sense is that a 25 basis-point move would essentially be a non-event in financial markets.” Similarly, Goldman’s CEO Lloyd Blankfein said last week: “It will be jarring when we see an interest-rate hike because we haven’t had one for some time, and then I think people will get out the smelling salts, take a big sniff and recover.”
It looks reasonable that after a big sniff the stock market should recover any losses attributable to the Federal Reserve’s initial liftoff, which has been so widely anticipated since early this year – and there might actually be a huge relief rally in stocks, especially if during her press conference on September 17th, Fed chairman Janet Yellen reiterates that any further rate hikes will be small and very gradual. In this way Yellen might trigger a year end rally in stocks.
