James Bevan: Equities, go-go stocks and prospects for a bear market

Equity markets have started the new year wrong footed by several developments.

First, China’s weak December official manufacturing PMI (Purchasing Managers Index – compiled by the China Federation of Logistics & Purchasing) and the Caixan/Markit unofficial M-PMI renewed fears of decelerating Chinese economic growth.

The former wasn’t as weak as the latter, and the output component of the official measure remained solidly above 50.0 at 52.2, as it has since February 2009 but nevertheless, Monday’s 7% plunge in the Shanghai and the weakness in the yuan also raised alarm bells about China among investors.

The market reaction seemed to confirm that China’s economy is in serious trouble. However, the fall in stocks was exacerbated by fears that a ban on selling shares would expire on Friday. The FT reported “China is to extend a ban on stock sales by large shareholders until permanent rules to restrict such sales take effect, as authorities seek to calm market fears over the lock-up that was due to expire on Friday.”

There was more bad news from China. The Caixan/Markit NM-PMI fell to 50.2 during December, the weakest reading since July 2014. That suggests that the transition from manufacturing to services isn’t proceeding well. However, that’s totally at odds with the official NM-PMI, which rose to 54.4 in December, the highest since August 2014. Little wonder that China’s stock market is in a tizz.

State side

Then we have the US, where the economic outlook was wrong footed by December’s disappointing M-PMI, released on Monday, and slower auto sales for the last month of 2015, reported on Tuesday. On Wednesday, there was more bad news about the NM-PMI. The good news was that US auto sales totalled 17.4 million units last year, the best year since 2000 – but the bad news is that December’s annual rate dipped to 17.3 million from 18.2 million the month before.

It is hard to imagine that car sales can get much better, which means that the booming auto industry may not do enough to offset the bust in energy-related manufacturing. That would explain the drop in December’s M-PMI, compiled by ISM, to 48.2, the lowest since June 2009. The Markit measure of the US M-PMI remained above 50.0 at 51.2 during December, but that was a big drop from November’s 52.8 and the lowest since October 2012.

There wasn’t any good news in the ISM (Institute for Supply Management) and Markit measures of the NM-PMIs. Both fell in December, though they remained solidly above 50.0 at 55.3 and 54.3, respectively.

Meanwhile there’s nervousness on US GDP growth. The Atlanta Fed’s GDPNow model aims to forecast GDP by monitoring the same economic statistics that the Bureau of Economic Analysis uses in its initial estimates of GDP.

GDPNow is updated frequently by the Atlanta Fed as new data become available. Yesterday, the model projected that GDP grew by 1.0% (saar) during Q4-2015, up from Monday’s estimate of 0.7%, reflecting a swing in net exports’ contribution to Q4 GDP from a preliminary estimate of negative 0.2ppt to a positive 0.2ppt following yesterday’s trade report.

But it still remains below the model’s previous prediction of 1.3% on December 23, reflecting weak construction spending and ISM manufacturing numbers at the start of the week.

Then yesterday’s November merchandise trade report showed 1.1% month on month and 4.0% year on year drops in real exports.

In current dollars, total construction spending dipped 0.4%mom during November – the first decline since June 2014. While residential construction remains on an uptrend, non-residential and public construction have stalled in recent months.

World Bank

Also this week, the World Bank cut its global growth forecasts 2016 based on deeper contractions than expected in Brazil and Russia and meeker output in most of the world’s biggest economies, including the U.S. and China. The World Bank cut its forecast for global growth in 2016 by 0.4 percentage point to 2.9%, so only slightly higher than last year’s downward-revised growth rate of 2.6%.

In response to this deluge of new year’s bad news, a couple of Fed officials offered some delusional discussions of several rate hikes in 2016.

FRB-SF President John Williams on Monday told reporters: “I could easily see it be three or five or more or less depending” on what happens with the economy. But he noted that the median view of FOMC officials is four rate increases, saying that would leave the central bank overnight target rate at around 1.35%, which he said is “a reasonable guess” for what’s likely to happen.

In a CNBC interview, Fed Vice Chair Stanley Fischer echoed that four rate hikes would be “in the ballpark.” As Bloomberg noted on 4^th January, in an article titled Fed Vice Chairman Fischer’s hawkish tone may have added to market angst: “On Sunday, Fed Vice Chairman Stanley Fischer said the U.S. central bank should be open, in the future, to raising interest rates to ward off potential asset bubbles. How much financial stability concerns should play in monetary policy remains an unsettled policy at the U.S. central bank. Prior to the crisis, the Fed’s leadership did not support hiking rates to ward off asset bubbles.”

Geo political

We also have geo-political challenges. North Korea claimed to have detonated an H-bomb and this comes hot on the heels on the Iran/Saudi tensions.

Typically geo-political disturbances are largely ignored by stock markets and mark downs are viewed as buying opportunities by investors but this year is widely expected to be fraught with more dangerous disturbances than usual, so markets are skittish.

Just as stock markets sank miserably during the first few trading days of 2016, pessimists had already prepared long worry lists for the year and added the plunge in Chinese stocks and heightened Middle East tensions this week.

Another item on everyone’s worry list is the pricing of equities, proxied by the US market’s price/earnings (P/E) multiple, which is widely viewed as historically high. And for sure the P/E is high, but there are different messages from the details.

Thus, the forward P/Es on six out of 10 sectors are lower today than they were at the end of 2014. The only sectors that saw a notable increase in their earnings multiples were Energy and Consumer Staples.

Here’s a list of sectors’ forward P/Es today and where they stood at the end of 2014: Energy (28.3, 16.9), Consumer Staples (20.1, 19.0), Consumer Discretionary (18.3, 18.2), S&P 500 (16.5,16.3), Tech (16.3, 15.7), Health Care (16.1, 17.0), Utilities (15.6, 17.3), Industrials (15.6, 16.1), Materials (15.5, 15.8), Financials (13.6, 14.2), and Telecom (12.5,13.4).

Go-go stocks

Two of the sectors with the highest multiples – Energy and Consumer Staples- don’t include any go-go stocks like Facebook, Amazon, Netflix, and Google, indicative of overheated valuations.

In fact, it looks as if it’s pessimism and not the optimism of an overheated bull market, that’s driving their multiples higher.

Thus with a forward P/E of 28.3x, Energy has the highest multiple among the 10 sectors in the S&P500. The sector’s multiple has soared as earnings have fallen sharply while the stock prices of energy stocks haven’t fallen as much. So the high multiple reflects depressed earnings expectations, not speculative excess. That said, the most expensive oil in the world may be in the US stock market given the Energy sector’s elevated P/E.

The Consumer Staples sector has the second-highest forward earnings multiple, at 20.1, even though it’s expected to grow earnings by only 5.4% this year.

Some industries within the sector, notably Brewers and Distillers & Vinters, became frothy as a result of the M&A boom but other areas have lofty P/Es mostly because they are in defensive areas with decent yields.

Household Products, for example, has a 20.9 forward P/E on earnings that are expected to decline by 2.1% this year. Likewise, earnings in the Soft Drinks industry are predicted to rise only 5.7% yet the forward P/E is 21.5.

Without these high-multiple sectors, the S&P 500’s valuation looks a bit more reasonable. Excluding the depressed Energy sector and the defensive Consumer Staples sector, the S&P 500’s forward P/E shrinks to 15.6 from 16.5.

Another sector with an outsized P/E is Consumer Discretionary, at 18.3, which might not be so bad given the expected earnings growth of 14.5% over the next year. This is one sector that is affected by go-go stocks, since it includes the Internet Retail industry, which includes Amazon and Netflix.

The Internet Retail industry, with a 60.6 forward P/E, has one of the highest multiples among the S&P 500’s industries, and it’s increased since end 2014, when it was “only” 45.3. However, earnings growth is expected to be 52.1% this year.

The impact of the go-go stocks shouldn’t be ignored. The S&P’s forward P/E would fall to 15.7 without the impact of just the four ‘FANG’ stocks and if we deduct the FANG stocks, the depressed Energy sector, and the defensive Staples sector from the S&P500 P/E calculation, the index’s multiple falls to 14.7. Thus the vast majority of stocks look much more reasonably priced than the broader index’s multiple would imply.

It’s way too early to assume that we are due and will have a bear market in the near term.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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