Tag Archives: andrew lapthorne

A frazzled Goldilocks?

Whatever measure you look at, equities in the US are overvalued, arguably in bubble territory. Investors poured record amounts into equity funds in recent weeks as the market melt-up takes hold. One of the intriguing features of the bull market over the past 18 months has been the extraordinary low volatility. Hamish Preston of S&P Dow Jones Indices estimated that the average observed 1-month volatility in the S&P 500 in 2017 is “lower than in any other year since 1970”. To illustrate the point, the graph below shows the monthly change in the S&P500 over recent years.

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The lack of any action below 0% since November 2016 and any pullback greater than 2% since January 2016 is striking. “Don’t confuse lack of volatility with stability, ever” is a quote from Nassim Nicolas Taleb that’s seems particularly apt today.

Andrew Lapthorne of SocGen highlighted that low risk markets tend to have a big knock on effect with a “positive feedback mechanism embedded in many risk models”. In other words, the less risk is observed in the market and used as the basis for model inputs, the more risk the quant models allow investors to take! [The impact of quant models and shadow risks from passive investing and machine learning are areas I hope to explore further in a future post.]

One risk that has the potential to spoil the party in 2018 is the planned phased normalisation of monetary policy around the world after the great experimentations of recent years. The market is currently assuming that Central Banks will guarantee that Goldilocks will remain unfrazzled as they deftly steer the ship back to normality. A global “Goldilocks put” if I could plagiarize “the Greenspan put”! Or a steady move away from the existing policy that no greater an economic brain than Donald Trump summarized as being: “they’re keeping the rates down so that everything else doesn’t go down”.

The problem for Central Banks is that if inflation stays muted in the short-term and monetary policy remains loose than the asset bubbles will reach unsustainable levels and require pricking. Or alternatively, any attempt at monetary policy normalization may dramatically show how Central Banks have become the primary providers of liquidity in capital markets and that even modest tightening could result in dangerously imbalances within the now structurally dependent system.

Many analysts (and the number is surprising large) have been warning for some time about the impact of QE flows tightening in 2018. These warnings have been totally ignored by the market, as the lack of volatility illustrates. For example, in June 2017, Citi’s Matt King projected future Central Bank liquidity flows and warned that a “significant unbalancing is coming“. In November 2017, Deutsche Bank’s Alan Ruskin commented that “2018 will see the world’s most important Central Bank balance sheets shift from a 12 month expansion of more than $2 trillion, to a broadly flat position by the end of 2018, assuming the Fed and ECB act according to expectations”. The projections Deutsche Bank produced are below.

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Andrew Norelli of JP Morgan Asset Management in a piece called “Stock, Flow or Impulse?” stated that “It’s still central bank balance sheets, and specifically the flow of global quantitative easing (QE) that is maintaining the buoyancy in financial asset prices”. JP Morgan’s projections of the top 4 developed countries are below.

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Lance Roberts of RealInvestmentAdvice.com produced an interesting graph specifically relating to the Fed’s balance sheet, as below. Caution should be taken with any upward trending metric when compared to the S&P500 in recent years!

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Of course, we have been at pre-taper junctions many times before and every previous jitter has been met with soothing words from Central Banks and more liquidity creation. This time though it feels different. It has to be different. Or Central Bankers risk been viewed as emperors without cloths.

The views of commentators differ widely on this topic. Most of the business media talking heads are wildly positive (as they always are) on the Goldilocks status quo. John Mauldin of MauldinEconomics.com believes the number one risk factor in the US is Fed overreach and too much tightening. Bank of America Merrill Lynch chief investment strategist Michael Hartnett, fears a 1987/1994/1998-style flash crash within the next three months caused by a withdrawal of central bank support as interest rates rise.

Christopher Cole of Artemis Capital Management, in a wonderful report called “Volatility and the Alchemy of Risk”, pulls no punches about the impact of global central banks having pumped $15 trillion in cheap money stimulus into capital markets since 2009. Cole comments that “amid this mania for investment, the stock market has begun self-cannibalizing” and draws upon the image of the ouroboros, an ancient Greek symbol of a snake eating its own tail. Cole estimates that 40% of EPS growth and 30% of US equity gains since 2009 have been as a direct result of the financial engineering use of stock buy backs. Higher interest rates, according to Cole, will be needed to combat the higher inflation that will result from this liquidity bonanza and will cut off the supply for the annual $800 billion of share buybacks. Cole also points to the impact on the high yield corporate debt market and the overall impact on corporate defaults.

Another interesting report, from a specific investment strategy perspective, is Fasanara Capital’s Francesco Filia and the cheerfully entitled “Fragile Markets On The Edge of Chaos”. As economies transition from peak QE to quantitative tightening, Filia “expect markets to face their first real crash test in 10 years” and that “only then will we know what is real and what is not in today’s markets, only then will we be able to assess how sustainable is the global synchronized GDP growth spurred by global synchronized monetary printing”. I like the graphic below from the report.

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I found the reaction to the Trump’s administration misstep on dollar strength interesting this week. Aditya Bhave and Ethan Harris, economists at Bank of America, said of the episode that “the Fed will see the weak dollar as a sign of easy financial conditions and a green light to keep tightening monetary policy”. ECB President Mario Draghi was not happy about the weak dollar statement as that would complicate Europe’s quantitative tightening plans. It was also interesting to hear Benoit Coeure, a hawkish member ECB executive board, saying this week that “it’s happening at different paces across the region, but we are moving to the point where we see wages going up”.

I think many of the Central Banks in developed countries are running out of wriggle room and the markets have yet to fully digest that reality. I fear that Goldilocks is about to get frazzled.

Goodbye 2014, Hello 2015!

So, after the (im)piety of the Christmas break, its time to reflect on 2014 and look to the new year. As is always the case, the world we live in is faced with many issues and challenges. How will China’s economy perform in 2015? What about Putin and Russia? How strong may the dollar get? Two other issues which are currently on traders’ minds as the year closes are oil and Greece.

The drop in the price of oil, driven by supply/demand imbalances and geo-political factors in the Middle East, was generally unforeseen and astonishing swift, as the graph of European Brent below shows.

click to enlargeEuropean Brent Spot Price 2004 to 2014

Over the short term, the drop will be generally beneficial to the global economy, acting like a tax cut. At a political level, the reduction may even put manners on oil dependent states such as Iran and Russia. Over the medium to long term however, it’s irrational for a finite resource to be priced at such levels, even with the increased supply generated by new technologies like fracking (the longer term environmental impacts of which remain untested). The impact of a low oil price over the medium term would also have negative environmental impacts upon the need to address our carbon based economies as highlighted in 2014 by the excellent IPCC reports. I posted on such topics with a post on climate models in March, a post on risk and uncertainty in the IPCC findings in April, and another post on the IPCC synthesis reports in November.

The prospect of another round of structural stresses on the Euro has arisen by the calling of an election in late January in Greece and the possible success of the anti-austerity Syriza party. Although a Greek exit from the Euro seems unlikely in 2015, pressure is likely to be exerted for relief on their unsustainable debt load through write offs. Although banking union has been a positive development for Europe in 2014, a post in May on an article from Oxford Professor Kevin O’Rourke outlining the ultimate need to mutualise European commitments by way of a federal Europe to ensure the long term survival of the Euro. Recent commentary, including this article in the Economist, on the politics behind enacting any meaningful French economic reforms highlights how far Europe has to go. I still doubt that the German public can be convinced to back-stop the commitments of others across Europe, despite the competitive advantage that the relatively weak Euro bestows on Germany’s exporting prowess.

Perpetually, or so it seems, commentators debate the possible movements in interest rates over the coming 12 months, particularly in the US. A post in September on the findings of a fascinating report, called “Deleveraging, What Deleveraging?”, showed the high level of overall debt in the US and the rapid increase in the Chinese debt load. Although European debt levels were shown to have stabilised over the past 5 years, the impact of an aggressive round of quantitative easing in Europe on already high debt levels is another factor limiting action by the ECB. The impact of a move towards the normalisation of interest rates in the US on its economy and on the global economy remains one of the great uncertainties of our time. In 2015, we may just begin to see how the next chapter will play out.

Low interest rates have long been cited as a factor behind the rise in stock market valuations and any increase in interest rates remains a significant risk to equity markets. As the graph below attests, 2014 has been a solid if unspectacular year for nearly all equity indices (with the exception of the FTSE100), albeit with a few wobbles along the way, as highlighted in this October post.

click to enlarge2014 Stock Indices Performance

The debate on market valuations has been an ever-present theme of many of my posts throughout 2014. In a March post, I continued to highlight the differing views on the widely used cyclically adjusted PE (CAPE) metric. Another post in May highlighted Martin Wolf’s concerns on governments promoting cheap risk premia over an extended period as a rational long term policy. Another post in June, called Reluctant Bulls, on valuations summarized Buttonwood’s assertion that many in the market were reluctant bulls in the absence of attractive yields in other asset classes. More recently a post in September and a post in December further details the opposing views of such commentators as Jim Paulsen, Jeremy Siegel, Andrew Lapthorne, Albert Edwards, John Hussman, Philosophical Economics, and Buttonwood. The debate continues and will likely be another feature of my posts in 2015.

By way of a quick update, CAPE or the snappily named P/E10 ratio as used by Doug Short in a recent article on his excellent website shows the current S&P500 at a premium of 30% to 40% above the historical average. In his latest newsletter, John Hussman commented as follows:

“What repeatedly distinguishes bubbles from the crashes is the pairing of severely overvalued, overbought, overbullish conditions with a subtle but measurable deterioration in market internals or credit spreads that conveys a shift from risk-seeking to risk-aversion.”

Hussman points to a recent widening in spreads, as illustrated by a graph from the St Louis Fed’s FRED below, as a possible shift towards risk aversion.

click to enlargeFRED High Yield vrs AAA Spread Graph

The bull arguments are that valuations are not particularly stressed given the rise in earnings driven by changes to the mix of the S&P500 towards more profitable and internationally diverse firms. Critics counter that EPS growth is being flattered by subdued real wage inflation and being engineered by an explosion in share buybacks to the detriment of long term investments. The growth in quarterly S&P500 EPS, as illustrated below, shows the astonishing growth in recent years (and includes increasingly strong quarterly predicted EPS growth for 2015).

click to enlargeS&P500 Quarterly Operating & Reported EPS

A recent market briefing from Yardeni research gives a breakdown of projected forward PEs for each of the S&P500 sectors. Its shows the S&P500 index at a relatively undemanding 16.6 currently. In the graph below, I looked at the recent PE ratios using the trailing twelve month and forward 12 month operating EPS (with my own amended projections for 2015). It also shows the current market at a relatively undemanding level around 16, assuming operating EPS growth of approx 10% for 2015 over 2014.

click to enlargeS&P500 Operating PE Ratios

The focus for 2015 is therefore, as with previous years, on the sustainability of earnings growth. As a March post highlighted, there are concerns on whether the high level of US corporate profits can be maintained. Multiples are high and expectations on interest rates could make investors reconsider the current multiples. That said, I do not see across the board irrational valuations. Indeed, at a micro level, valuations in some sectors seem very rational to me as do those for a few select firms.

The state of the insurance sector made up the most frequent number of my posts throughout 2014. Starting in January with a post summarizing the pricing declines highlighted in the January 2014 renewal broker reports (the 2015 broker reports are due in the next few days). Posts in March and April and November (here, here and here) detailed the on-going pricing pressures throughout the year. Other insurance sector related posts focussed on valuation multiples (here in June and here in December) and sector ROEs (here in January, here in February and here in May). Individual insurance stocks that were the subject of posts included AIG (here in March and here in September) and Lancashire (here in February and here in August). In response to pressures on operating margins, M&A activity picking up steam in late 2014 with the Renaissance/Platinum and XL/Catlin deals the latest examples. When seasoned executives in the industry are prepared to throw in the towel and cash out you know market conditions are bad. 2015 looks to be a fascinating year for this over-capitalised sector.

Another sector that is undergoing an increase in M&A activity is the telecom sector, as a recent post on Europe in November highlighted. Level3 was one of my biggest winners in 2014, up 50%, after another important merger with TW Telecom. I remain very positive on this former basket case given its operational leverage and its excellent management with a strong focus on cash generation & debt reduction (I posted on TWTC in February and on the merger in June and July). Posts on COLT in January and November were less positive on its prospects.

Another sector that caught my attention in 2014, which is undergoing its own disruption, is the European betting and online gambling sector. I posted on that sector in January, March, August and November. I also posted on the fascinating case of Betfair in July. This sector looks like one that will further delight (for the interested observer rather than the investor!) in 2015.

Other various topics that were the subject of posts included the online education sector in February, Apple in May, a dental stock in August, and Trinity Biotech in August and October. Despite the poor timing of the August TRIB call, my view is that the original investment case remains intact and I will update my thoughts on the topic in 2015 with a view to possibly building that position once the selling by a major shareholder subsides and more positive news on their Troponin trials is forthcoming. Finally, I ended the year having a quick look at Chinese internet stocks and concluded that a further look at Google was warranted instead.

So that’s about it for 2014. There was a few other random posts on items as diverse as a mega-tsunami to correlations (here and here)!

I would like to thank everybody who have taken the time to read my ramblings. I did find it increasingly difficult to devote quality time to posting as 2014 progressed and unfortunately 2015 is looking to be similarly busy. Hopefully 2015 will provide more rich topics that force me to find the time!

A very happy and health 2015 to all those who have visited this blog in 2014.

An ice age or a golden one?

The debate on whether the US stock market is overvalued, as measured by the cyclically adjusted price to earnings ratio (CAPE) as developed by Robert Shiller, or whether CAPE is not relevant due to weaknesses in comparing past cycles with today’s mixed up macro-economic world, continues to rage. I have posted several times on this, most recently here and here. In an article in this week’s Economist, Buttonwood outlines some of the bull and bear arguments on the prospects for US corporate growth and concludes that “America is an exception but not as big an exception as markets suggest”.

Bulls argue that, although the CAPE for the S&P500 is currently historically high at 26.5, earnings growth remains strong as the US economy picks up speed and that at a forward PE around 16 the S&P500 is not at excessive levels indicative of a bubble. The latest statistics compiled by the excellent Yardeni Research from sources such as the Bureau of Economic Analysis show that earnings, whether S&P reported or operating earnings or NIPA after tax profits from current production or based upon tax returns, continue to trend along a 7% growth projection. Jim Paulsen, chief investment strategist at Wells Capital Management, believes that “this recovery will last several more years” and “earnings will grow”. Even the prospect of increased US interest rates does not perturb some bulls who assert that rates will remain low relative to history for some time and that S&P500 firms still have plenty of cash with an aggregate cash-pile of over $1 trillion. The king of the bulls, Jeremy Siegel recently said that “If you look at history, the bull markets do not end when the Fed starts raising interest rates. Bull markets could go on for another 9 months to 2 years“.

Bears point to high corporate profits to GDP and argue that they are as a direct result of low real wages and are therefore unsustainable when normal macro conditions return. Others point to the surge in share buybacks, estimated at nearly $2 trillion by S&P500 firms since 2009, as a significant factor behind EPS growth. Société Générale estimate a 20% fall in Q2 buybacks and (the always to be listened to) Andrew Lapthorne warns that as debt gets dearer firms will find it hard to maintain this key support to stock prices as in the “absence of the largest buyers of US equity going forward is likely to have significant consequence on stock prices”. The (current) king of the bears, Albert Edwards, also at SocGen, provided good copy in a recent report “Is that a hissing I can hear?” saying that “companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes“. Edwards believes that an economic Ice Age is possible due to global deflationary pressures. Another contender for king of the bears is fund manager John Hussman and he recently commented: “make no mistake, this is an equity bubble, and a highly advanced one“.

One commentator who I also respect is the author behind the excellent blog Philosophical Economics. A post last month on CAPE highlighted the obvious but often forgotten fact thatthe market’s valuation arises as an inadvertent byproduct of the equilibriation of supply and demand: the process through which the quantity of equity being supplied by sellers achieves an equilibrium with the quantity of equity being demanded by buyers”. As such, the current macro-economic situation makes any reference to an average or a “normal period” questionable. The post is well worth a read and concludes that the author expects the market to be volatile but continue its upward trajectory, albeit at a slower pace, until signs that the real economy is in trouble.

For me, the easy position is to remain negative as I see valuations and behaviour that frightens me (hello AAPL?). I see volatility but not necessarily a major correction. Unless political events get messy, I think the conclusion in a previous Buttonwood piece still holds true: “investors are reluctant bulls; there seems no alternative”. Sticking only to high conviction names and careful risk management through buying insurance where possible remain my core principles. That and trying to keep my greed in check…..

Reluctant Bulls

There was a nice piece from Buttonword in the Economist where he concluded that despite all the indicators of the equity market being overvalued that “investors are reluctant bulls; there seems no alternative”. This seems like a rationale explanation for the relatively irrational behaviour of current markets.

He highlighted indicators like the high CAPE, figures from the Bureau for Economic Analysis (BEA) on the profit dip in Q1, high share buybacks, figures from SocGen’s Andrew Lapthorne that the ratio of corporate debt to assets is close to its 2009 peak, and a BoA Merrill Lynch poll which shows that 48% of institutional investors are overweight equities whilst a net 15% believe they are overvalued.

Despite the bearish indicators everywhere, investors seem frozen by central bank indecision on whether economies still need help by remaining accommodative or that the recovery has taken hold and monetary policy needs to start to tighten.

Andrew Lapthorne released some analysis earlier this month highlighting that a significant amount of the previous year’s earnings growth was down to M&A from Verizon and AT&T and concluded that EPS growth by M&A and from share buybacks is a classic end of cycle indicator. Lapthorne produced the graph below of historical peaks and troughs in the S&P500 and noted that the average historical 1% down days is 27 per year since 1969 an the S&P500 has only had 16 in the past 12 months and that we have gone through the 4th longest period on record without a market correction of 10% or more.

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SocGen peak to through

Albert Edwards, also at SocGen, points to the difference in the BEA profit statistics and those reported being down to the expiration of tax provisions for accelerated depreciation and he concludes that “the bottom line is that the U.S. profits margin cycle has begun to turn down at long last“.

Even the perma-bull David Bianco of Deutsche Bank has cautioned against overvaluation calling the market complacent and moving into mania territory using their preferred measure of sentiment, namely the PE ratio divided by the VIX. The graph below from early June illustrates.

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DB Price Earnings VIX Ratio

From my point of view, I think the chart of the S&P500 for the past 10 years tells its own story about where we are. As Louis Rukeyser said “trees don’t grow to the sky“. Nor do equity markets.

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S&P500 Past 10 Years

Then again, always look on the bright side……

To recap on the bear case for the US equity market, factors highlighted are high valuation as measured by the cyclically adjusted PE ratio (CAPE) and the high level of corporate earnings that look unsustainable in a historical context. I have tried to capture these arguments in the graph below.

click to enlarge50 year S&P500 PE CAPE real interest rate corp profit&GDPCurrently, the S&P500 PE and the Shiller PE/CAPE are approx 10% and 30% above the average over the past 50 years respectively.

On earnings, Andrew Lapthorne of SocGen, in an August report entitled “To ignore CAPE is to deny mean reversion” concluded that “mean-reversion in earnings, though sometimes delayed, is as undeniable as the economic cycle itself. That peak profits typically accompany peak valuations only reinforces the point. When earnings revert back to mean (and below), the valuation will also collapse.” The graphic below from that report highlights the point.

click to enlargeSocGen Mean Reverting ProfitsThe ever bullish Jeremy Siegel, in a recent conference presentation, again outlined his arguments raised in the August FT article (see Shiller versus Siegel on CAPE post). The fifth edition of his popular book “Stocks for the long run” is out in December. Essentially he argues that CAPE is too pessimistic as accounting changes since 1990 distort historical earnings and the profile of S&P500 earnings has changed with bigger contributions from foreign earnings and less leveraged balance sheets that explain the higher corporate margins.

Siegel contends that after-tax profits published in the National Income and Product Accounts (NIPA) are not distorted by the large write downs from the likes of AOL and AIG. The changing profile of NIPA versus S&P reported earnings through historical downturns illustrate that historical S&P reported earnings are unreliable, as illustrated in the graph below.

click to enlargeNIPA versus S&P reported

However, even using NIPA data, a graphic from JP Morgan in late October shows that currently the S&P500 is approx 20% above its 50 year average.

click to enlargeS&P500 CAPE with NIPASiegel even proposed that current comparison should be against the long term average PE (1954 to 2013) of 19 including only years where interest rates were below 8% (which incidentally is only slightly higher than the 8.2 5o year average used in the first graph of this post).

The ever insightful Cliff Asness, founder of AQR Capital Management, counteracts such analysis with the recent comment below.

Does it seem to anyone else but me that the critics have a reason to exclude everything that might make one say stocks are expensive, and instead pick time periods for comparisons and methods of measurement that will always (adapting on the fly) say stocks are fair or cheap?

However, nothing is as black and white in the real world. The rise in corporate net margins has been real as another recent graphic, this time from Goldman Sachs, shows.

click to enlargeGoldman Sachs S&P500 net margin

Earnings from foreign subsidiaries have increased and S&P500 earnings as a percentage of global GDP show a more stable picture. Also leverage is low compared to historical levels (104% debt to equity for S&P500 compared to a 20 year average of 170%) and cash as a percentage of current assets is also high relative to history (approx 28%). Although there is signs that corporate leverage rates are on the rise again, future interest rate rises should not have as big an impact on corporate margins as they have historically.

JP Morgan, in another October bulletin, showed the breakdown of EPS growth in the S&P500 since 2010, as reproduced below, which clearly indicates a revenue and margin slowdown.

click to enlargeJP Morgan S&P500 EPS Annual Growth Breakdown October 2013David Bianco of Deutsche Bank has recently come up with a fascinating graphic that I have been looking at agog over the past few days (reproduced below). It shows the breakdown of S&P500 returns between earnings growth, dividends and PE multiple expansion.

click to enlargeDeutsche Bank S&P500 Growth BreakdownBianco, who has a  2014 end target of 1850 and a 2015 end target of 2000 for the S&P500, concluded that 75% of the S&P500 rise in 2013 is from PE expansion and that “this is the largest [valuation multiple] contribution to market return since 1998. Before assuming further [multiple] expansion we think it is important that investors be confident in healthy EPS growth next year. Hence, we encourage frequent re-examination of the capex and loan outlook upon new data points.

David Kostin from Goldman Sachs, who have a 2,100 S&P end 2015 target, stated that “multiple expansion was the key U.S. equity market story of 2013. In contrast the 2014 equity return will depend on earnings and money flow rather than further valuation re-rating.

Even well known pessimists like David Rosenberg and Nouriel Roubini are positive albeit cautious. Dr Doom has a 2014 target for S&P500 of 1900 (range 1650 to 1950) although he does give the US equity market an overall neutral rating. Rosenberg, who describes the current rally as “the mother of all liquidity rallies“, cites the US economy’s robustness over the past year as a sign that 2014 should see a further strengthening of the US economy.

So clearly future growth in the S&P500 will depend upon earnings and that will depend upon the economy and interest rates. Although I am still trying to get my head around a fascinating article from 2005 that shows negative correlation between equity returns and GDP growth, that brings me back to the macro-economic situation.

I know this post was to have represented the positive side of the current arguments but, as my current bear instincts can’t be easily dispelled, I have to conclude the post with the comments from Larry Summers at a IMF conference earlier this month that the US may be stuck in a “secular stagnation” and that the lesson from the crisis is “it’s not over until it is over, and that is surely not right now”.