Tag Archives: Nouriel Roubini

Crazy Days

I have been somewhat out of the loop on the market over the past 2 months, partly due to work and partly due to a general apathy towards trying to understand the current market reasoning. I am very much in a risk off mode on a personal basis having moved mainly into cash since April to protect YTD gains (and take the hit on YTD losses!). At the end of April, I posted my thoughts about the equity market (with the S&P500 being my proxy for the “equity market”). Since then, the equity market has sea sawed 7% down in May and 7% up June to date, now in sight of new all-time highs. The volatility has primarily centred around the China trade talks and the economic outlook.

With the 10-year US treasury yield now just above 2% compared to around 2.5% at the end of April, clearly market expectations have changed. At its meeting last week, the Fed highlighted an increase in uncertainties to the global economy and stated that “in light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion”. The market is loving the new Powell put rhetoric (he does seem to be overcompensating for the year end 2018 “error”) and some are taking language such aswe will act as needed, including promptly if that’s appropriate” to mean multiple cuts this year, as many as three this year have even been advocated. Equity markets seem to be missing the point that multiple rate cuts will mean the economy has deteriorated rapidly, with a recession a real possibility. Hardly a reason for all time high equity markets!

There’s also the issue of the Fed’s current benchmark rate of 2.25% to 2.5% which is not exactly at normal economic boom levels given it historically has taken cuts of 3-4% to reverse recessionary slowdowns. Powell may be counting on the shock therapy of an early and relatively large cut (50 bps?) as an antidote to any rapid worsening of the trade war with China (or the outbreak of a real war with Iran!). In such an outcome, it is inevitable that talk of QE will re-emerge, providing yet more distortion to this millennium’s crazy brand of monetary policy.

A whole host of other things are bothering me – I highlighted high valuations on the hot business software stocks (here), Slack’s valuation (now over $18 billion. It had $135 million of revenues last quarter!!), a bitcoin rally, the fantasy-land UK conservative party leadership contest (the UK used to lead the world in the quality of its political debate, how did it get to this?), and, last but not least, the Orange One and Iran and well everything else to do with Trump. Sorry, that turned into a bit of a rant.

And so, we come to the G20 meeting of the world’s greatest leaders this week. Maybe it’s my mood but I found myself agreeing with the analysis (here) of Dr Doom himself, known as Nouriel Roubini to his friends. Roubini highlights three possible scenarios on the US China talks – an agreed truce with a negotiated settlement by the end of the year, a full-scale trade & tech & cold war within 6 to 12 months, or no trade deal agreed but a truce whereby tariffs agreed to be capped at 10% to avoid escalation. The third option is in effect a slow-burn trade war or a managed trade escalation.

I would agree with Roubini that either the first (but without the settlement this year) or third options are the most likely as both sides have reasons to avoid a rapid escalation. China needs time to prepare its economy for a prolonged conflict and to see how Trump fairs politically. Trump can portray himself as the John Wayne figure his man-child self longs to be in standing up to China and can pressure the Fed to stimulate the economy from any short-term impacts. Unfortunately, a managed escalation of a trade war is exactly like a managed Brexit. Impossible. You are either in or out. Have a deal or don’t have a deal. Could a grand deal be struck with this G20 meeting proving the turning point? Its possible but unlikely in my view (I’m referring to a real deal, not a fantasy/pretend deal). I hope I’m wrong.

Against this backdrop, forgive my lack of insight into the current collective wisdom of the market but an all-time high equity market makes little sense to me. And that’s me being polite.

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”.