Michael Maehl: Well-performing stock market met with reluctance
Many indicators suggest skittishness unwarranted
Michael MaehlAugust 17th, 2017
According to the Wall Street Journal, “America’s largest companies are on pace to post two consecutive quarters of double-digit profit growth for the first time since 2011, helped by years of cost-cutting, a weaker dollar, and stronger consumer spending.”
Further, according to data from FactSet, second-quarter earnings have grown 10.1 percent. It added that the proportion of companies beating sales estimates is running well above the five-year average of 53 percent. S&P Capital IQ originally forecast earnings to grow by 6.2 percent.
July saw the S&P 500 up for the ninth consecutive month. It’s been positive in 16 out of the last 17 months. And the Dow has set new highs over 30 times this year so far—but you know what they say about past performance not guaranteeing future result.
Regarding investors, incomes are up at a 4.4 percent annual rate in the past six months compared to just a 2.9 percent pace for spending. Some claim consumers are in trouble, but the facts suggest otherwise. Consumer debts are at a record high in dollar terms, but so are consumer assets.
So, very good market news, all in all. Goldilocks-like, even. And yet, while many investors are participating in the bull market, I get the feeling that a lot of them aren’t happy about doing it either because they’re still waiting for the downside to hit in the form of a major market sell-off or are concerned about the overvalued commentaries.
That also could be why fund flows still suggest the strong investor preference for bonds over stocks has yet to reverse. Here’s what I mean.
Jason Zweig, writing in his Aug. 4 Wall Street Journal column, reported that in July alone—a month of multiple new market highs across indices—investors have pulled $17 billion out of U.S. stock mutual funds and exchange-traded funds, while adding $29 billion to bond funds. Further, since 2000, investors have worked against their own best long-term interests as they have withdrawn $500 trillion from U.S. stock mutual funds. That’s a market in which millions of small investors have been selling, not buying. Euphoria hasn’t left the building. It hasn’t even arrived!
Bonds? Really? They’d best not listen to Alan Greenspan, who, as the former Federal Reserve chairman, has some awareness of how the markets work. He’s now warning of a bond bubble.
“By any measure, real long-term interest rates are much too low and therefore unsustainable,” Greenspan said in an interview with Bloomberg on July 31. “When they move higher, they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.” The phrase “not discounted” basically means it’s not priced into the investment yet.
Our low volatility readings have prompted rampant speculation around an “inevitable mean reversion.” Whereas high readings on Wall Street’s so-called fear gauge, the VIX, have been reliable buy signals, the opposite isn’t the case. Low volatility historically says little about the direction of future stock returns.
I believe we’ve been getting an overabundance of focus on how complacent the markets have been. It’s true that the S&P 500 hasn’t had a 5 percent pullback since July 2016. That’s the longest such streak without a minor market correction since 1996. The VIX, which is a supposed to be a measure of implied or expected volatility, is at or near its lowest levels in history. So?
Those are just facts, not indicators or predictors of anything in particular. There’s nothing inherently bearish about all-time highs. In fact, all-time highs tend to be followed by even more all-time highs. That’s because, on average, forward returns are positive after all-time highs. Even better, and as noted by recent market action, record highs tend to occur in periods of lower volatility. Since 1900, the Dow’s volatility on all-time high days was less than half of its average of all days.
Complacency is one of the issues the financial media is all over right now. The other is their continued reference to the S&P’s cyclically-adjusted price-to-earnings ratio (aka, CAPE) which is currently around its historically highest levels. The CAPE is a widely followed valuation metric developed by Nobel Prize winners John Campbell and Robert Shiller. Let’s look at what this is based upon, in order to help you better understand what the talk is all about.
For many years now, the CAPE has been used by the media as their default measure to suggest that stocks are overvalued. In his Aug. 7 Monday Morning memo, FirstTrust economist Brian Wesbury observed that in August 2013, with the CAPE at 23.4, the market was being called overvalued. Having made its all-time top at 44.20 in December 1999, the CAPE today is about 30.50, again generating more of the “we’re doomed” type commentary.
So, are we?
Caveat emptor, say analysts at Goldman Sachs. They pointed out recently that annualized returns on the S&P 500 10 years out were in the single digits or negative 99 percent of the time, when starting with valuations at current levels.
One big, basic flaw of the CAPE is that it uses a 10-year backward time horizon for earnings. As a result, it still includes the massive drop in earnings from 2008-09, skewing the results to the negative and painting what I believe is a consistently overly pessimistic view of the current stock market. All these comparisons will look better once those 2008-09 earnings reductions drop out of its 10-year earnings window.
But, say you do take the Shiller P-E (price-to-earnings ratio) at face value. The situation still may not be as bad as some claim.
According to Wesbury, going back to December 1999, the Shiller P-E’s 44.20 peak corresponds to an earnings yield of 2.26 percent. At the time, 10-year Treasury Notes were yielding 6.28 percent. In that environment, investing in Treasury securities was the better deal.
For stocks to be as “bad” as they were in May 2007, the 10-year note would have to be about 4.4 percent today—it’s about 2.2 percent now—which remember, even then didn’t mean bonds beat stocks.
BlackRock is the world’s largest money manager. Richard Turnill, its global chief investment strategist, speaking on CNBC on Aug. 3 said BlackRock’s capital market assumptions indicate that an “investment in global equities is expected to deliver a real return far in excess of holding an investment in cash over the next five years.” Reflation is alive and well, and encouraging economic stability across the world.
Their analysts said, “Our tracking of the global economy suggests we have entered a period of sustained above-trend growth. The current economic cycle, while unusually long and slow, appears to have ample runway. Our analysis suggests its remaining lifespan can likely be measured in years, not quarters. It is important to remember that periods of short-term market volatility are the norm, even in an economic expansion. We see no immediate red flags to suggest impending sustained market dislocation.”
Further, the corporate earnings picture is definitely improving globally. While share buybacks and cost-cutting helped move bottom-line growth in recent years, first-quarter sales growth in the U.S. appears to be the strongest in more than five years. Solid earnings and improving revenues, particularly among cyclical companies, are supportive of global growth.
We know that risk and reward are attached at the hip in the financial markets. There are very few opportunities to earn big returns without accepting some form of big risk.
But, it’s also true that there are many opportunities to accept outsized risk without receiving outsized returns.
Don’t confuse a lack of volatility with stability, ever. Daily price swings among sectors cancel each other out at the index level, one of the reasons that the S&P 500’s daily moves have lately remained historically quiet.
I can see no signs of either excessive optimism or pessimism in our markets today. While there’s no doubt this bull could stop at any time, investor euphoria typically present at tops of markets not widely evident. Consider the equity risk premium.
A positive equity risk premium—the excess return that investing in the stock market provides you above a risk-free rate, such as that from Treasury issues—suggests that a large number of investors remain skeptical about the ability of earnings to grow from here.
When investors have been confident and the economy strong, they’re willing to accept a lower yield from stocks because they expect to more than make that up with price appreciation. Today, we have the opposite. As a result, investors remain willing to accept the much lower return on Treasuries in exchange for what they see as safety.
Currently, the economic indicators suggest we still have room for growth in this market.
Interestingly, and despite misgivings by some about the current valuations, many strategists won’t tell you to change drastically your current asset allocation if it’s still compatible with your long-term needs and goals.
Michael Maehl is a financial adviser and Spokane-based senior vice president of Opus 111 Group LLC, a Seattle-based financial services company. He can be reached at 509.747.3323.