RMG Investment Bulletins
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As we head towards the end of 2017, we all naturally begin to think about the year ahead and what it may hold. For us, the real surprise in 2017 was the continued re-rating of US equities, in particular. Are investors discounting a Trump inspired surge in growth? What will the Fed and other central banks do next year, and will their actions have much impact in markets and the real economy? Less surprising is the current low level of global bond yields. With the ECB and BoJ still pursuing negative interest rates and large QE programmes, investors are being forced to reach for yield. But the financial repression is simply staggering. Will investors remain comfortable sat in these low/negative yielding assets if growth remains strong and monetary policy is tightened?
We are living in the most extraordinary period in financial history with equities, bonds and credit markets collectively more expensive than ever before (according to analysis from Goldman Sachs). The flipside of expensive assets is lower future returns regardless of short term economic outcomes and central bank policy making. Not only do investors have to ask themselves whether they are comfortable holding these assets for long time periods for close to zero or negative returns but they should also ask themselves whether the close to zero returns will be achieved with an increase in volatility in the next couple of years.
The trouble with predictions is, not only can they turn out to be wrong, but even if they are right, timing is a problem. Although we have great confidence in saying that US equities are basically at valuation extremes only seen in 1929 or 2000, and that returns over a 7 to 12 year period will be close to zero or even negative, what we don't know is when the current bull market will end.
The bullish narrative seems to hinge on financial conditions remaining easy, even though the Fed may be tightening. There is also a very strong momentum narrative behind the market, which has not suffered a correction of even 3% in over a year (something that happens on average at least every couple of months). We would also point to the continuing reach for yield as supporting the momentum narrative. At the moment, these factors remain supportive, however, we would argue that it is almost impossible for them to become even more supportive in 2018, and it is likely that they will be less supportive.
First, US financial conditions, according to the index compiled by Goldman Sachs, have only ever been easier in 2014, a time when the Fed was still printing money aggressively. Since the summer of 2014, the Fed have raised overnight interest rates four times, recently embarked on balance sheet reduction and 10 year Treasury yields are broadly unchanged. Now, we don't know exactly how Goldman calculates their index, but what we do know is that credit spreads and the US Dollar can also influence financial conditions (see chart 1 below comparing the US financial conditions index to investment grade credit spreads).
We have argued before why US Treasury yields and the Dollar should be higher in 2018. If we are wrong, we don't think they will be much lower. We also expect the Fed to continue tightening policy, and we think that credit spreads should widen. Again, if we are wrong on credit spreads, we struggle to see them much lower. Simply put, we doubt that financial conditions can get any looser in the US, and there is a strong case to say they will be tighter; perhaps quite a bit tighter than some imagine today.
Chart 1 - Goldman Sachs US Financial Conditions and Investment Grade Credit Spreads
As for market momentum, the last year it has been incredibly sustained, and without any meaningful correction. Chart 2 below shows the S&P 500 with the price to sales ratio in the lower panel. We have put a few markers on this chart. First, we have highlighted the fact that the market is now as expensive as it was in 1999/2000 on a price to sales basis. We have also shown how the market went through a topping process in both 2000 and 2007 before entering a bear market, and how a very similar topping process seemed to be in progress in 2015 and into early 2016.
Chart 2 - S&P 500 with price to sales
Just as financial markets seemed to be on the cusp of a new bear market in early 2016, central banks came to the rescue. The ECB cut rates in both late 2015 and early 2016 and extended their QE programme. Their language at the time was also extremely dovish. The Bank of Japan also cut rates into negative territory in January 2016 to complement their QE programme and was using extremely dovish language. The US Federal Reserve backed away from raising rates and became very dovish. We also had the Chinese authorities doing whatever it took to pump prime their economy and financial system.
This massive policy response has worked, in terms of boosting equity markets, and as shown by the post January 2016 trend channel drawn on the chart, the upside momentum in US stocks has been incredibly persistent. Indeed, the calmness that has descended on markets since Q1 2016 has been encouraging a large move into many similar momentum strategies, including those that increase leverage when volatility falls. To date, these momentum strategies have helped to create a virtuous cycle since Q1 2016, but for how long? These momentum strategies will need to sell if volatility rises, meaning trend followers will sell if the market actually does undergo a 3% to 5% correction; and that selling may create a negative feedback loop that quickly leads to a 10% correction.
So our point is this; financial conditions are likely to get tighter in 2018, and at some point, momentum will dissipate, perhaps even turn negative for a time. And so the simple question is, if/when this happens, with markets at their most expensive in history, US equities should finally enter a multi-month topping process similar to those seen in both 2000 and 2007.
A chart for US stocks that we show quite regularly is Chart 3 showing the Cyclically Adjusted PE Ratio, but with an adjustment for margins (which vary over time but historically have been mean reverting). Overlayed against this valuation metric is the subsequent 12 year annualised nominal total return for the S&P 500. The correlation between the two series is about 93%, which means it is one of the best models for predicting future buy and hold returns over a decent investment period. As can be seen, this model is currently predicting about -2% nominal total return per annum for the next 12 years. With the dividend yield about 2%, this means price falls by about 4% each year in simple terms. On this valuation model, the US equity market is more expensive than in 1929 and 2000.
The model is not perfect (no perfect model exists), and Hussman has highlighted three periods when market returns were visibly better than expected; 2000, 2007 and 2017. Of course, the first two coincided with historic market highs and before 50% bear markets. Frankly, we expect something similar to happen in the current cycle, with the worst of the bear market to be seen after a multi-month topping process.
Chart 3 - Hussman margin adjusted CAPE and subsequent 12 year annualised nominal total return for S&P 500
According to work by fund manager GMO, not only can we expect poor returns from US equities over the next 7 years, they expect poor outcomes for all assets. Chart 4 below shows their expected real total returns for various assets over the next 7 years. Only Emerging market assets are expected to generate anything like a positive real return, but even here, way below the long term average return from US Equities. What this chart is basically telling us is that we have a bubble in nearly all assets.
Chart 4 - GMO 7 year Asset Class Returns
We want to throw in a couple of sentiment charts here, because despite valuations metrics approaching record highs this year, we have both institutional fund managers and retail investors jumping into the market with both feet. Chart 5 shows that (according to the Bank of America Merrill Lynch Global Fund Manager Survey) there are a record number of fund managers taking higher than normal risk. So, these guys have recently bought assets and historically, the next step at some stage will be to scale back on risk by selling some assets.
Chart 5 - Record number of Fund managers taking higher than normal risk
These fund managers are taking more than normal risk, even though they recognise that equities are as expensive as at the all-time peak bubble period in 2000. Surely the next step, after either an event or more likely just loss of market momentum, will be for these bullish fund managers to de risk by selling assets?
Chart 6 - Net % of Fund Managers saying equities overvalued
As for retail, well they are ploughing more money into equities than at any time post 2007. Not only have they been buying ETFs, they have been buying US mutual funds. We point out this retail investor behaviour as, historically, retail investors have a habit of being very late to the party in bull markets, and then bailing out near the end of the bear market. Their current behaviour appears to be consistent with the thesis that the current US equity bull market is very mature indeed.
Chart 7 - Investor flows into US ETFs and mutual funds
So, we have very expensive global equity markets (the most expensive ever in the US), near record easy financial conditions and investors of all stripes jumping into markets in recent months. Can it get any better than this, and what happens if the trend changes? Investors seem to have forgotten what the last corrective period (in late 2015 and early 2016) was like. They don't seem to recognise that the rise in risk assets since early 2016 is almost exclusively down to ultra-easy central bank policies, and that these same central banks are moving to tighten policy now; with more to come in 2018.
Although we fully admit that it is impossible to predict the timing of any equity market top and reversal, we think the process follows the broad script seen at most market peaks. Central banks are taking away the punch bowl, and this will at some stage have an impact on both the real economy and financial markets. Corporate profits will be impacted if the real economy slows, and as financial conditions tighten the equity market will lose momentum.
The process of losing momentum in financial markets will lead to a 5% to 10% equity market correction, and deteriorating returns in credit markets. With many investors having recently abandoned all reasonable valuation methodologies, and become simple momentum investors and yield seekers, they will look to de risk after the market loses momentum and signs of profits slowing and credit spreads widening. This whole process will have the look of a market topping process similar to those seen in 2000, 2007 and also the aborted 2015/16 period.
If we are right that we are close to a multi-month topping process, the key question for all the momentum and yield seeking investors is how will central bankers react to a market topping period. Will they come to the rescue like they did in Q1 2016, or will they let prices fall?
We have discussed recently how central banks may struggle to repeat the Q1 2016 support package. If inflation is rising and above 2%, how can they reverse tightening and flood the system with liquidity again?
For what it's worth, we think that 2018 will be a much different year than 2017. It may not be apparent in the early part of the year, but we do expect a multi-month topping process to begin as central banks tighten policy and the corporate performance (which looks good today if you only look at earnings) begin to deteriorate. This topping process could be a messy affair and frustrating for both bulls and bears alike.
An alternative roadmap for 2018 also falls into the central bank policy error camp. Nobody can discount the possibility that equities continue to march higher in an almost straight line. This could happen if central banks continue to err on the dovish side of the ledger, and investors/traders continue to bid up prices in a simple momentum/reach for yield strategy. If this happens, we fear that it just makes equities even more expensive, and that ultimately the bear market will start from a higher level, but be even more severe to correct the ever greater over valuation. We see this as a lower probability outcome, but certainly not a zero probability.
To conclude, we have all the hallmarks of a very mature financial cycle, replete with extreme valuations, iterations of investor mania behaviour and now central banks removing the punch bowl. For those investors who are now simply following the herd, and sitting in risk assets waiting for the market topping process to be complete before selling, we fear that history is not on their side. Waiting for the optimal selling point is simply not practical, and history shows that the exit is extremely small if you wait for an obvious momentum sell signal to be generated.
We fully accept that the problem is different this time. In 2000 and 2007, investors could sell equities and credit, and hold cash or short/medium dated Government bonds and receive over a 5% nominal return. Today, all assets are very highly valued, priced for negative total returns for a decade or more, and yet cash yields are extremely low as well, probably negative in real terms, and perhaps nominal terms as well.
There really are very few obvious places to hide within a conventional long only world. We continue to believe that investors will be rewarded over time by diversifying into trading and relative return strategies, even if they have underperformed in 2017. So, as we approach the start of 2018, we would highly recommend that active investors who haven't already, start searching for those true diversifiers.
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The flavour of our equity market comments in the last couple of months have been focused on the US which we believe to be in the third bubble of the last 20 years. We have little doubt that investors will look back at the current period as a truly dreadful time to be invested in the broad US indices (yes, a nod here to the passive craze), however, our preference was for lower prices later in the year, and not necessarily immediately. As explained last week (Link here), we had taken some of our fixed income profits and bought bearish equity options as we think equity markets are due a decent pullback; one that should be the start of a major topping process.
For a day on May 17th, we felt quite pleased with ourselves as markets finally seemed to be waking up to the downside risks that we think are real. However, yet again the dip was bought and prices recovered quickly. Even though we have so far been proved wrong as our bearish options are losing money, our losses are capped to the amount of premium invested (paid for out of profits already booked), and our roadmap for lower prices later this year remains our base case. Let's start with the US and then spread the net more broadly.
At the moment, we all know that the leaders in the US bull market are the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix and Google). Broadly speaking, these stocks account for the majority of this year's gains for the US equity market, with many other stocks lagging quite badly. There is a saying that a rising tide lifts all boats, and when a small group of stocks is leading the way and many stocks are simply not participating, this should be viewed as a caution flag on the overall market.
Looking at the S&P 500 Index (shown in chart 1 below), it is clear that the trend has been up since the US election last November. What we think is interesting is that there is a clear momentum peak in early March when the index first traded to 2400 points. Since that time, price action was mostly sideways until the last few days when new high ground was reached. So far, the new all-time high price has not been confirmed by simple momentum indicators such as MACD and RSI. We also note that there are similar bearish divergences on the weekly S&P 500 chart.
So our point is that we have a momentum peak on March 1st and the current move to new price highs is looking a little tired. To try and highlight how the FAANG stocks have been almost the sole driving force for market gains since March 1st, we note that they are up collectively about 13%, the Nasdaq is up 7.37% and the S&P is up only 0.83%. In the negative column, the Dow Industrials are down 0.17% and the Russell 2000 is down 2.22%. And remember two sectors that were meant to be leading the reflationary charge post the election; the banking and energy sectors. Since March 1st, they are down 8.56% and 8.52% respectively.
Chart 1 - The S&P 500 Index
Other technical indicators that we monitor are flashing similar warning signals to the simple momentum indicators shown above. Chart 2 below shows the S&P 500 alongside the spread between high yield bonds and US treasuries and also the number of stocks listed on the NYSE that are trading above their own 200 day moving average. It is interesting to see that high yield spreads and stocks above their own 200 day MA both matched the performance of the S&P 500 into the momentum peak on March 1st, and since then, have failed to keep up.
Combined with negative divergence on simple momentum indicators, these measures of broad equity market health are flashing warning signals that the bull trend is maturing. In particular, we believe a deterioration in corporate bonds, as measured by their yield spreads over US Treasuries, should be taken very seriously by investors. One to watch.
Chart 2 - S&P 500 with HY spreads and NYSE stocks above 200 day MA
Taking a step back, what we think is really important to bear in mind here is 1) the maturity of the bull market which is now into its eighth year 2) the bubble valuations which indicate zero returns for buy and hold investors for up to 12 years 3) the maturity of the business cycle and 4) the fact that the Federal reserve is raising interest rates and historically they do so until something bad happens.
Chart 3 below is one we have shown many times, and is a chart of US market capitalisation relative to adjusted corporate gross value added (blue line) alongside subsequent 12 year total nominal returns from the S&P 500 (red line) - chart courtesy of John Hussman. Historically, the relationship between the two is extremely strong, and the prospective total nominal return for the next 12 years is as good as zero. So unless this time is different, which we very much doubt, investors are currently taking on all the risk that equities entail for zero prospective returns at a time when the health of the market is deteriorating and the Fed (who back in March noted how expensive equities are) is raising rates. This is simply not rationale investor behaviour.
Chart 3 - Market cap/GVA and subsequent 12 year returns
Peak to Peak annualised nominal total returns
Mar '00 to Oct '07
Oct '07 to Oct '16
Mar '00 to Oct '16
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