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By Stewart Richardson on 03/12/17 | Category - Equities

To view a PDF copy of this report, click here.

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.

By Stewart Richardson on 04/06/17 | Category - Equities
To view a PDF copy of this report, click here. 
We were on the road in Switzerland this week, and as we travelled along the northern shores of Lake Geneva, the view across to the French Alps is simply stunning. Many market commentators will describe markets via analogies such as "we're in the 8th inning" and our view of the mountains has inspired this week's analogy on markets.

According to Wikipedia (emphasis is ours);

"The death zone is the name used by mountain climbers for high altitude where there is not enough oxygen for humans to breathe. This is usually above 8,000 metres (26,247 feet). Most of the 200+ climbers who have died on Mount Everest have died in the death zone. Due to the inverse relationship of air pressure to altitude, at the top of Mount Everest the average person takes in about 30% of the oxygen in the air that they would take in at sea level; a human used to breathing air at sea level could only be there for a few minutes before they became unconscious. Most climbers have to carry oxygen bottles to be able to reach the top. Visitors become weak and have inability to think straight and struggle making decisions, especially under stress."

So the Death Zone is extremely dangerous, humans struggle to survive there unaided for more than a very short period and have an inability to think straight. 

Chart 1 (courtesy of Bank of America Merrill Lynch) shows an old favourite metric for measuring the value of US equities. We say old favourite, as this was the metric that Warren Buffet remarked in 2001 "is probably the best single measure of where valuations stand at any given moment". As can be seen, the US equity market, by this measure, is at the second highest (most expensive) level back to 1970 (actually in history, but the chart only goes back to 1970).

Chart 1 - US Equity Market Cap relative to GDP
The guys at Merrills have kindly pointed out that this metric will hit a new all-time high if the S&P 500 can trade to 2620 points which is about 7% above current levels. Quite frankly, we are amazed (and appalled) that the market is as close to the all-time bubble high valuation and significantly above the 2007 valuation level. Having invested through both prior periods, we struggle to rationalise how investors can sit here today have anything but the minimum exposure. How did we get here? The main reason is of course the trillions in liquidity that central banks have injected into the system along with zero or even negative interest rates.
In mountaineering terms, we are at 800+ metres altitude and entering the death zone. We know it is extremely dangerous to our health if we try and reach the summit, and unaided, we would probably only survive a few minutes. As in late 1999, we know that final move higher to the peak must be done as quickly as possible and we also know that the greatest number of fatalities have occurred in this zone. At the moment, we do have some help in the form of central bank largesse, however, this help is being slowly withdrawn. 

We suspect that many investors are not receiving enough oxygen, and they are displaying signs of being unable to think straight and make sensible decisions, especially under stress. That stress is either the fear of missing out or so-called career risk, which encourages investors to maintain exposure to equities as being in cash could lead to underperformance, and potentially the end of careers. Of course, many believe that central banks will provide an unlimited supply of oxygen, and that risks (despite all the historical evidence) can be managed quite safely. We have to point out that, after markets peaked in early 2000 and late 2007, the S&P 500 declined by over 50% on both occasions. The use of the word peak is very appropriate; markets simply do not hang around at these sorts of valuations for long. Just like mountaineers trying to scale Everest, the move to the peak and back down again is done as quickly as possible.

Regardless of whether central banks are removing policy accommodation, the US equity market is at extremely dangerous levels. We were clearly wrong in holding a bearish view in the last few weeks, but we limited our risk to a very small amount of our capital, and we fight to live another day. And with the major central banks meeting in the next two weeks, we will be able to get a sense of how much help to the system they are removing.

Last week's US employment report was a rather messy report. Although the unemployment rate fell again to 4.3%, indicating extreme tightness in the labour market, the number of jobs (especially full time) was disappointing and the labour force participation rate fell again as more workers dropped out of the labour force. Overall, we thought it was a poor report, although not bad enough to stop the Fed from raising rates on 14th June. The real news will be their guidance in terms of further rate rises and plans to reduce their balance sheet. We still believe that the Fed is intent on tightening in a steady fashion, and will likely keep going until something breaks.

Before the Fed meets, we have the ECB meeting this coming Thursday. Our view remains that Mario Draghi does not want to make any decision on tapering or interest rates at this time. Yes, he has to update us before the year end and we know that there are some of the ECB council who are more eager to remove accommodation than Draghi is. However, in recent speeches Draghi has sounded quite dovish. But this is all rather nuanced. Currently, the ECB still has an easing bias on interest rates, and so perhaps this is removed and any decision on tapering and rates is deferred to September.  Draghi may not even want to discuss policy removal at this meeting but, if they do, we suspect the market will take this as the signal that the normalisation process has started for sure.
What is interesting is that we are getting mixed messages from the markets. With bond yields in core Europe slipping again in recent weeks, is that a sign that bond investors are less than sure that the ECB is close to signalling the normalisation process, or is it a natural reaction to the softer than expected inflation data? FX traders on the other hand seem to be wagering that the ECB will pull the trigger next week. We, on the other hand are not so sure, but the situation is not clear. Let's start by thinking big picture, and look at a chart we used a couple of weeks ago in our bond market comments.

Chart 2 - US and German 5 year yields
As can be clearly seen in the lower panel, the difference between the US 5 year yield and the German 5 year yield is very close to historic highs. If you buy the US 5 year bond you will receive an annualised yield of 1.72% and if you sell the German 5 year bond you will also receive an annualised yield of 0.45% (as the German 5 year bond has a negative yield). So, assuming no yield changes over time, this long short trade will pay 2.16%.

It is our expectation over time that the yield difference over time will narrow, and so the return on that long short strategy we hope will be much higher than 2.16% annualised. We should be indifferent as to how the yield difference narrows, however, it is likely to occur in one of two ways. In a benign environment, the ECB will taper their bond purchases and lift the deposit rate out of negative territory, and it would be likely that German yields move some way back above zero. The alternative is likely less than benign in that the US suffers a recession (due to the Fed tightening until something breaks?) and cuts interest rates back to zero and prints more money.

As noted, for the trade to work, we should be ambivalent, but it is noticeable how the bond markets have completely given up on the Trump reflation narrative and that yields (especially at the long end - thereby causing yield curves to flatten) have been falling again. If we are right that the yield differential does narrow, this should be very important to FX traders. Chart 3 below shows the 5 year yield differential alongside the EUR/USD FX rate. Although the fit is by no means perfect, the two move together reasonably well over time. Currently, there is a bit of a divergence and the Euro is looking a bit rich compared to interest rate differentials.

Chart 3 - EU/US 5 year yield differential and EUR/USD FX rate
Chart 4 below shows the EUR/USD FX rate alongside the speculative positioning on the IMM data. Although the IMM data only captures a small per cent of the FX community, over time, it is not a bad representation of overall market positioning. As can be seen, net positioning has moved from a sizeable short Euro position at the time of the US election to the biggest net long position in the last five years, and in fact, the second biggest net long position since the financial crisis.

Chart 4 - EUR/USD FX rate and speculative position on the IMM
So we have a challenge at the moment. Although we can see why the Euro should be stronger against the Dollar over the longer term (as the interest rate differential narrows), we think that the Euro is overbought in the short term, and we worry that the long Euro trade has become too popular with the fast money crowd. We would also note that one of our sentiment indicators has moved from only 15% bullish on the Euro at the recent low in early March to 81% as of last week, also indicating a short term crowded long Euro position amongst small traders.

To try and wrap things up here, ahead of the ECB, we think that the FX market has become a bit too optimistic on the Euro and we would not be buying it up here. Of course, if Draghi lays out an explicit path to ending QE and raising the deposit rate, then we have to expect the Euro will move higher. However, Draghi has been reasonably dovish in his recent public statements, and with the recent decline in core inflation, we just don't think he is ready to pull the trigger on normalisation at this meeting. We will be looking to buy Euros on a pullback to the 1.08/10 area given our bigger picture view, depending on what Draghi does say on Thursday.

As for our broken record message on US equities, we can only watch with growing incredulity as the market scales bull market heights that have only ever been seen once before in history. The air up here is very thin indeed, and unhealthy for us mere mortals. Yes, progress is being made with the help of central bank oxygen, but this help may not last as the market embarks on the last leg up to the summit. In any event, we know the last two times that markets were scaling such valuation heights, after the peak had been scaled, the way back down was fast and furious ending with two 50%+ bear markets. For our part, we have chosen to not even try and scale the summit; we don't think the central bank oxygen supply ever really got into our oxygen tank and in the big picture, we think the potential downside is much greater than the upside.

By Stewart RIchardson on 28/05/17 | Category - Equities

To view a PDF copy of this report, click here.

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

If there is anything different this time, we think it is the dramatic (and in some respects understandable i.e. low fees) shift to passive investing. Every bubble in history starts with a decent story, is super charged by loose monetary policy and ends with investors acting irrationally as they jump aboard blind to the price they are paying. Back in 1999, the most extreme example was investors valuing internet companies on how many hits their website received even if there was barely any revenue. In 2007, it was the housing bubble and financial leverage that was ignored. Today, investors are buying passive index funds purely on the basis of low fees and an extrapolation of past index returns into the future. They do not consider the valuation metrics of the companies in the index. 

Chart 4 below, again courtesy of John Hussman, shows the median price to revenue of S&P 500 companies. Whereas the aggregate measures show that the market is not quite as expensive as it was in 1999, that period was skewed by ridiculous valuations for a small group of stocks, whereas many old economy stocks at the time were not that expensive. Today, all stocks are expensive, there is nowhere to hide, and anyone who is holding a bullish view just because the aggregate measures are not quite as expensive as in 1999 deserves to be handed their head.

Chart 4 - Median price/revenue of S&P 500 companies
Our simple view is that US stocks will undoubtedly influence the direction of most other markets. If we are right that a bear market is coming for US stocks it will be very difficult to make money in other geographical areas. That said, European stocks and Emerging Market stocks do offer better value for long term investors than the US. Chart 5 below shows the estimated 7 year real returns for various assets as predicted by GMO (who have a great long term track record in forecasting long term market returns – as an FYI chart 6 shows their forecast returns as at February 2009; what a difference a bull market makes!).

According to GMO's work, no asset today offers returns anywhere nears the long term historical average, but Emerging Market stocks do offer the best value.

Chart 5 - GMO predicted 7 year annualised real returns
Chart 6 - GMO predicted 7 year annualised real returns as at February 2009

Frankly, we are not that convinced that the time is right to jump into EM or European stocks, and if we had to take a position, we would make a relative value play of being long those markets against being short US stocks. For most of the post 2009, this would have been a losing trade as US stocks massively outperformed. However, US stocks are losing relative momentum and we think that the tide is turning. Chart 7 below shows the US relative to Europe and Emerging Markets. As indicated, it appears to us that US stocks are no longer outperforming Europe. And against EM, a break below the shelf of support probably ushers in a period of EM outperformance.

Chart 7 - US stocks relative to Europe and EM
So to wrap things up in terms of our views on equity markets. We believe that the US is in its third bubble in the last 20 years, and that the post 2009 bull market is maturing fast. Although we think that investors should be at their minimum weighting already, we suspect we have to wait until later this year before markets begin to really see any meaningful downside pressure. Bull market tops normally take time to build, and so we should expect a period of back and forth (building volatility) in the months ahead before the bear market really takes hold. Charts 8 and 9 illustrate the topping process for the S&P 500 at the end of the last two bull markets. 

We need to be patient whilst a topping process plays out, and for the most part, we will be looking to take bullish positions in selected non US markets (e.g India where we hold a small exposure) whilst looking to establish bearish US exposure when we believe the market vulnerabilities are increasing, as we think they are today.

Chart 8 - The 2000 topping pattern

Chart 9  - The 2007 topping pattern

By Stewart Richardson on 27/11/16 | Category - Equities
To view a PDF copy of this report, click here
With equity investors jumping on the Trump bandwagon, pushing the S&P 500 up by 3.5% since just prior to the election, we thought we would share some of our long term, bigger picture thoughts on equity markets.

The vast majority of people seem to think that the wealth of a nation can be measured by the performance of the stock market. This is in some respects understandable, as the media forever come up with headlines linking economic performance with that of the stock market. However, the stock market is simply the price that we pay for owning the underlying wealth generating assets. Price can change because of a very small trade whilst the performance and value of a company barely changes on a day to day basis.

So, what is the wealth of a nation? Can it be measured accurately? And how can investors profit from owning a share of that wealth? John Hussman (who really is a must read for those who want a good perspective on market valuation and the fundamentals that matter) describes the wealth of a nation as;

"Broadly defined, [the true wealth of a nation] includes a nation's accumulated stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, inventions, organizational knowledge and systems), and its endowment of basic resources such as land, energy, and water".

Shares quoted on the stock market obviously tap into some or all of these resources in some way, and a well-managed system that encourages, incentivises and protects its wealth will deliver prosperity. Fail to encourage productive investment at every level, and you'll find an economy in long-term decline.

In our opinion, the US has been poorly managed in recent decades (as have many advanced and emerging economies). Yes, we have seen periods of rapidly rising share prices, and we have also seen periods of great technological advancement. However, there is no doubt that productivity has been extremely poor, especially post GFC and the three major bull markets of the last 20 years that have been supported if not encouraged by central bank policies. Now that a Trump presidency appears set to offer a different outcome from the status quo that has dominated for a decade or two, the question is whether his policy mix will increase the wealth of the nation, and if so, how can investors benefit from this.

Back to one of the questions posed earlier, can the wealth of a nation be measured accurately? The simple answer is - no it can't; not with the available data. Although we could try and build a sort of balance sheet and hold assets such as housing, capital goods, factories and public infrastructure at say book cost or fair value but how should we value intangible intellectual capital and basic resources. We have not ever seen this attempted, and so economists have come up with a short cut known as Gross Domestic Product. This is how we measure the size of an economy, and although we know that it has many flaws, it is the best short hand we have. Now that we can define wealth, and accept that GDP is a crude short hand for measuring the wealth of a nation on an annualised basis, we need to understand how the value of the stock market relates to GDP, and how investors can profit from the wealth of a nation.
We have shown this indicator a few times in the past (the so-called Buffett indicator). Chart 1 below from John Hussman shows the market cap/GDP in blue (inverted). It also shows the subsequent nominal annualised total return over the following 12 year period in red. The correlation between the two is extremely high at over 90%. With the current reading of market cap/GDP at its third most extreme in at least 100 years of data, we should not expect future returns to be anything but below average. Yes, if Trump manages to generate a much improved economic outcome, we have to believe that the returns from holding equities over the next 12 years will be better than the 2% predicted by this model, but probably not by much.

Chart 1 - Market cap/GDP and subsequent 12 year nominal annualised total returns
The reality is that we do not expect Trump to generate meaningful improvement in the performance of the US economy. He is likely to spend money on infrastructure and lower the headline corporate tax rate, but unless he encourages productive private capital formation, improves the educational base of the workforce and manages the basic resources of the country better, any improvement will be modest and won't affect the expected market returns.

Here, we would like to introduce a chart from Crestmont Research that we may have used before. Chart 2 below shows the S&P 500 and, in the lower panel, the price to earnings ratio of the market using 10 years of data. Crestmont have separated out secular bull and bear markets, defined as movements in the P/E ratio rather than price. Investors should be acutely aware of the price they are paying as measured by the P/E ratio in this example. This chart really does show that it pays to be involved in the market during secular bull markets and it's best to avoid equities in a secular bear, even though price may not actually fall from the peak P/E to the trough P/E.

Chart 2 - The Crestmont P/E chart
So, intuitively we think that investing into equities for the long term makes sense, but really what we should be thinking is that investing into equities for the long term makes sense when the price to earnings ratio is at or below average. However, when the P/E ratio is at the expensive end of the historical range as it clearly is today, even though we are arguably 16 years into the current secular bear market, returns are very likely to be sub-standard. To attack this from a slightly different angle, rather than divide historical returns into secular bull and bear markets as Crestmont have done, chart 3 below (courtesy of Lance Roberts at Real Investment Advice) shows the rolling 20 year REAL returns from US equities and the cyclically adjusted P/E ratio or CAPE.

Chart 3 - US equities rolling 20 year REAL returns and the Cyclically Adjusted PE ratio (CAPE)
What is obvious from this chart is that peak valuations follow on from periods of strong price appreciation, and vice versa. What really fascinates us is that history shows that there have been quite long periods when 20 year rolling real returns have in fact been negative despite the widely held belief that equities are the best long term investment. What is less obvious from this chart is that after three of the strongest post WWII bull markets in the last 20 years, REAL returns have been just a little over 5% annualised, and that's the good news. With valuation extremely rich, and the likelihood that we are still in a secular bear market (as described by Crestmont), we can't really expect returns over the next 10 to 20 years to be above average.

From our thinking, Trump is unlikely to deliver an economic miracle and unlikely to create an environment in which the true wealth of the nation grows at a faster rate than that seen historically. Even if he does, investors are paying a very high price to participate in the equity markets. Historically, it is best to assume that annualised nominal total returns over the next 12 years or so will be barely positive, and real return over the next 20 years will be modest, perhaps even negative.

This is not to say that there will not be opportunities to get bullish in the years ahead, but to be so from either a cyclical or secular standpoint, price has to fall considerably. How much could price fall by? According to the market cap to GDP model, in order for potential future returns to be in the 10% area, the S&P 500 will have to fall by between 40% and 55%. To be able to offer the opportunity of greater returns, price would have to fall even further, and if that were to happen, the cyclically adjusted P/E ratio would decline to a level that would indicate the start of a new secular bear market.

Of course anything can happen in the short term. The current momentum in the market could carry the market higher in the weeks and months ahead which would no doubt delight traders. However, investors really do need to consider whether being invested into equities today is going to generate the returns that they are expecting or hoping for in the next 10 to 20 years. Frankly, we think that buy and hold investors will be extremely disappointed by future returns, and are likely to endure a bear market similar in magnitude the 2000/2003 and 2007/2009 declines.

What is different from the previous two bear markets is that there are no obvious alternatives to equities. Whereas bonds and cash both offered yields of over 5% in 2000 and 2007, today the yield is nearly zero for cash and not much more than 2% for a well-diversified portfolio of government and corporate bonds issued in US Dollars. So, with prospective returns likely to be very modest from all mainstream assets in the years ahead, we continue to believe that investors need to think about style diversification instead of asset class diversification. Although there can be no guarantee of success, managers who have a more flexible trading style may well generate better returns in the years ahead than those generated from a buy and hold position, and with perhaps less risk. 

However, what seems rather perverse to us is that ETF flows indicate that the average punter is investing into index funds like never before, and arguably locking into a buy and hold strategy at possibly one of the worst time in the last 100 years. It appears to us that passive investors really are just focusing on the upside whilst forgetting that bear markets do come and go. To illustrate just how frustrating the passive approach can be if an investor buys at the end of a bull market, we have calculated the total nominal returns from a peak to peak perspective (i.e. a whole cycle of a bear market and the subsequent bull market) from March 2000 to Oct 2007, from Oct 2007 to the present, and also from March 2000 to the present

Peak to Peak annualised nominal total returns

Equity Market

Mar '00 to Oct '07

Oct '07 to Oct '16

Mar '00 to Oct '16













This peak to peak type analysis (and yes, we have assumed a peak right now, but just for illustration purposes) illustrates that the buy and hold approach does generate positive returns, but once costs (albeit relatively small in a passive Index) and inflation are taken into account, the returns look pretty miserly especially when an investor has to live through a very painful bear market during a full cycle.

So, to try and wrap up. Although the market seems very content to buy into the Trump reflation narrative, our suspicion is that his policy mix will not improve the US' economic performance over the long-term, and the "wealth of the nation" will continue to grow in line with historical trends. The price that investors are paying to get exposure to the wealth of the US is extremely rich today for those who profess to be long-term investors. At best, this group needs to manage their return expectations as the next 10 to 20 years are likely to be disappointing (as the last 16 years have!). For those that can be patient, and are happy to wait out the current bullish market narrative, we fully expect much better opportunities in the next few years to invest with the potential to generate high single digit of even double digit returns. These opportunities will be seen after a significant decline in price and P/E ratio. 

By Stewart Richardson on 07/02/16 | Category - Equities
Equity markets certainly decided to look at the negatives from the US employment report released at the end of last week. That does not happen in bull markets.
On the surface, and ignoring a few inconsistencies, the employment report was not bad at all. The problem is that employment is a lagging indicator (coincident at best) and so does not tell us anything much about future prospects for the economy.
To be fair, it is obvious to every economist that employment has been the bright spot within US data for some time. Yes, we can all question the quality of the jobs created (and we do) and point out that the unemployment rate itself has been flattered by a collapse in the participation rate. But at the end of the day, employment growth has been strong. In our opinion, this leads many to claim two false premises; first, that with the unemployment rate so low and wage growth picking up, the US economy cannot possibly suffer a recession. And second, as consumer spending makes up around 70% of the economy, and with decent employment and wage growth, a US recession cannot be imminent because the consumer is doing well.
The chart below shows the year on year percentage growth rate in the number of employed persons. As can be seen, employment growth peaks and starts declining well ahead of recessions (as indicated by the red arrows). Now, the deterioration has been quite mild so far, and so many will claim that it is far too early to ring the alarm bells. That may be true, and so we really need to understand what drives job creation, and what may happen in the next few quarters.
Chart 1 - Annualised growth rate in the number of persons employed
To try and dispel the two myths noted above, we would point out that the most volatile domestic component of the US economy is business investment, as shown in chart 2 below. The data for the chart is nominal rather than real, and what is interesting is that Personal Consumption Expenditures and Government Spending have only once dropped into negative territory on this basis since WWII. What this data is really saying is that with business investment being the most volatile component, although it may only be a small part of the GDP calculation, it is in fact the driver of changes in GDP.
It is the swings in business investment that determine weak or strong growth. We therefore believe that those who are looking at consumer spending to have a view on the US economy are in fact looking in the wrong place. They need to look at what drives changes in business investment to determine whether the economy will be strong or weak.
Chart 2 - Year on year changes in the major domestic components of US GDP
So, what drives changes in business investment? Well, as chart 3 below shows, it is the change in corporate profits. When profits growth is strong, companies will invest more which is great for the economy and creates more jobs (and therefore gives consumers more money to spend). When profits fall, companies will reduce capex and reduce the number of people they employ.
Chart 3 - Business investment growth and corporate profits growth
Now, on the way we have calculated corporate profits for the chart above, profits growth is only just dipping into negative territory year on year; hardly a disaster. However, the simple year over year number is now down by over 5%, as seen in chart 4 below. Of course, the profits performance can give false signals as seen in 1986 or be very early as seen in Q4 1998. However, we believe that if profits continue to decline, then we will soon slip into recession. If only we can predict corporate profits in the future!
Chart 4 - US Corporate Profits (y/y %) versus GDP
In chart 5 below, the blue line shows corporate profits after tax as a percentage of GDP - a simplistic measure of profit margins. The orange line shows the subsequent 4 year annualised profits growth. The message here is that profit margins post the financial crisis jumped to record levels, and we do not believe that this represents a new paradigm. Because profit margins are mean reverting, high profit margins are followed by both lower margins and lower (or in the current case negative) profits growth.
Chart 5 - Corporate profits as a % of GDP and subsequent 4 year annualised profits growth
We have previously made the case that executives focus far too heavily on managing earnings and trying to boost their share prices. We aim to speak about this at more length in a separate note, as we believe that this has become a structural headwind for the economy. Why do executives focus on boosting share prices? Because the vast majority of their compensation is in the form of share options.
What this means is that companies are substituting capital with labour to boost production. Capex actually hurts short term profits (although benefits profits in the long term) and management would prefer to use cash flow to buy back shares. We believe that this short term focus by management helps explain why low paying job creation has been strong in recent years (substituting labour for capital). Management are incentivised to boost share prices even though this may in fact be hurting their companies potential long term performance.
It appears to us that a period of weak profits in the quarters ahead (as indicated in chart 5) is baked in. If this happens, then because of the warped management incentives that companies now have, executives will do everything they can to boost profits, which ultimately means reductions in capex (business investment) which is the swing factor between growth and recession. Furthermore, executives will have to cut jobs (how many companies announce job cuts and share buybacks in the same set of results?) which will ultimately impact consumers.
So, at the margin, we believe it is a combination of contracting profit margins that are baked in, together with warped executive incentives and already negative profits growth that are the best indicators to watch at the moment. In fact, given this set of circumstances, the single best indicator to watch is the equity market itself. If we were executives of a large US company, knowing that we would personally gain the most from our share options if the share price was high and rising, the most troubling item in our daily/weekly management meetings would be a falling share price. If the share price was falling, we would feel compelled to cut back on all costs including capex and wages in order to try and boost the bottom line and convince investors that our shares were worth more.
Collectively, if the equity market as measured by the S&P 500 is falling, will executives collectively sit there and do nothing? Or will they cut costs and risk collectively causing a recession? We think they will cut costs and risk causing a recession.
The chart below of the S&P clearly shows that share prices are falling. Investors are worried about falling profits and the risk of a recession. This becomes a vicious circle and the next month or two could easily tip the balance. Momentum is clearly turning lower (the 40 and 80 week moving average crossover is a decent trend indicator of bull and bear markets), and further earnings and macro disappointments could easily encourage further selling by investors. Indeed, data shows that all investor groups (institutional, hedge funds and retail) have been net sellers in recent years, and it is only the buying of companies themselves (and up until recently reserve managers and central banks) that has supported share prices. Declining profits and lack of access to bond markets will severely impact corporate cash flow and end the buyback mania, at which time equities may be extremely vulnerable.
Chart 6 - S&P 500 weekly with 40 and 80 week moving averages
So, apologies for the length of this report, but we wanted to explain a little of why we think that a recession is more likely than many believe (although this view is clearly gaining popularity). It is the link between share prices and executive compensation to decisions on business investment and jobs creation that will drive changes in growth of the economy. Share prices have only levitated in the last couple of years because of aggressive share buybacks funded increasingly by bond issues.
Companies are finding it harder to fund buybacks with cheap bond issuance and with share prices now falling, it appears the game is up. Executives either slash costs to generate cash to buy shares which will be self-defeating, or they focus on long term investment and stop buying shares. Neither outcome is desirable for share prices.
Our analysis indicates that equity markets in the US and likely globally are very vulnerable and the Fed is unlikely to raise rates this year. We expect high quality bonds to perform well and the US Dollar is likely to remain quite mixed. The next few months hold the potential to be extremely volatile and central banks may move to even more extreme policies despite the reality that current policies do not appear to be working as they would like. We fear that it is time to really batten down the hatches. 

By Stewart Richardson on 14/11/15 | Category - Equities
Given the tragic events in Paris on Friday it may be hard to remember that it was an ugly week for equities, with developed markets down by 2-3% and emerging markets down by 5%. Other risk assets fared badly too, with high yield bonds down about 2% on average, Copper down about 2% and WTI Oil down about 8%. After the October rally, markets either had to pause for refreshment if the bull market was still intact or they would roll over to the downside, adding weight to the argument that a new primary bear market began in the Summer.

Warren Buffett once said "only when the tide goes out do you discover who's been swimming naked". This refers to what happens during bear markets when all of a sudden it becomes obvious not only which companies have either been fraudulent (Enron in 2001). It also refers to those companies where perhaps aggressive accounting technique or "balance sheet management" helped boost share prices in the good times but clearly to the detriment of shareholders in the long term.

In our opinion, the likelihood that a primary bear market began in the Summer is high, and after last week's across the board declines in risk assets, a lot higher than the week before. Market lore tells us that market tops are a process, and part of that process is the creation of divergences during which fewer and fewer indices, sectors and stocks participate in each new rally to new highs. What is particularly worrying at the current time is that only one major index made a new high in the recent rally. The topping process has been going on for over a year now, and the new high in the Nasdaq 100 appears to have been the last gasp in a dying bull market.

Chart 1 below shows the performance of major indices over the last 12 months. There are a few comments to make here. First, as noted above, the Nasdaq 100 was the only index to reach new high ground post the Summer correction. Second, aside from the Nasdaq, every other major US equity index is lower year to date and over the last 12 months. Third, broad indices like the New York Stock Exchange Composite, and more cyclical indices like the Dow Jones Transportation Index are lagging badly, which is a bearish sign.

Chart 1 - Performance of Major US Indices
It has been widely reported that the FANGs have been leading the market higher. Some have even been painting the FANGs as one decision stocks; when do you buy because they are only going higher, just like the nifty fifty in the late 1960s and tech stocks in late 1999. When the market begins to focus so narrowly on what has become seen as one decision stocks, the likelihood of a major market top increases. The FANG stocks are Facebook, Amazon, Netflix and Google (now known as Alphabet).

The FANGs began to crack on Friday, which should be seen as a very worrying development, because when the last holdouts cave in, there are no high flyers left to capture the imagination. On Friday, the FANG stocks fell by 3.8%, 3.5%, 4.8% and 2.2% respectively; more than the broader Nasdaq which fell by 1.5%. These stocks trade on 12 month trailing P/E multiples of 103x, 904x, 265x and 32x. Only Google is on anything resembling a reasonable valuation. The others are speculative investments at these levels and it would appear that they are now at risk of leading the market lower.

We said above that the topping process has been going on for over a year. By saying this, we are referring to one of the best indicators for measuring the health of the corporate sector. In the chart below, we show the S&P 500 (in green) along with the spread between junk bonds and US Treasuries (in red) between 2007 and mid 2009; the period covering the Global Financial crisis. The theory is that both should rise and fall together as they simply reflect different parts of the capital structure of the corporate sector. 

When times are good, investors will be happy to hold both the equity and the bonds issued by companies. However, with the return from bonds being asymmetric (the return is capped by the coupon but you could lose 100% of your capital in the event of default), investors in corporate bonds have historically started to sniff out problems way ahead of equity investors. Conversely, they also spot opportunities before equity investors around important lows, and as the economy is about to improve, thereby improving the ability of companies to service their debts. This indicator has a good track record of diverging at important turning points in the equity market cycle. 

Chart 2 - The S&P 500 (in Green) and Junk Bond Spreads over US Treasuries (in red) 2007 to 2009
We have updated the chart to show the current position in chart 3 below. As can be seen, junk bond spreads peaked in June 2014 and have under-performed during the recent rally.

Chart 3 - The S&P 500 and Junk Bond Spreads over US Treasuries 2012 to Present
Further evidence of the narrowing leadership can be seen in chart 4 below illustrating the S&P 500 along with the cumulative number of stocks advancing less stocks declining. In a healthy bull market, more stocks should be rising than falling so that the advance/decline index rises alongside the equity market. However, at bull market highs, headline indices are pushed higher by a diminishing group of momentum stocks that capture the public's attention (often lauded by the Mainstream Media).
As can be seen, the advance/decline index peaked in May three months before the market began to fall in Late August. During the October rally, the advance/decline index has resolutely failed to fully participate and is peeling away again now.
Chart 4 - The S&P 500 with NYSE Cumulative Advance/Decline Index
We believe that the technical evidence set out above is compelling. The US equity bull market was entering its frail dotage in the post Fed QE world in 2015. Although a few glamour stocks propelled the Nasdaq 100 to a new post Summer high, the majority of stocks have been in a primary bear market for some time now. If the glamour stocks are finally cracking (and we really don't understand why some investors are paying P/E multiples in the hundreds for these stocks), then the risk is of an accelerating decline in the months ahead.

Of course, the post 2009 market environment has been massively distorted by central bank policies of zero rates and money printing. Can global stocks really go down if the ECB and Bank of Japan are still printing aggressively? It appears to us that European and Japanese stocks are beginning to dance to the drumbeat set by US/Global equities and less than that set from the printing presses. 

The Fed have boxed themselves into a corner and markets are now working against them. Already, the NYSE Composite, Russell 2000 Small Cap and Dow Jones Transportation indices are below the levels set at the time of the September Fed meeting. The Vix index closed at 20.08 last week compared to 21.35 ahead of the Fed meeting. US real and nominal bond yields remain elevated around the same levels seen at the time of the September Fed meeting. 

There is four weeks until the December Fed meeting at which they are universally expected to raise rates. If financial conditions deteriorate further in the weeks ahead, the Fed will feel in a very uncomfortable position indeed.

One last comment before we wrap up. Post the US employment report and strong Services sector ISM report of two weeks ago, we sensed that investors collectively began to believe in the US economic recovery. However, we continue to believe that the post 2009 recovery is very mature and leading indicators continue to be soft. Although most indicators are not flashing recession yet, we can easily see how this could happen. With the intense corporate focus on the bottom line, mostly via financial engineering, an equity bear market will be the event that tips the US into recession. 

The main reason we can foresee this is that companies have leveraged their balance sheets to buy back shares, thereby making themselves more vulnerable in the event of a recession. We fully expect that companies will cut jobs and capex in the event of a bear market thereby hurting the economy. In fact, this process looks very circular indeed. The worse the economy, the more pressure on corporate cash flows, the more they cut jobs and capex. As cash flow dries up and bond markets baulk at financing debt for buybacks, the more vulnerable the equity market is.

In chart 5 below, we show the NYSE Composite along with New Orders for Capital Goods (Capex) and weekly jobless claims. The historical pattern is clear. When stocks go down, management cuts capex and jobs to try and improve the bottom line. With corporate debt so high, a new recession would impact revenues and therefore the ability of companies to service their debt. It is the combined performance of equities and bonds that is so important to the economy, and it is the strength of the economy that is important for the health of a very leveraged corporate sector. This is a very circular situation which is not healthy in our opinion.

Chart 5 - US Equities v. Capex v. Jobless Claims
To conclude, we believe that equity markets entered a primary bear market in the summer. The process began more than 18 months ago with the under-performance of Emerging Markets and then high yield bonds. This is akin to Warren Buffet's tide going out, and there are a few notable examples (IBM and Macy's) where financial engineering simply hasn't worked. Other examples of naked swimmers are being seen in the Biotech sector where high profile names are down more than 50% and in the Technology sector where previously popular names are under are also down more than 50% (Twitter and GoPro).

The advance from the September low looks to be the last gasp in an aged and frail bull market. Risk assets are under pressure despite ultra-easy policies around the world. If we are wrong, then perhaps equities can continue sideways to higher for a few more months/quarters. If we are right, then traditional portfolios will struggle as they did in the late Summer. Furthermore, we believe the risks of a global recession escalate in the event of an equity bear market, and there is little that central banks can do to help with the tools they are currently using.

For those who took no action in the Summer and who are worried of a rerun of the August/September market meltdown, then they should be using the October rally to reposition their portfolios. We have added to some bearish equity positions this past week and will remain structurally bearish so long as the Summer highs remain unbroken.


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RMG Wealth Management LLP is authorised and regulated by the Financial Conduct Authority (FCA). These reports are for general information purposes only and do not take into account the specific financial objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed.