What a stunning few days in the local and global equity markets, with the combination of earnings confirmation and central bank actions driving very high levels of stock specific and index volatility.
Don’t get me wrong, stocks like Telstra (TLS), Sydney Airport (SYD), Transurban (TCL), Treasury Wine Estates (TWE) and Baby Bunting (BBN) have done wonderfully for my portfolio, but it’s time to consider the overall picture of where markets are.
After a period of pretty subdued volatility, it seems pretty clear to me that the next few months are going to be a bit of a bumpy ride and we need to be very certain of where we are invested.
I have been writing that it’s a very important two weeks for Wall St and the Australian Securities Exchange and that has turned out to be accurate.
This all begs the question: is it time to sell in May and go away?
Let’s firstly look at the S&P/ASX200 where, after the rate cut on Tuesday, the index hit what would be classified as “valuation resistance” in terms of 12 months forward P/E ratio. The chart below from Morgan Stanley depicts the situation clearly.
This is interesting because, as you can see above, this has historically been the top of the range with an average 27.6% PE de-rating from hitting this level to the next trough based on the four times we have hit this level in the last 16 years.
I would have to agree that on pure forward earnings based P/E ratio valuation, the S&P/ASX200 does appear capped around 5300 at the index level. Unless we see major positive earnings revisions to FY17 numbers, which at this moment in time seems unlikely, I think the S&P/ASX200 as an index will struggle to break through that valuation resistance.
Of course, it’s a market of stocks not a stock market, that is why I will remain invested in the growth stocks I like (which you read about in these notes), but take index protection out against my Australian investments. I do think it’s time for some index protection against Australian holdings, but that is a tactical position I will take rather than a structural one after the index has bounced almost +10% in quick time.
Earnings and valuation fears
According to Thomson Reuters, at the July 2015 peak last year, the S&P 500 was trading on a 12 month forward PE of 17.12 times. Subsequently, the S&P slumped 12% over earnings and valuation concerns, prompted by a raft of negative issues. However, after a double bottom at 1870, the S&P miraculously recovered to close near the year’s high with a strong end-of-year rally.
At the start of 2016, however, valuation fears resurfaced again and the S&P fell a further 12% in a savage Jan/Feb sell off. Once again, valuation fears proved to be the catalyst, with March quarter earnings forecast to fall 8.3%. If realised, this will mark four consecutive quarters of declining earnings. The last time this occurred was in the GFC from June 2008 to March 2009.
Lazarus recovery for US equities
Amid a loud chorus of bearish sentiment, the Feb meltdown was viewed by many as the second leg of a new equity bear market. Or so it seemed? In the meantime, another stunning, Lazarus-like recovery has seen the S&P surge nearly 15% from the Feb 10 low to the recent peak of just over 2100.
As the chart below shows, before last week’s 1.5% correction, the S&P 12 month forward PE was trading at 17.82 times or 4% higher than the level, which prompted last year’s sell off. To be sure, equities are expensive with the forward S&P PE trading at a 19% premium to the 25-year average.
What has changed?
While US earnings continue to deteriorate, some of last year’s fears have subsided. The Fed has backtracked from an earlier forecast of four rate rises, to just two for this year. A weaker US dollar has supported a dramatic rebound in the oil price, which has recovered 65% from the Feb low.
The Chinese government has implemented another large credit-fuelled fixed asset investment program. The stimulus is working, with recent data providing confirmation of an economic recovery, especially for the housing sector. Elsewhere however, US, European Union and Japanese economic data remain mixed.
Is the rally sustainable?
The reporting season has been disappointing, with many industry leaders posting weaker earnings on significantly downgraded forecasts. The prime example has been Apple, which reported earnings of $1.95 versus expectations of $2.00. This compared to $2.31 in the prior corresponding period. In addition, tech heavyweights Alphabet (Google), Microsoft and Intel have all suffered 10-15% falls after weaker than expected results.
The first FactSet chart below shows the widening gap between US earnings and equity prices over the last few years. It’s clear that S&P earnings plateaued in 2014 and speculation of an earnings recession appears well justified.
The second chart shows the significant gap between Q2 16 earnings forecasts and equity prices, as analysts further downgrade 2Q 16 estimates. Certainly, it’s difficult to expect further price gains driven by PE expansion rather than earnings growth.
Bond yields vs earnings.
Despite an obvious “earnings recession”, elevated equity valuations remain supported by multi-decade lows for bond yields. In turn, low bond yields are a product of a benign inflationary outlook and a low growth environment.
Indeed, the latest CPI reading confirmed that inflation remains very low by past standards. In addition, last Friday’s US GDP reading revealed 2Q annualised economic growth at just 0.5%. While 1Q GDP figures are seasonally weak, all the recent data suggests the US economy remains fragile. As such, the Fed failed to provide any guidance on the timing of any rate rises.
The implication is the Fed “put” remains in place for equity investors. Once again bad news is good news. Are investors becoming complacent again? Prior to last week’s fall, the VIX had declined to 13.4, near the Aug 2015 low of 12.5. It’s worth noting this level preceded the Chinese equity meltdown last year.
Clearly, investor sentiment can change quickly. Recently, I wrote on the positive factors supporting commodities. At the time, negative sentiment was pervasive. Subsequently, the resource sector has staged an impressive rally.
I’m not sure whether investors will continue to look past deteriorating earnings growth, and equity markets will remain supported by the Fed and low bond yields to subsequently make new highs. But I am certain of one thing. The outlook for US economic and earnings growth is uncertain. The strong equity market rebound and the VIX confirm that investors have become complacent to risk once again. That means volatility is set to return. In fact, volatility has proved to be the only constant since the end of the Fed’s QE policy. It’s time to be tactically cautious and I have taken out index protection against my US stock investments.
Broadly, it does appear things are lining up for sell in May to be prudent. More accurately, take some profits in May after a mighty bounce.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
