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Aon Retirement and Investment Blog

Not all bad for equities but support is weaker

Overview and Conclusion

A year ago, we argued that though US market valuations were high on a standalone or intrinsic basis, they might be able to persist at those levels[1].This was attributed to the market's continuing good relative value – i.e. its attractiveness versus bonds in a yield-hungry world. In other words, high standalone valuations for stocks were unlikely to create serious difficulty for the market so long as economic conditions and the profits backdrop stayed in reasonable shape.

Even after the recent weakness in stocks, the S&P 500 index has done well over the past year, currently up about 10% on year ago levels. Though last year's assessment was correct, we need to look ahead now and ask whether the market can continue to maintain this form. We address this question below by looking at what, if anything, over the past year has changed which may impact the market's fortunes. As before, we continue to regard the US market as the key bell-weather for global equities, as other markets are very unlikely to decouple into any serious downturn. 

Our conclusion, in brief, is that the market's support levels are weaker today. Even though a key valuation marker for the US market has looked better given strong recent earnings growth, overall, we see valuations as more of a problem now for reasons we explain below. This comes at a time the continuing longevity of this economic expansion is under question. Small disappointments can also become bigger market shocks given the extent of volatility trading. All is not bad, however. Many traditional bear market triggers are absent. From what we see it does not appear that large and sustained falls are near. 

Weighing it up, however, equity exposure de-risking does look reasonable to do if opportunity arises and affordability conditions are met. 

Are valuations now a sell signal?
A year ago, 10 year US treasury yields were hovering just below 2.3%. Today, they are some 70 basis points higher. This is a key reason why the US equity risk premium (the expected excess return of equities over bonds) has fallen. The bond/equity valuation picture is therefore clearly less good.  The US equity risk premium, by our calculations, is now within touching distance of its long-term average (see chart).  This is not a disaster by any means, but it does convey a message on the lower standing of one of the critical supports for equities in recent times, its attractiveness versus bonds.

How are the standalone valuations doing? There has been improvement in perhaps the most widely used valuation marker – the 12 month forward PE (Price-Earnings) ratio. This has fallen from almost 18x a year ago to some 16.5x times today and is less elevated against history than earlier[1].

A quick look at the other valuation markers shows, however, that this improvement has not extended to the other ratios in common use. Valuations still sit very much in the top quartile of history, and profitability (Return on Equity), though high by historic standards, is not quite matching those valuations. As we commented last year, if we took the dotcom period out as being clearly a 'bubble', these valuations are pushing up against the very top end of historic market levels normally seen[2].

It is true that the forward PE ratio improvement does provide some consolation. Earnings have indeed been doing well.  As the chart shows, the recovery in profitability since the 2015/16 slump has been pronounced. Given the long period of many years over which PE multiples expanded as the market rose by more than profits, this is a particularly welcome development. 

The first quarter 2018 has seen particularly strong revisions and upward guidance from a majority of US companies. This is reflecting strong domestic and international business conditions as well as successful business models such as for technology companies. A weaker US dollar has also helped support earnings though at the time of writing there is a mild strengthening trend. 

To summarise: We have some negative developments from the growing challenges bonds pose to equities. This sits alongside rather better news on earnings and profits, but the overall valuation picture is adverse. Taking both relative and intrinsic valuations together, our take is that the valuation picture is now clearly less good than a year ago. Further rises in bond yields or earnings disappointments could be an uncomfortable negative catalyst. 

Of course, valuations are only part of the story. What else could topple the market? A few other developments could do that and have played a role in previous bear markets. Here are just a few possible triggers of more deep-seated market weakness and turmoil and our view on them.
Could there be a recession or large economic downturn coming?
One threat to the market might come from an economic downturn that threatens corporate profits and margins. This could be a sharp slowdown, or more severely, a recession, that has typically knocked 20-50% off profits in the past. 

What are the probabilities of this happening? Economic forecasting, especially predictions of recessions, are much more art than science. There are model based predictions of recession probabilities, the best known being from the Economic Cycle Research Institute (ECRI). ECRI's readings are currently robust, so recession probabilities appear very low[1].

A market-based read of recession prospects which has had a good track record of calling trouble in the past is the slope of the yield curve between 2 and 10 years. Curve 'inversion', i.e. the 10 year yield moving lower than the 2 year yield, has historically been a reliable signal of impending economic difficulty. As the chart highlights, it is becoming concerning that the yield curve has flattened significantly, the slope currently at the low end of historical ranges and clearly flatter than a year ago. However, Quantitative Easing and Operation Twist, where the Federal Reserve has been involved in large purchases of bonds, sometimes with the specific intention of bringing down long duration yields has made the yield curve message muddier.  

As we have noted elsewhere, the recent failure of long-duration yields to rise much, even as quantitative easing reverses, has been something of a surprise. Recession clouds may not be very dense now, but the bond market is signalling something less than cheerful. What is it that the bond market trying to tell us? It could be signalling that the US Federal Reserve's rising short-term rates will slow the economy. With inflation now on the rise, amidst limited capacity slack, higher short-term interest rates are normal counter-cyclical monetary policy. However, higher rates and tighter money from the reversal of quantitative easing, could also be bringing the almost decade long economic expansion to a close if the economy struggles to withstand higher rates. Recent trade conflicts add to concern. All of this could explain longer-dated yields not moving much as investor demand for safety stays high.  

Against a year ago, we see higher risks of a material slowdown or recession for the US (and global) economy on a 12-24 month horizon. This is important to the market outlook, if not immediately, then over the next 12-18 months.

To summarise: the failure of long-duration yields to rise even as intermediate and short-dated yields move higher is a concern. There are more reasons, as above, to see the expansion phase of the business cycle as being at risk of ending. 

Is credit market behaviour signalling trouble for equities? 

In the case of most equity market peaks' (8 out of the last 9 to be exact), credit spreads have widened significantly (high yield spreads typically by greater than 100bp) at a time when the broader equity market has usually carried on rising. It is only later that equities have finally declined. In other words, credit has 'led' equities. Can we expect credit to do so this time?

Credit spreads have moved off their lows in recent weeks, but there is little sign of undue stress. We might have expected to see it in the differential between high yield and investment grade bonds reflecting a flight to quality. This picture is very benign now, the reduction in differentials seen after the 2016 energy-led difficulties in the high yield market still continuing. We can also look at the volatility of spread movements as a guide to market mood.  This, too, continues to decline. In other words, other than a marginal widening of credit spreads seen in the past few weeks, there is little indication of impending trouble. 

To summarise: The current state of affairs in credit is not signalling problems for equities. Looking ahead, we do expect some upward pressure on credit spreads. Going by historical experience, however, we need to see credit stress first before we worry about a major equity market upset. 

Could excessive optimism be a market forewarning?
Excessive optimism can be a troublesome issue for equity markets as it indicates too much herding on the bullish side, which can be a contrarian indicator. Too much optimism would equate to market danger. Pessimism may indicate a buying opportunity. 

Sentiment indicators abound. The American Association of Individual Investors publishes the so-called bull-bear ratio, a well-known one. In fact, just before the market volatility arrived in February, the sentiment score had moved to a high level (see chart). Several other such measures of investor optimism had also been high at the turn of the year. This read was a good contrarian selling call.

The problem with sentiment surveys is, that though they signpost some peaks and troughs, they will not help us differentiate between a market 'dip' and a proper bear market (i.e. market falls that exceed 20%). They are more of a trading tool.

The recent levels for this indicator are, in any case, in the neutral zone. Optimism has been shaken, but pessimism has not really taken hold either. Had it moved to a pessimistic stance, using the normal contrarian approach, this might have helped the market, but this is not so.

Other sentiment indicators are the opposite of a pro-equity stance. Retail flows have been much more focused into bonds than equities, over many years and institutional investors have sold. Only companies have been consistent buyers.

Excessive herding or optimism can also be indicated by a build-up of speculative leveraged bets on the market. Margin debt is the amount of debt taken on by leveraged margin investors. It has generally risen secularly as a ratio to market capitalisation, but was an indicator of herding in the lead up to the financial crisis (see chart, which also shows periods of large change). It is clear, however, that there is no large expansion of leveraged positions recently.

To summarise: Retail investors' elevated bullishness going into 2018 was a timely signal for the market sell-off and revival in volatility in February. Bullishness is not excessive at present. Flows have not been equity-friendly overall. In our view, flows and sentiment are, in fact, supportive for equity markets at present.

Is volatility trading a problem?
A related question is whether the extent of direct and indirect volatility trading is a problem in making a market downturn more likely. As well known, the activities of two exchange-traded volatility products (ETP's) that had a relatively small market value of about $3 billion was a factor in the transmission of higher volatility into large market declines in February.

The ETP's, however, understate the extent of trading related to market volatility. There is much more positioning these days among both institutional and retail investors around collecting the volatility risk premium (the tendency for realised volatility to be lower than option implied option volatility). The popularity of these strategies clearly does have potential to spill over into market activity when volatility shifts, as we saw in February.  Alongside, there is also the volatility-related trading activity of a number of strategies in the hedge fund arena, whether it is risk parity, CTA's or other strategies that base market exposures on volatility levels. 

To summarise: Quantifying the impact of these strategies is not possible. However, the decline in volatility, the long-standing rewards from the volatility risk premium and more volatility-associated market trading makes the market more vulnerable to technical shocks. Unlikely to be a market downturn trigger on its own, it can amplify declines by increasing the market's pro-cyclicality.

Is sector 'dispersion' providing a warning signal? 
We do not think this is the case. Heightened sector dispersion in valuations can indicate anomalies since it suggests too much herding in certain sectors. It did during dotcom. However, sector dispersion has been on the wane (see chart).

The case of technology's strong outperformance in recent years is often touted as an example of market excess. However, technology's run does not look and feel like a bubble – valuation ratios do not look very extended. There are some good reasons such as greater regulatory interference to believe that the technology sector's strength may ebb. However, this is not tantamount to saying that technology's change of fortunes will create the conditions for large and sustained market falls. Technology is not overly expensive, is throwing off good cash flow and there is no massive capex boom. This is not a re-run of the dotcom period.

Bringing it together
A year on, here is what has changed and where the main concerns and risks for the market lie. 
  • Valuation support is weaker. Relative value support has dropped. Intrinsic value is better on forward PE ratios, given recently strong earnings growth. However, the market is a little worse on other measures versus a year ago and it remains hard to get away from the overall picture of valuations being high.
  • Bond market signals are growth-pessimistic, warning of higher risks for the decade long economic expansion. There is now more reason to believe that the cycle is approaching an end, and it is clear that the market is now very sensitive to growth expectations.
  • A closer link between volatility levels and market support is providing a pro-cyclical bias to the market that is concerning. This may not itself be the trigger for market falls, but its demonstrable amplifying role is problematic. 
On the other side of the coin, some of the ingredients for trouble in past bear markets do not appear to be signalling danger at present.
  • Credit markets are behaving well to date, though this may not continue for long.
  • There is no excess optimism, and sentiment is, if anything, a market support.
  • Sector dispersion is not an issue
Our overall view is that the equity market is on shakier ground than a year ago. A bear market may not be imminent, but there is a stronger case for equity de-risking in portfolios today. What form this should take opens up another discussion which we will take up in another note on the topic.
Tapan Datta is the head of the Global Asset Allocation Team and is based in London. 
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“Content prepared for U.S. subscribers, but available to interested subscribers of other regions.”
[1] Businesscycle.com as of May 4 2017

[1] As before, we use the longest run of data available, which go back at least two decades.
[2] Past performance is not a guarantee of future results

[1] How expensive are equity markets…really? Aon, May 2017

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