Chart Of The Week
Turn on financial television at any random time, and you’re likely to soon hear the argument that still-high U.S. stock market valuations are “justified” by extremely-low interest rates. We’ve countered that these low U.S. rates are simply a reflection of the secular slowdown in economic and earnings growth.
With May Day marches and demonstrations cancelled, the workers of the world have one less opportunity to remind us of the ever-widening wealth gap and the evils of the “Top 1%.” It’s a shame, because this was the year that we active managers would have stood shoulder to shoulder with those protesters voicing our own contempt for the “Top 1%”… of the S&P 500.
We view the coronavirus pandemic as the final straw that tipped an already vulnerable U.S. economy into recession, rather than the watershed event that will change the way we view growth, profitability, and even the nature of work itself. But even economic “optimists” like us need to recognize that the recovery back to last cycle’s earnings peak will be a long and grinding one. There’s a good chance that the four-quarter trailing S&P 500 GAAP Earnings Per Share cycle peak of $139.47 will not be exceeded until 2023 or 2024 (Chart 1).
Market momentum now seems to outweigh simple math in the minds of most investors, and we are not entirely immune. Today our tactical funds are positioned with net equity exposure of 50%, the midpoint of the normal 30-70% range. That’s a higher allocation than if we considered only business cycle dynamics and equity valuations.
An occasional critique of our valuation work is that we consider “too much” market history to form a judgment as to what constitutes “high” or “low.” This type of feedback declined during and after the financial crisis (when historic valuation thresholds were temporarily revisited), but it has become more pointed as the U.S. market has soared to new highs.
This year’s upswing in money-supply growth has been one of many factors that’s prevented our economic work from triggering a recession warning. Following a two-year decline, year-over-year growth in M2 bottomed near 3% late in 2018 and has trended upward all year, reaching 6.7% in the latest week (Chart 1).
With promised breakthroughs on Brexit and the trade war miraculously occurring on the same day, few pundits now believe the market is anywhere close to an important peak. (A peak in the S&P 500, that is, since peaks occurred long ago in the ACWI, MSCI Emerging Markets, NYSE Composite, Value Line Arithmetic, S&P MidCap 400, and the Russell 2000.)
The Momentum style—in which investors buy what has been going up recently—represents an optimistic, hopeful, “I’ll take some of that” mentality. The Low Volatility factor entails a pessimistic, fearful outlook in which investors want (or need) to stay invested in stocks but desire downside protection in case the market performs badly.
This week’s massive stock market leadership flip has certainly remedied some of the breadth weakness we discussed in this month’s Green Book. But we can’t help wonder whether the move is analogous to performing a transplant on a 95-year-old. The patient might survive the surgery, then die while under anesthetic.
Will this economic cycle end with “fire” (overheating) or “ice” (a whiff of deflation)? Interestingly, hedges against both outcomes have performed well in recent months, with both gold and Treasury bonds spiking. For many reasons, though, we believe the U.S. expansion is more likely to end in a deflationary bust.
Factors provide investors with the ability to shift their portfolio’s characteristics to fit a particular economic and market outlook. Value might look appealing under one set of conditions while Quality might be more desirable in another. We developed a research platform that analyzes various drivers of factor returns, summarized in Exhibit 1.