Despite a bounce in risk assets in the last two weeks, February has been pretty brutal for many investors. Yes, losses are a lot less than those seen at mid-month, but long term confidence in markets is quite poor. We have had many meetings recently with investors to discuss the recently launched RMG FX Strategy UCITS fund and we get the impression that not many investors believe that valuations are attractive enough to be committed bulls in either bonds or equities (please see HERE for details on the fund). We also get the feeling that a growing number of investors are increasingly worried that Central Banks are nearing the endgame for policy stimulus and may have actually created some nasty unintended consequences with their unorthodox policies.
As we write this commentary, it looks like the G20 meeting in Shanghai has come and gone without any meaningful policy debate. What a waste of time and taxpayer money most of these shindigs are! Looking ahead into March, we have an ECB meeting on the 10th, the Bank of Japan on the 15th and the US Federal Reserve meeting concluding on the 16th. Having been incredibly dovish back in January, everybody is expecting a lot from Mario Draghi. Indeed, there are some who think he will deliver a “nuclear” attack on deflation. Expectations are for no change from either the Fed or the Bank of Japan, but we think there is a chance that the Bank of Japan may cut rates further into negative territory. We’ll come back to central banks below.
On Friday evening the Financial Times ran with an article, “Momentum matters as earnings estimates go from bad to worse”. In the article, the FT notes that, on Thomson Reuters estimates, earnings for the S&P 500 fell by 3.7% year on year in the fourth quarter of last year. To top that, downgrades to Q1 2016 have been simply dreadful. At the beginning of January, the consensus had it that Q1 would see earnings for S&P 500 companies rise by 2.3% year on year. Eight weeks later, the consensus is expecting earnings to fall by 5.7% in Q1. This is a truly stunning deterioration in such a short space of time.
The deterioration is not confined to the US, as estimates for the MSCI index have plummeted by 12% since last summer. However, the earnings picture may be even worse than this, so the article says, as the numbers quoted above are of the pro-forma type, or as the Soc Gen team call them, “made up profits”. Investors should really use GAAP earnings as they are “generally accepted” rather than made up by companies themselves.
The FT asks what the difference is, and says the following; “Companies are treating management bonuses and recruitment costs as one-off expenses, even though they are part of the true cost of business. The same is true of regulatory and litigation expenses, and M&A fees. Sometimes, even the effect of currency moves is excluded.” Seriously, how can any investor rely on pro-forma numbers ahead of GAAP numbers?
According to the article, using GAAP earnings, US profits have been falling for five consecutive quarters rather than three when using pro-forma. Furthermore, pro-forma earnings are some 29.5% higher than GAAP earnings, a gap that was last seen in 2007 (gulp!). To top it all off, on GAAP earnings, the S&P trades on a P/E multiple of 21.5 which the FT points out is a level only seen near bull market peaks such as 2007 (double gulp!).
We have long been of the view that in a bull market, companies are able to “find” ways of boosting earnings on a pro-forma basis, and investors simply don’t care as they are making money. This process was, in our opinion, exaggerated by QE from the Federal Reserve which allowed companies to borrow excessively in order to buy back shares which boosts earnings per share (and the share price of course!). However, in a bear market environment without QE, the game is very different. With the gap between pro-forma and GAAP earnings near record highs, and economic growth disappointing, the recent and stunning deterioration in earnings guidance from companies is a sign that they have no more magic tricks to deliver.
We also believe that the financial engineering chicanery is ending. How long can a highly leveraged corporate sector keep issuing bonds to buy back shares? Not much longer, but record buyback announcements and higher investment grade bond issuance in Q1 could well be a last hurrah for financial engineering which is arguably the only reason that US equity markets continue to levitate and outperform its global peers.
As well as analysing fundamental data that we believe are the drivers of markets, we also try to understand that markets can remain irrational far longer than we would expect. So we have to watch price action and determine the probability that prices will go up or down. We have continued to make the case this year that the path of least resistance in equities will be down, albeit that two weeks ago we did say that markets looked very oversold and some respite was likely. Although the bounce (in the US in particular) has been a bit more fast and furious than we expected, we continue to look for a sell signal. Here is our thinking, and apologies to those who consider technical analysis a form of voodoo investing;
Chart 1 – The S&P 500
We believe that US equities are at a critical juncture. The bullish argument is that the market is forming a “W” pattern just as it did last Autumn. If this scenario plays out, then we can expect the market to approach or even exceed the all time highs. However, some of the best setups we use is when price looks like it is breaking out and then fails. The case today is that the S&P looked like it was breaking out on the upside in Friday’s trading, but by the close, had given back the day’s gains and closed down on the day. To confirm the bearish signal, we need to see the market close down on Monday.
Of course, all trading setups have a point when the setup fails, and in this case, it would be above Friday’s high of 1963 on the S&P 500. We have also highlighted back in October a pattern that looked bearish (ie a failed break out followed by another down day) but was quickly proved wrong. The point to make here is that we may be in the process of a bearish reversal or we could be on the bullish leg of a “W” pattern. For our part, we are taking the bearish view this weekend and will be happy to admit we are wrong if the S&P 500 trades above 1963. With our bearish structural thesis very much in place, we believe that it is right to look for bearish setups to trade with, and with our stop only 0.75% above the market, and the recent 1800 lows likely to be seen in a bear market (and more!), the reward/risk ratio looks to be very attractive.
We would also point out that a number of commodities and Emerging Market currencies generated bullish failures at the end of the week, such as Oil, Copper and Silver in commodities and Mexican Peso, South African Rand, Turkish Lira and Singapore Dollar in EMFX.
When we see bullish failures across a number of risk assets, it increases our confidence that the bullish failure signal in US equities is valid. In an interconnected world, these bullish failures indicate to us that most risk assets are turning bearish again after a couple of weeks of respite. If we are wrong, then we guess the reason will be excitement about more central bank stimulus. Perhaps a “nuclear” attack by Draghi against his deflation nemesis will get the bullish juices flowing again. However, the recent market reaction to the BoJ’s move into negative rate territory, alongside increasingly negative remarks from both fund managers and investment banks about the efficacy of QE and negative interest rates, indicates to us that any bullish central bank euphoria could be very short lived.
So, as we close out February, we see a bearish setup in many risk assets, and have a very close “stop” that will alleviate those bearish signals. But let’s not get carried away if markets do move higher. Central banks are losing credibility fast, global growth has slowed to stall speed and corporates earnings estimates are being hacked back. Structural problems remain evident in Europe and China, policymakers at the G20 are simply not prepared to do anything, and EM problems continue to mount. As Shakespeare wrote, “beware the ides of March”.
Stewart Richardson
Chief Investment Officer
