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, 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
Stewart Richardson
RMG Wealth Management.
