My partner Owen Williams published this report for the week. Soon the Owen Williams Reports will be named the WMA Cara Reports as Owen and I integrate our services.
Have Equities Reached A New Permanent Plateau?
The current bull market was born in 2009 during an environment of gloomy pessimism and dirt cheap company valuations. Equity prices rose mainly on these two factors until 2011, which was marked notably by the European Sovereign Debt Crisis and the Standard & Poor’s downgrade of U.S. government credit. U.S. stocks, as measured by the S&P 500 saw their deepest correction (over -18%) during this bull market during the summer of 2011. After 2011, the investment world discovered that crisis period extraordinary monetary policy measures could be applied even after crisis periods. Investors found a new reason, other than traditional company fundamentals, to buy equities as investment slogans became phrases like “lower for longer”, “QE-forever”, and TINA (there is no alternative to equities).
With high unemployment and fears of deflation, the Federal Reserve adopted extraordinary policy measures as an everyday tool for stimulating economic growth, inflation, and full employment. As we now know, zero interest rate policy (ZIRP) and massive asset purchases have had little effect on inflation and job creation. Of course printing money is always inflationary, but as the Federal Reserve injected the new money into the economy through the purchase of bonds to drive interest rates lower, the Personal Consumption Index (PCE) has remained stubbornly below the Fed’s 2% target. Indeed inflation has occurred, not on Main Street (in the PCE measure), but rather on Wall Street (the S&P 500 measure). The Federal Reserve’s miss-targeted monetary policy nevertheless has been maintained (even dubbed as “successful” by Yellen), as the Fed fully understands the systemic risk to the economy should asset prices come down. Hence we have seen a nervous Fed back-track on promised rate hikes whenever a risk arises that could send equity prices falling (China growth, Brexit, run-up to U.S. election). The “success” of Federal Reserve ZIRP and asset purchases has now been emulated by the Bank of Japan and the European Central Bank (who took ZIRP a step further, as nominal rates in both Japan and Europe has gone negative, NIRP). In the last couple years we have entered a new financial world, a world of central bank administered financial markets.
Valuations: A Thing Of The Past
Many investors are frustrated by the equity market today as the paradigm has changed. Traditionally, value investors have scrutinized company financials and calculated various earnings metrics to uncover firms with undervalued stocks prices. Company fundamentals and the earnings growth outlook had been the primary driver of a company’s stock price, prior to the new role central banks have assumed in financial markets.
One very telling chart that we have been showing compares the EBITDA per share of S&P 500 companies to the index price. EBITDA earnings are less manipulated than bottom line earnings. We have seen in the past two business cycles that EBITDA/share tracks closely the S&P 500, with price showing a slight leading tendency.
The extraordinary divergence this cycle reflects stock prices rising for reason other than company earnings fundamentals.
A similar measure using operating margin (below) tells the same story. Something has indeed happened – earnings are no longer the principle driver of stock prices in today’s “new normal”.
Our belief is that company valuations no longer matter in a world of central bank controlled markets. If investors have truly become value agnostic, equity markets may indeed have reached a permanently high plateau. While this proposition seems preposterous based on old thinking, in a world where all-powerful and unchecked central bankers can resort to any means to pump up asset prices, the assumption of permanently high asset prices may be valid.
Learning To Live In Administered Markets
Investor have come to realize that the central banks can not allow the asset prices bubbles, that have resulted from years of inappropriate monetary policy and asset purchases, to burst. If the S&P 500 were to fall -20% from current levels, trillions of dollars of capital would be wiped out and the next severe recession will likely be triggered. The Fed knows this, banks know this, and now individual investors know this. Although this creates a tremendous moral hazard problem, it also places a floor on equity prices. Many have been expressing desire to buy more equities on the next pull-back. As a result, pull-backs have been limited to a drop of a few percentage points, with deeper declines also seeing the Fed and other central banks intervene to support markets (as seen in the summer of 2011 and early 2016, notably). Looking at the chart of the now second longest bull market in history (see chart below) reveals an interesting fact. We counted the number of “false starts” to the downside for all post-World War II bull markets. We defined “false start” as a pull-back of at least -5% on the S&P 500 which takes out the recent prior low before the price reverses up in a sharp V-shaped manner. In prior bull markets, “non-false start” corrections have been more prevalent, defined as either an ABC three wave down pattern or some consolidation at the level of the correction low.
Our table below compares our false start metric across prior bull markets.
The question we must ask is, why is there such enthusiasm to buy market pull-backs this cycle before any confirmation that the pull-back is ending or before any consolidation/basing period? Conspiracy theorists would say that “official purchasers” (such as a government or central bank) have been supporting drops in equity prices to support the post-crisis recovery. A more likely response is simply that investors, particularly high-frequency programme traders, have become conditioned to buy rapidly without asking questions. The mentality of investors living in central bank supported markets has changed. Knowing that asset price downside will be limited by central bankers, investors have no hesitation this cycle to quickly “take a chance” as soon as prices come off highs. Again, an endemic moral hazard problem has taken root. In sum, as long as investors believe in the ability and the will of central banks to support assets prices, we will have achieved a permanent high plateau in risk asset prices.
Investing In Administered Markets
Many have called this the most hated bull market. The reason is simply that the rule book for investing has been rewritten by central banks’ permanent zero or negative interest rate policies and ongoing asset purchases. This has been disconcerting to many seasoned investors who have previously sought to buy undervalued stocks with strong earnings potential. More savvy investors are having a particularly hard time this cycle knowing the degree of earnings manipulation taking place. First, company share buybacks are rampant this cycle, as companies borrow at inappropriately low rates and use this borrowed money to buy back outstanding shares. As the outstanding shares diminish, the reported earnings per share (EPS) automatically rise. Second, Wall Street systematically overestimates earnings each year, then revises estimates down throughout the year so that companies can “beat” earnings estimates. While this game is not new, it has been aggravated this cycle by ZIRP encouraging companies to take on debt to retire outstanding shares. As an investor, even if you realize that earnings are poor, you need to detach the decision of investing in stocks from the earnings reality. If you can not separate earnings from stock price performance in your head, you’ll just need to stay out of the markets.
Another lesson for investing in the new financial world is to change your assessment of risk. Cautious, risk-averse investors have been the big losers since 2009. Although managing risk had been prudent in the pre-central bank controlled world, today it an obstacle for your investing. While we don’t advise going all in with high beta stocks today, tempering down your caution will improve your portfolio performance in the future. Of course another pull-back in stocks will occur. However investors need to think of buying more aggressively during any future risk-off episode that we may see. Even if investors panic, in the new financial world you can rest assured that central banks will limit any significant downside in broad equity markets.
Conclusion
Risk assets in countries with central banks actively controlling financial markets have attained a new, permanently high plateau. Financial markets are integrally linked to economic strength, and as such central banks have unofficially adopted asset price stability as a policy objective. While this creates numerous administered financial markets strewn with problems of moral hazard, it is now the new financial world we live in. We see only two factors that could undermine our hypothesis of a permanently high plateau in risk asset prices within central bank administered countries. First, governments check the power of central banks to execute innovative, extraordinary monetary policy. A populist government, such as we expect with the Trump administration, may jawbone this idea, but we expect the complete independence of the Fed to remain sacred. The second risk is that investors lose confidence in the central banks to support financial markets. This is the greater risk that needs to be monitored. While many know that the emperor has no clothes (central banks do not have the fire power to support prices in an extreme event), as long as investors perceive that the central banks are holding a steady hand on financial markets, investors can remain serene during any future market pull-back.
