Blue Skies Are Here Again
Financial markets are hitting on all cylinders this week as we are finally seeing coherence among risk assets. European and U.S. equities are gapping higher with numerous indexes hitting all-time records, government bond markets are resuming their tailspin as credit spreads tighten, the dollar index is falling, and gold miners and the VIX are plummeting. Risk is back on…in a big way. Political risks have receded with clarity following the first round of the French election, Trump is still talking a good game with his insistence on a 15% corporate tax rate, and markets are only focusing on positive earnings announcements. It would seem that markets are taking a page from Willie Nelson’s lyric book:
Blue skies smilin’ at me
Nothin’ but blue skies do I see
Bluebirds singin’ a song
Nothin’ but blue skies from now on
I never saw the sun shinin’ so bright
Never saw things goin’ so right
If things are going so right and we’ll have nothing but blue skies from now on, why do we feel so distrustful of financial markets? One reason is that, knowing that equities climb a proverbial “wall of worry”, we are reminded that a blue skies scenario also means that markets are assuming that risk has abated. Investors should recognize that their expected return on an asset is directly linked to the risk undertaken. This is why the expected return on a 3-month T-Bill is many times inferior to the expected return on a biotech start-up’s stock. If buying equities today entails relatively little risk, future returns should be proportional. Why has the risk environment changed? Several reasons: (1) the election/referendum uncertainty over the past year has been lifted; (2) there is a general perception that central banks will maintain a steady hand under risk assets; and (3) few doubt that earnings of U.S. companies will be bolstered by the Trump economic miracle.
The second reason for our distrust is the selective emphasis that markets are placing on news items. As we detail below, markets are seemingly disregarding, or underestimating, geopolitical and economic events unfolding.
In the first section of this Commentary, we review several signs that markets are foreseeing less risk on the horizon. Again, paradoxically, this abatement of risk is not typically a good omen for future returns of risk assets. In the second section, we give our assessment of risks being overlooked by the markets today.
Party Like Its 1999
The spread between the French 10-year OAT and the European benchmark German 10-year Bund has contracted rapidly this week. What French election risk?
When crap floats. Italian 10-year debt is now yielding 2.29%, Spanish 10-year debt is at 1.68%, and even slimy Greek 10-year debt is down over 150 basis points this year to 6.43%. Recall that safe haven U.S. 10- year T-Notes are yielding 2.33% at the moment. Thanks Mario Draghi. Let’s keep massively mispricing risk and see where this experiment ends.
Among European equity indexes, the German DAX has kicked off the festivities by breaking out to new all- time highs. If it’s the mode in the U.S. to push equities to all-time highs, Europeans are likely to emulate, as always, the example set by Americans.
Our U.S. equity/government bond spread shot up this week and is essentially back to all-time highs at 1.53x. We wouldn’t exactly say that today’s levels represent a generational buying opportunity for U.S. stocks. But until the 200-day moving average in the chart below turns down, few will understand that today is likely a generational selling opportunity.
The Nasdaq Composite has closed above 6000 this week. What tech bubble?
More proof that equity valuations are still attractive. The Cyclically Adjusted PE Ratio (CAPE Ratio) introduced by Robert Shiller is still under 30x. The historical median P/E of 16.12 is no longer relevant thanks to central banks, right? No need to worry about valuations until the CAPE ratio gets up to 45x.
Of course many strategists made the “easy call” to predict more volatility in 2017 (a more palatable prediction than calling for an equity correction). Wrong again.
When you think that the market is going to rise, you double down and make leveraged bets. Margin debt-to- GDP is the poster child for complacency regarding risk. A generational buying or selling opportunity for equities? Each investor must decide for him/herself.
Finally, with U.S. credit spreads sitting at 9-year lows, who can refute the blue sky scenario that markets are relaying?
Say What ?
Our Top-10 list of 2017 “head scratchers”.
- Markets rallied this week on the good news that a pro-European candidate will win the French election. Phew, there won’t be a Frexit. Markets welcomed news that the integrity of the European Union will remain intact, with equity indexes soaring on Monday. Sort of like when markets decided that Brexit and the risk of disintegration of the EU wasn’t that bad an option either. Go figure.
- The whole North Korean stand-off is either a big charade that will fizzle out when Trump invites Kim Jung-il to Mir-a-Lago to play golf….or an enormous example of the parochial forward-looking vision of financial markets. It’s hard to belief that, if military action is imminent in North Korea, that neither bond nor equity markets seem to have priced in this risk.
- The U.S. dumps 60 Tomahawk missiles into Syria, without the backing of UN Security Council, and the S&P 500 rallies +1% the next day. We still believe, if Kim Jung-il manages to drop a nuclear bomb on a U.S. city, that the Dow will fall 2% to 3% (at which point dip buyers will rush in since Congress will authorize more Federal spending for the war effort).
- The list of Trump-failures in the first 100-days keeps growing (immigration ban, wall with Mexico, border tax, healthcare reform), yet markets have no doubt that Trump’s tax plan will glide through Congress this year. However Trump’s plan to slash the corporate tax rate to 15% is setting up a showdown with House Speaker Paul Ryan, who has called for a tax plan to pay for itself. A rate that low would make it difficult to find ways to increase revenue or eliminate deductions to offset it, meaning that the plan wouldn’t be revenue-neutral, or permanent. Can markets really not care that the plan is sustainable? More short-term gains for long-term pain? As Speaker Ryan stated, “you can’t completely redesign the budget tax system for nine-and-a-half years, and then flip it back in 10 years”. In sum, there are only two options here (1) Trump gets his 15% tax rate and blows open the federal deficit (long-term negative for financial markets) or (2) Trump will run into a problem with Congress over his budget and something other than the 15% rate will be compromised upon (short- term negative for financial markets). No need for a PhD in economics or political science to call this one – this whole tax plan will prove to be a lose-lose proposition for investors from today’s asset price levels.
- Speaking of the Trump agenda, wasn’t his protectionist trade policy supposed to be detrimental to free trade and the global economy? Wall Street and the financial media have buried this potential risk.
- Markets are really counting on Trump’s promise to deliver 4% annual U.S. GDP growth, as shown by the ratio of U.S. market cap-to-GDP ratio. Of course a boastful Trump will insinuate that lots of great things during his term, but it is for each investor to decide on the reality of the new president’s promises. The odds of not seeing 4% GDP growth over the next couple years are in fact very high….making the chart below very vulnerable should be denominator not accelerate in a big way.
- Valuations in general. Is Wall Street and the financial media playing some Jedi mind trick on the investing public? “No, valuations are still reasonable given the blue sky economic landscape. We continue to recommend that you buy equities at current levels”. Check out the spread between the S&P 500 price and S&P 500 aggregate EBITDA per share. Pretty soon we’ll be able to drive a truck through this gap.
- Wait, didn’t the Federal Reserve say something about beginning to reduce the size of its balance sheet this year? Meaning less liquidity. Meaning that a liquidity-driven bull market will be losing its mojo. Nah, let’s forget this risk. If the Fed ever begins shrinking its balance sheet, financial markets will, of course, react in an orderly manner.
- Company insiders are buying their companies shares at the slowest pace since 2009. But what do these Bozos know about the potential upside for equities. Party on!
- Is sentiment extremely optimistic, still pessimistic, or somewhere in between? Our Market Sentiment Indicator is mildly optimistic. The Investor Intelligence measure suggests we are closer to an optimistic extreme. Or does sentiment even matter, as no one has a clue what is happening in financial markets today?
Conclusion
After 35 sessions of downward consolidation from the March 1 st high on the Dow Jones Industrial Average, in just two sessions this week Bulls brought the index back to all-time highs at 21,000. Few doubt in the blue skies scenario being scripted by Wall Street. To be sure, the sky is not falling…yet. But before getting too comfortable, remember that equity markets have always topped out as risks evaporate while the economy gets portrayed as solid. The stock market cycle always leads the economic cycle, a fact to keep in mind as we celebrate the blue skies this summer.
