Why US equities need a trade deal
The Mark Twain character Pudd’nhead Wilson once stated: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”
The US stock market safely negotiated October this year, as the S&P 500 index gained 2% in the month and has kicked on again in November to reach a fresh all-time high. The Dow Jones Industrials and NASDAQ Composite have also surged to new peaks so investors with exposure to US equities have plenty to be thankful for as we approach the annual Thanksgiving holiday (28 November).
Market accidents are usually caused by the combination of rising interest rates, earnings disappointments and an economic downturn or recession, in conjunction with lofty valuations which provide no protection from this trio of challenges.
“The good news right now is that interest rates are falling, the US economy is growing and the third-quarter earnings season is almost finished, with positive earnings surprises outpacing negative ones by a ratio of 4.4 to 1.”
The good news right now is that interest rates are falling, the US economy is growing and the third-quarter earnings season is almost finished, with positive earnings surprises outpacing negative ones by a ratio of 4.4 to 1, according to research from Standard & Poor’s.
What could possibly go wrong? Well, Pudd’nhead Wilson would clearly still argue “quite a lot” and it is therefore worth checking each of those possible catalysts for a correction, just to ensure that investors can manage risk most effectively in the context of their own personal portfolio strategy, target returns and time horizon.
It is easy to pin the latest surge in US stock prices on Federal Reserve policy. The US central bank has cut interest rates three times this year and begun to intervene in the interbank lending markets, too, with a resumption of its bond-buying programmes. While chair Jay Powell is insisting this is not a return to Quantitative Easing, the renewed expansion of the Fed’s balance sheet would say otherwise. Its assets have just swollen at the fastest pace since the height of the financial crisis in 2008.
That means a lot of cheap cash is looking for a home and equities seem to be a logical choice for many, as price momentum is tempting and the 1.9% dividend yield compares favourably enough with benchmark US 10-year Government bonds.
Federal Reserve is running a fast-and-loose monetary policy once more
Source: FRED – St. Louis Federal Reserve database.
The economy, stupid
The US economy is still growing more than a decade into the post-crisis recovery and the third-quarter GDP growth number of 1.9% was steady enough.
However, it is worth noting that the Atlanta Fed GDP Now and New York Fed Nowcast services are forecasting an increase in the fourth quarter of just 1.0% and 0.7% respectively.
“[Forecasts for Q4 2019 GDP growth of between 0.7% and 1.0%] hint at a loss of momentum and raise the stakes for the trade talks between Washington and Beijing in particular.”
This does hint at a loss of momentum and raise the stakes for the trade talks between Washington and Beijing in particular, since the surge in the benchmark US equity indices is at least partly predicated on Presidents Trump and Xi reaching a settlement.
US economy seems to be losing some momentum
Source: FRED – St. Louis Federal Reserve database, Atlanta Fed GDP Now for Q4 2019 estimate
That apparent slowdown may be weighing on corporate profits growth, too. Although the majority of US companies skipped past consensus estimates for Q3, that may have owed as much to expectations management as strong performance. Research from Standard & Poor’s shows that S&P 500 earnings per share (EPS) are set to fall in aggregate in Q3, even though share buybacks are adding about 4% to the stated EPS number – so the actual operating performance is even worse.
Corporate earnings growth is sagging too
Source: Standard & Poor’s
“Hopes for the future are providing support to share prices, since analysts are pencilling in a rapid return to double-digit profits growth, helped by a trade deal.”
Hopes for the future are providing support to share prices, since analysts are pencilling in a rapid return to double-digit profits growth, helped by a trade deal. Yet investors had better hope they are right. Aggregate EPS forecasts for the S&P 500 have fallen by 8% since March 2018, according to S&P, while the index has risen by 17%. History suggests that stocks cannot defy such gravity for ever.
The other effect of prices rising as earnings estimates slide is that valuation multiples expand. Based on consensus estimates, the S&P 500 trades on 19.4 times forward earnings for this year and 17.5 times for next year. These are not unprecedented levels but they are toward the top of the range – and need the consensus earnings forecasts to be right (when they have been consistently too optimistic for 18 months).
To try and take the guesswork out of analysts’ forecasts, Professor Robert Shiller’s cyclically-adjusted price earnings (CAPE) ratio looks at valuations across a 10-year cycle and adjusts for inflation for good measure. This approach suggests that US stocks have only been more expensive for any length of time on two occasions – in 1929 and 1999 – and both of those episodes ended very badly.
“[The Shiller CAPE] approach suggests that US stocks have only been more expensive for any length of time on two occasions – in 1929 and 1999 – and both of those episodes ended very badly.”
The counter argument here is that Shiller’s approach has warned about US equity valuations for years, to absolutely no avail. And this is quite true. The Shiller CAPE ratio is a useless near-term timing tool. But consider this: if you look at the Shiller multiple and then set it against the 10-year compound annual return from US stocks that actually followed, buying at these valuation levels has never worked well on that 10-year view.
Poor long-term returns have followed when the Shiller CAPE has previously reached current levels
Since that is the sort of time horizon that would test the patience of many a portfolio builder, this is worth considering, especially if an investor’s style is to happily go with the flow and chase near-term momentum. And in this scenario, a trade deal would perhaps help stocks to hold their ground and not make fresh advances.