Risk On?

Risk On?

This morning I spoke with Matt Ray on America’s Morning News about the recent market action. Are we back to risk on? Here is a bit more detail on our discussion.

Equity markets have rebounded to an impressive extent after the recent correction, with the S&P500 less than 5% away from its all time highs, last seen in late May, while the VIX, the measure of volatility has closed in on a two-month low after having spiked up in August.

So were all those machinations between the summer and today much ado about nothing?  To answer that, we need to understand what drives returns.  The answer, like most things in life, is it’s complicated. Over the long-term, investment returns are based on fundamentals – ideally finding a company with an excellent management team that has products or services that are in high demand for a growing demographic with shares at an attractive price. But, in the short to medium-term, returns are all about risk – are investors seeking risk or withdrawing from it?

Today, the answer to the question of affinity for risk relies more and more upon bureaucrats, which makes the investor’s job an awful lot like a fortune-telling gazing into her crystal ball.

Fig-2-1-Fortune-teller

 

Who the hell knows what insanity will get blurted out next… particularly if Donald Trump has access to a mic or a twitter feed!

The Fed has now become a primary source of uncertainty, (contrary to what they claim is their intent) while politicians and bureaucrats muddy the waters in countless ways, such as when Hillary Clinton took to twitter to bash biotech pricing.  I understand her outrage, but in today’s world of instant communication via social media, a few words can have an enormous impact and countless unintended consequences.

We’ve seen high profile investors like David Einhorn with Greenlight, John Paulson, and Michael Novogratz of the flagship Fortress macro fund, (which is now liquidating) struggling to live up to their reputations as fundamentals are easily overwhelmed by bureaucrat commentary and the market’s tendency to try to read central bank tea leaves.

So where are we today?  The S&P 500 is again closing in on its all-time high, but if we look a bit deeper we see that 63% of the stocks in the S&P 500 are still below their 200-day moving average and credit spreads remain elevated. When I see lack of breadth like this, meaning that indices are moving up based on a small group of stocks, and we see credit spreads still indicating that investors aren’t running towards risk, I remain cautious.

If we look at history to get an idea of probabilities, the S&P 500 has found itself below its 200-day moving average with more than 50% of the stocks within it also under their 200-day -moving average 24% of the time.  Annualized returns when the market has been in this position have been 9.7%, which sounds pretty good, except the maximum interim loss during those times has been 50%! (Hat tip to John Hussman for his data) So you may get decent returns, but there’s a good chance you’ll lose your lunch in the process.

If we look at the economic fundamentals, we have more cause for concern:

  • Total US business sales are down 3.09% year-over-year
  • US capacity utilization is also down year-over-year, (we are using less of our ability to make stuff than we did last year)
  • Industrial production contracting in 8 of the last 9 months
  • The producer price index is down 1.1% year-over-year, not exactly a sign of impending inflation)
  • Retails sales fell yet again in September
  • The Federal Reserves GDPNow currently estimates 3Q GDP to be 0.9%, (not exactly an overheating economy)
  • This morning we also learned that China’s GDP growth rate slowed to 6.9%, which is the weakest since the Great Recession. That will hurt Germany (major exporter to China) which is already suffering from Russia’s slowdown (big exporter to them as well) as it tries to keep the rest of the Eurozone afloat.  Mario Renzi is doing his best to get Italy turned around, but give the man a break!

If we look at earnings so far with 58 companies having reported, it isn’t exactly inspiring either

  • The percentage of companies beating on earnings is above the average, which sounds pretty good until…
  • The percentage of companies beating on revenues is below average
  • This means that earnings beats are coming from cost-cutting and financial engineering with things like share-buybacks – no indicative of long-term growth
  • As far as valuations, today the forward price-to-earnings ratio is 16, which above the 5-year and 10-year average of 14.1, which means that despite the dour fundamentals, stocks are still rather pricey.
  • Within the S&P 500, nine companies have offered weak December quarter outlooks compared to only one that has raised expectations

With fundamentals not giving us much to go on, in the short-to-near term it is all about that risk, which means investors need to be focused on how will the major indices behave as they approach their 200-day moving averages?  If they blow right past the 200-day AND if we see credit spreads (the different between the risky stuff and the safer stuff) get narrower, then it is back to game on, likely through the rest of the year, regardless of what is happening under the covers.

maxresdefault