Market Narrative Makes for Record Gap between Hope and Reality

Market Narrative Makes for Record Gap between Hope and Reality

There is just no escaping the reality that markets are driven by narratives and people are highly trainable – just ask Dr. Ivan Pavlov. For years investors have been trained to believe that markets cannot go down because central bankers will step in and do something that will prop them back up. This has essentially become a self-fulfilling prophecy. The most recent narrative has been the Trump reflation and economic acceleration trade in which narrative versus reality has reached a whole new level of wackiness.

As reported in the Financial Times recently, Morgan Stanley has found a record gap between the hard and soft US economic data, which is the difference between sentiment and reality.


The difference between quantifiable data and reports based on sentiment has never been so wide, prompting a sharp divergence in expectations for first-quarter US economic growth, according to an analysis by Morgan Stanley.

Source: Morgan Stanley flags ‘record gap’ between hard and soft US economic data

The prevailing narrative, as we head into earnings season, is that businesses are full of optimism and animal spirits are taking hold of the economy with robust growth right around the corner.

Apparently, those animal spirits aren’t looking to borrow to pay for that accelerating growth. It is possible that some businesses are holding off on borrowing until we learn what changes might be made to the tax code, but such a profound decline in borrowing does not support the assertion that businesses are gearing up for accelerating growth. This does support our Asset-Lite Business Models investing theme, as in such uncertain times, businesses look to limit long-term investments and focus just on those areas they can deliver value with minimal investment risk.

Investors have learned since the financial crisis that betting on the market going down is a fool’s errand as central bankers have stepped in every time to prop asset prices back up. We learned, oh did we learn. The markets now trade within a very tight band, with median volatility in 2017 lower than 95% of all trading days going back nearly 30 years and yet there is this. Note that the red line denotes the level on April 3rd, 2017. Only two other times in the past 5 years has uncertainty been this high yet the VIX is lower than 95% of all trading days over the past 30 years? I’d say those bears have learned to ignore the bell of weakening fundamental data.


Those watching the fundamentals and thinking that meant something had their shorts handed to them as the bulls smugly wagged their knowing fingers. The market will not go down, it will not go down I say… until the day the market sees what is behind that magic curtain.

Perhaps this might start to lift that curtain just a tad.

HT to Variant Perceptions

This chart shows that in recent years US equity price increases have been driven by rising PE ratios rather than improving business fundamentals, much more so than in years past where PE ratio shifts, in contrast, were often a drag on returns. What we found particularly interesting is the relationship between increases in government spending and PE ratios. The Trump Trade expects an increase in fiscal stimulus. That means increased government spending which has historically been associated with falling PE ratios – something to keep in mind as we watch the battles in D.C.

Looks to us like bonds are also thinking this accelerating growth/reflation story may not be quite right.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

Your Tematica team will be watching carefully as this narrative gets tested further and will keep you posted when meaningful events occur, so stay tuned!

‘Trump Bump’ for Dow Industrials Is Biggest Post-Inaugural Move Since FDR – 

‘Trump Bump’ for Dow Industrials Is Biggest Post-Inaugural Move Since FDR – 

This morning I was on Varney and Company on Fox Business talking about the impressive run-up in U.S. stock indices. While we were on air, the U.S. markets opened and shortly thereafter the Dow broke to new highs at 20,700.

Only one other president in history has seen such remarkable gains since their election. After John F. Kennedy’s election, the S&P 500 gained 13.05 percent while post-Trump’s election we’ve seen a 9.7 percent gain. The post-election moves this time have been remarkably steady, as we’ve experienced 89 days without a 1 percent decline and the VIX has remained at multi-decade lows. Last Wednesday 8 percent of the S&P 500 saw new all-time highs.

An article in today’s Wall Street Journal declared,

“President Donald Trump has been doing a lot of bragging about the stock market rally lately. How does it measure up? By some measures, the rally that took place during Mr. Trump’s first 30 calendar days in office has been the largest since 1945. Since inauguration day on Jan. 20 through Friday, the Dow industrials climbed more than 4%.”

The strength in stocks hasn’t been just domestic, as the majority of the largest stock markets around the world are in overbought territory and not one of the thirty largest country-based ETFs is in oversold territory.

To put the U.S. gains in perspective, the Market Vector Russia ETF (RSX) has gained even more than the S&P 500, up 15.3 percent since the election versus 9.4 percent for the S&P 500 ETF (SPY).

Since President Trump’s inauguration, the iShares MSCI Mexico Capped ETF (EWW) has gained the most of any asset class, up 7.2 percent versus the S&P 500 (SPY) up 3.7 percent.

Pricing in the U.S., as we keep mentioning here, is at elevated levels, with the S&P 500 at the highest forward 12-month P/E/ ratio since 2004 at 17.6. This is well above historical norms as the 5-year average is 15.2, the 10-year is 14.4 and the 15-year is 15.2.

That forward P/E also assumes an exceedingly robust growth rate in EPS for the S&P 500 to be over 11% in the coming year, which is a profound change from what we’ve seen over the past 4 to 5 years. If we don’t get that kind of explosive growth, then today’s valuations are even more stretched.

Implicit in those assumptions is the impact of corporate tax and regulatory reforms on margins and the impact of individual tax reforms on spending. With the level of divisiveness in D.C. paired with 23 Democrats in the Senate up for reelection in 2018, Trump is facing an uphill battle to get his plans passed. Regardless of where one stands concerning the president, roughly half of the country is opposed to him, and those opposed are very vocal. House and Senate Democrats will be facing a lot of pressure from their constituents to not cross the isle and join the Republicans.

That being said, the level of momentum we see in this market is irrefutable, so shorting it is a dangerous business. Those who hop in now need to understand that they are going in for momentum, as the likelihood that all these hopes and dreams don’t come through promptly is pretty high, which means better buying opportunities are likely in store later on.

Source: ‘Trump Bump’ for Dow Industrials Is Biggest Post-Inaugural Move Since FDR – MoneyBeat – WSJ

What The Financial News Isn’t Telling You That You Need to Know

What The Financial News Isn’t Telling You That You Need to Know

Investors as a group are notorious for chasing returns, which means everyone piles into whatever has been working best lately and more often than not tends to be late to the party. The catch this time around is whatever has been working best lately is whatever has gone up in price the most. All this is completely antithetical to the mantra, “Buy low and sell high,” as that requires selling that which was been performing stupendously and buying that which has been getting gut punched like Rocky did my Mister T in the first half of Rocky 3. Imagine hearing that kind of advice on mainstream financial TV!


In our defense, we humans are genetically programmed to buy high and sell low because that’s what you do when you follow the herd and rely on headlines for insight. Remember, our ancestors were the ones that had the good sense to run deep in the crowds when that sabre-toothed tiger got the munchies.

With that in mind, recall that yesterday we talked about how investors have been choosing passively managed funds over active funds at an accelerating rate in a market that has gained more in the past three months, (S&P 500 up 7.6 percent) than in the two years prior to the election, (S&P 500 up 3.3 percent).

That move up has been oddly calm, with the S&P 500 having moved less than 1 percent intraday now for 40 consecutive trading days. That is the longest streak in at least thirty-five years! As Real Vision Television founder Raoul Pal likes to say, suppressed volatility invariably leads to hyper-volatility.  The following chart shows just how low volatility has been relative to historical norms.


The VIX is currently just slightly above the lowest levels we’ve seen in the past twelve years and is well below the average over that time frame. This stands in stark contrast to the level of global economic policy uncertainty and the current P/E valuation accorded to the S&P 500.

Within just the States, the level of political uncertainty is also well above the median, reaching the 82nd percentile!


So we have volatility at exceptionally low levels with significantly heightened policy uncertainty both in and outside the U.S., yet stocks are trading at historically very pricey levels according to a wide range of metrics. The chart below shows the S&P 500 Cyclically Adjusted Price-Earnings Ratio (CAPE) going back all the way to 1881. According to this metric, stocks have only seen these levels just prior to the 1929 crash and the dotcom bust.


As of 12/30/2016, (the latest date for which comparative data is available) the U.S. was quite expensive on a relative basis, with a CAPE of 26.4, the third highest in the world, trailing behind Denmark at 33.3 and Ireland at 31.2. The CAPE of the U.S. was trading at a 60% premium over developed Europe and an 89% premium over emerging markets.

If we look at trailing-twelve-month price to cash flow ratio, as of 12/30/2016, the U.S. was trading at a 25% premium to developed Europe and a 41% premium to emerging markets.

If we look at trailing-twelve-month price to sales ratio, as of 12/30/2016, the U.S. was trading at a 73% premium to developed Europe and a 46% premium to emerging markets.

If that doesn’t have you convinced that we are in heady territory, BMI Research recently pointed out that the technicals in the U.S. market are setting up for some seriously unattractive returns over the next three months based on historical norms.


The bottom line is investing is all about probabilities and with stocks in the U.S. at such lofty level with a whole lot of perfection expectation priced in, the downside risk relative to upside potential is something that ought to not be ignored.

So the question is, what could push U.S. equities higher aside from P/E ratios moving further out into the stratosphere? Check back tomorrow for our discussion on just that.

S&P 500 hits record $20T market cap as warning signs mount

S&P 500 hits record $20T market cap as warning signs mount

This morning the S&P 500 reached $20 trillion in market cap for the first time in history even though investors have been flocking out of active management funds and into passive ones, such as exchange traded funds (ETFs), at an accelerating rate. This is typically the behavior we see nearing market tops.

As markets move deeper into expensive territory, meaning higher P/E ratios, many active professional investors start to put on protection and/or increase their cash balances as they see less upside potential relative to downside risk. If the markets continue to press higher, those managers will then obviously underperform. Often this is when we see investors’ confidence rise as passive outperforms active and with that, we see accelerating fund flows into passive over active management. We saw such moves in 1999-2000 and 2006-2007, typically marking an impending market top.

Investment managers that have stood the long-term test of time, such as Jeremy Grantham of GMO, are watching clients walk out the door as we see the reemergence of “This time is different” theory with increasing belief that high P/E ratios this time mean something different. We saw similar moves away from those tried-and-true managers in 2000 and 2007. Today’s market is not one that would be wise to short as confidence remains high, but watch out for the catalyst that reverses the assumptions upon which all that investor faith is resting.

Investors pulled a net $340.1 billion from U.S.-based actively managed funds last year, according to Morningstar, while pouring a record $504.8 billion into U.S.-based passively managed funds.



Vanguard crossed the $4 trillion mark in January after collecting an estimated $49 billion in net new cash from investors during the month. Of those January flows, about $45 billion went into index funds while the balance went to actively managed funds.


In 2016, index funds accounted for about 85% of the total net new cash Vanguard attracted.


These flows have led to the size of passively managed assets in the U.S. to grow significantly faster than active, which have nearly flatlined in recent years.


This confidence in more rules-based approach has come at a time when equity valuations are more stressed than at any other time in the past decade. As P/E ratios get stretched, upside potential continues to shrink while downside risk grows.

Meanwhile trailing 12-month net margins look to be rolling over – yet another warning sign.


And despite investor enthusiasm, corporate guidance hasn’t been all sunshine and roses. The disconnect between investor enthusiasm as evidenced by P/E ratios above what we’ve seen in over a decade and corporate guidance is another warning sign.

But that hasn’t stopped analysts from reflecting investor enthusiasm. This chart pretty much speaks for itself – that is a lot of perfection expectation!


While investment newsletter writers fan the flames of enthusiasm, which has also typically been a signal of an impending market top.

The share of newsletter writers who are optimistic on the stock market climbed to 62.7% this week, the highest level since 2004, according to Investors Intelligence, which surveys more than 100 newsletter writers each week for its Sentiment Index.

A reading above 55% suggests a trading top is forming, while topping 60% means “it is time to start taking defensive measures,” according to Investors Intelligence.  The measure has been above 55% for 11 straight weeks, and above 60% for four of them.


Remember Bob Farrell’s Rule No.9. “When all the experts and forecasts agree, something else is going to happen. This is not magic. When everyone who wants to buy has bought, there are no more buyers. At this point, the market must turn lower and vice versa.”

On a more positive note, so far EPS growth for the December quarter is around +5 percent for the S&P 500 versus the +3 percent bottoms up consensus estimate at the beginning of that quarter. So there is some cause for optimism, but the level of success that the markets are pricing in is exceptional. Since the market’s bullish moves have been based upon expectations around President Trump’s reduction in regulation and taxes, it is noteworthy that he recently acknowledged that the repeal and replacement of the Affordable Care Act, a major talking point during the election, could be pushed back into 2018. We suspect that isn’t the only change that won’t be implemented as quickly as the market expected.

Sources: Vanguard Reaches $4 Trillion for First Time – WSJ and Newsletter Writers Are the Most Bullish Since 2004 – WSJ


Earnings Season Review

So far earnings this season have been surpassing estimates, which is nice to see but needs to be viewed in the context of estimates that were quite subdued given the actual 2.9% contraction in the economy in Q1. The tough thing is that now the market is priced for perfection, which is a bit reminiscent of prom night expectations. According to data from Bloomberg, the S&P500 is trading around 17.4 current P/E and over a 16.2 forward P/E multiple, (translation – share prices for stocks in the S&P500 are about 17.4 times the current earnings) which is very much on the high side since 2007. This means the market is priced towards perfection. We’ve got some serious headwinds to these hopes with the geopolitical tensions, plus the ramifications of changes in Federal Reserve policy as now five Fed Presidents are pressing for not only the end of QE but also for a rate hike this year. July 30th we learned that not only did the economy grow much more in Q2 than expected, 4% versus 3% consensus expectations, but inflation hit 2.3% versus 1.4% in Q1. That inflation rate is above the Fed’s target, so concerns are increasing that the Fed will end up being behind the curve with respect to managing the impact of all this liquidity. In the QE world such good news for the economy can become bad news for the markets because, not only has the probability of getting cut off from more of that lovely QE addiction increased, but we are also more likely to get put on an exercise regiment with rising Fed fund rates as well! Although the Fed’s QE exit plan is likely to result in some increased volatility across asset classes, we welcome monetary policy inching ever closer toward normalization.

Then there is the political side. Throughout history, occasionally a seemingly contained, regional conflict can have unanticipated ripple effects that increase global tensions to such a point as to have significant economic and political impact. Thus it should come as no surprise that a Potomac Research Group poll of institutional investors found that “Global unrest from Ukraine to the Middle East has changed the mindset and investing outlook of leading investment professionals.” The poll of hedge fund, pension fund and money market managers found that nearly half believe foreign events will have a greater impact on the equity markets than domestic versus last year when 65.7% believe domestic events were more important. This is particularly troubling given that 88.6% of those surveyed believe that President Obama has been ineffective in dealing with foreign issues and incidents while only 5.7% said that the President’s foreign policies were effective. So far only 32% claim that recent geopolitical events have driven them into less aggressive investments, which means that more shifting could occur if perception of the risks worsens sufficiently. For full details of the poll go to

Bottom Line: Markets are priced for a goldilocks economy which while possible, is not likely. Most of what you can buy for your portfolio is priced pretty richly, but this seemingly ceaseless upward climb could continue for longer than anyone might imagine, putting traders in a challenging position. Do they choose safety, which may cost them participation in this powerful rally, or do they jump into the expensive end of the pool and risk losing in a pullback that will eventually come… the question is when. As we mentioned above, the early signs in stock and bond liquidity preferences are indicating that a pullback may come sooner than later.

Market and Earnings Season Update

Market and Earnings Season Update

Over 700 companies have reported earnings so far this season. As of Friday 4/25, 61.1% of all U.S. companies had beaten consensus earnings estimates, which is just slightly below the 62% from last quarter and is consistent with the rate we’ve seen during the current bull market.









When earnings season began, top line revenue estimates were relatively weak, but have improved over the last five days. Currently 55% of the companies reporting have beaten estimates, up from 50% last week.










The two prior charts show that so far, things are looking decent during this reporting cycle, but nothing to get giddy about. The big change this quarter, and it is decidedly something to get giddy about, is guidance. The past 10 quarters companies have given the markets pretty grim forward outlooks, with a negative guidance spread, meaning more companies lowering guidance than raising, in each of the last 10 earnings seasons. This season we finally see a positive ratio.










Last earnings season investors bought aggressively during the season, despite the negative outlooks. This season the opposite appears to be occurring with the average company falling 0.39% on its reporting day. Companies that beat estimates are not rewarded all that much, rising an average of 0.13% while those that miss are falling 0.52%.


Last week the market was a condensed version of what we’ve been experiencing for much of the year, a great deal of whipsaw back and forth action that hurts sentiment more than actual portfolios. The market closed Friday 4/25 at nearly the same place it was on the close of Thursday the week prior, (markets were closed on April 18th in observance of Good Friday). The much maligned Nasdaq is now about 6% off its recent cycle high while the S&P500 is 1.4% below its recent April 2nd high of 1890.9. If we go a bit deeper we find that while corporate earnings reports are painting a sunnier picture, stock prices have been struggling. Last weekend Barron’s pointed out that the average stock in the S&P500 has fallen 12.5% from its peak. The average consumer discretionary is down 16%, despite some positive March retail sales data. Internet stocks are down 18% on average with biotech, the darling of 2013, down 25%. The average large-cap has lost just under 9% with small cap falling nearly 16%. We’ve been warning for months that stocks have been richly priced, so while the fundamentals appear to be improving, prices are moving in the opposite direction, falling off their heady highs. For those who read these posts regularly, this will come as no surprise.


That being said, the majority of country stock markets are still above their 50-day moving average, including the U.S. which is just keeping its neck above water at 0.3% above this key support level. If we take a broader six month look, the S&P500 and the Dow 30 have been fairly consistently moving above their 50-day moving averages, so while it’s been painful, the longer-term uptrend remains in place. Small caps are a different story, with both the Nasdaq 100 and Russell 200 below their 50-day moving averages, where they have been for over a month. Nasdaq internet stocks are well below their 50-day moving average and still losing ground.


Bottom Line: After last year’s blow away market that greatly outpaced growth in underlying earnings, we are unsurprised to see some consolidation in prices. So far we see the longer-term upward trends holding firm for the more value-oriented firms that we tend to prefer. We’ve seen the usual reversal of last year’s highest fliers become this year’s dogs, in yet another example of why it doesn’t pay to chase returns.


GDP Growth not Exactly Glowing

GDP Growth not Exactly Glowing

GDP growth for Q4 2013, as expected, was recently revised downward from an initial estimate of 3.2% to 2.4% versus Q3 2013 growth which is estimated to have been 4.1%. GDP growth for the full year of 2013 is estimated to be about 1.9% falling from 2.8% in 2012. Even with the downgrade, growth for the second half of 2013 is now estimated to be 3.3% versus 1.8% in the first half, showing a decided improvement.

The primary drivers of consumption growth were Services, and a jump in spending on housing and utilities (from negative 0.31% to positive 0.14%), as well as Food Services and Accommodations which rose from 0.02% to 0.43% annualized. How much longer consumers can keep this behavior up with shrinking purchasing power remains to be seen.

The bad news emerges from Fixed Investment, which fell from 0.89% to just 0.14% annualized, as investment across the board dipped but mostly in non-residential structures (down negative 0.03% from 0.35%) and a fall in residential fixed investment from 0.31% to negative 0.32%.

Net trade contributed a surprising 1.33% to GDP growth, the most since the 2.39% increase in Q2 2009. How much longer can the US continue boosting its GDP on the back of the shale boom, and declining imports, also remains to be seen. Just like the inventory build-up from the later part of last year that now has to be soaked up, so too a reversal of net trade boost could become a drag on growth, unfortunately at a time when the consumer could also pull back.


Households continue to muddle along, with median household income just over $51,000, which is about where it was 20 years ago. Real disposable personal income recently fell by 2.7% from a year ago, which is the biggest one year decline since the semi-depression of 1974. While the official unemployment rate has fallen to 6.6%, the labor force participation rate, which is the portion of the population either employed or looking for work, is at 63%, a level we have not seen since 1978. If the participation rate was at pre-crisis levels, the unemployment rate would be closer to 13%.

Bottom Line: Enjoy the 2013 Q4 GDP surge as it may not last into 2014. Sustained growth in the economy and the housing sector in particular will remain constrained until household income levels improve on a consistent and stable basis.

Additionally, the low level of economic growth serves as a headwind to stock prices as revenue growth is more difficult in a slow moving economy. Low revenue growth leads to more difficult earnings growth, with the majority of earnings growth for much of the S&P500 over the past few years coming primarily from cost cutting, which has a limit. Future stock price appreciation will be heavily dependent on rising PE ratios, which are already at elevated levels relative to historic norms.

Valuation Matters

Valuation Matters

 Many popular investment “gurus” advocate the Buy and Hold Strategy, yet most never discuss valuation.  We believe that valuation matters most, so before we look at anything else, we determine whether an asset class is currently cheap, expensive or fairly priced.  If you pay too much for an investment, all the time in the world won’t fix it, even if you just invest in an index fund.  The chart below shows the S&P500 adjusted for inflation from January 1, 1873 to January 1, 2010.

This chart shows that if an investor purchased the index in 1966, they would have waited until 1991 for it to return to the same value!  For twenty five years their investment was underwater.  This chart also shows that we have yet to come close to the high reach at the turn of this century.

So how can an investor know that in 1966 or in 1999-2000, the S&P was overpriced?  One way is using the price to earnings ratio (PE).  The chart below shows the PE ratio for the S&P for the same time period.  The PE ratio be thought of as how much an investor is willing to pay for one dollar of earnings.  A PE ratio of 20 means that the market in aggregate is willing to pay $12 for $1 of annual earnings.

This shows that in 1966, the PE ratio reached a high near 25 and in around 2000, the S&P again reached a high of nearly 45!  This is just one measure of valuation that we use to help us determine if the stock market in general is over-priced, under-priced or fairly priced.  The mean PE ratio is 16.35 and the median is 12.87.  The lowest PE ratio occurred in December of 1920 at 4.78 and the highest PE ratio so far was in December of 1999, when the ratio reached a mind boggling 44.20. 

On 1/1/1982, the S&P PE ratio was again at a historical low of 7.4 and the inflation adjusted S&P was at 268.62.  If an investor purchased the S&P index at this point, and kept it until the PE ratio reached 43.8 on 1/1/2000, the S&P had risen to 1,823.78, which means the investors after inflation average annual return was 11.23%.  Compare this to the 25 years it took from 1966 to 1991 for an investor to simply get a return of their initial investment and clearly, valuation matters and buy and hold provides little aid for an over-priced investment.

We don’t believe we can time the market.  There was no way to know that the PE ratio was bottoming out in 1982, nor could we know in December of 1999 that the market had peaked, but we could see that in both cases a directional change was bound to occur.  We don’t believe we can get the timing exactly right, but we do see opportunities, both for gains and losses when valuations are above or below historical norms.

By the way, we currently believe that the S&P is again relatively over-priced.  If you remove the insanity that occurred around the turn of the century, the chart above shows that the PE ratio is again near historical highs.