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  • Market Update

    Here’s our in-depth assessment of the key factors that are creating current market conditions.

Conflicting Signals

Do you ever wonder why there are no sure things?

In the world of Big Data and artificial intelligence, how is it that the indicators and signals for the markets can be so uncertain, and even point in opposite directions?

Simply, why haven’t we figured out the markets to a tee just yet?

With the market price discovery mechanism an amalgamation of conflicting inputs and reasoning, we believe it makes the most sense to categorize signals as either bullish (good for the markets) or bearish (bad for the markets). The following data is current as of 8/20/18.

Signs and Signals that the Market is Bullish

The yield curve is getting flatter, but not yet inverted.

An inverted yield curve is usually a sign that a recession is coming. While the 10-year minus 2-year yield is currently just above 0.23% (Exhibit 1), it may still take a while for it to invert. Looking at the last three bear markets, it took an average of more than three years from where we are now to where the market topped.

Earnings and margins are still good.

S&P 500 earnings grew 18% from last year (Exhibit 2) and are expected to grow by more than 17% in the next 12 months. Profit margins are still near all-time highs.

Not everyone is bullish.

The AAII Investor Sentiment Bullish Readings minus the Bearish Readings is just over 7%. (We become the most concerned when everyone is bullish and few are bearish. Last January, more than 44% were net bullish. Near the height of the technology bubble, more than 61% were net bullish.)

Most technical indicators look good.

Moving averages, MACD, breadth, impulse, small companies relative to large ones – most of these indicators look good. The market doesn’t feel overbought and the leadership, while narrow, isn’t as narrow as it was in 2000. On the other hand, the S&P 500 could meet significant resistance at 2875 and retreat. If it breaks through and stays above 2875 (Exhibit 3), this could indicate that the market has technically rested and is ready to move higher.

Exhibit 1 - 10-year Minus 2-year Yield

Exhibit 1 – 10-year Minus 2-year Yield

Exhibit 2 - S&P 500 Earnings

Exhibit 2 – S&P 500 Earnings

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Exhibit 3 – S&P 500 at 2875

GDP growth looks good.

GDP year-over-year growth is at 2.8% and the trend looks like it may break above 3%. Compared with the last two bear markets, where GDP growth was elevated above 5% (2000) or slowly decelerating from 4.3% to 2.2% (2007), this economy looks like there is still some upward momentum.

Signs and Signals that the Market is Bearish

Valuations are high by almost every measure.

Price/Earnings, Price/Sales, Price/Cash Flow, Price/Book, EV/EBITDA, CAPE – they are all well above average. Even Forward Price/Earnings, which uses optimistic estimates from Wall Street analysts, is slightly above average. Some of these, like Price/Sales or CAPE are close to multi-decade highs. One of Warren Buffet’s favorite measures, the total US stock market-to-GDP (Exhibit 4), is also near multi-decade highs.

Growth has dominated Value as a style.

While we do believe in the “momentum phenomenon,” we also believe in mean reversion. We have a hard time believing that growth will continue to have such a large dispersion relative to value (Exhibit 5). We just don’t know when and how this will end.

The market is going on 10-years old.

One has probably heard the saying that “bull markets don’t die of old age.” We agree with this, but we also believe that sentiment usually doesn’t stay this high for this long. It’s quite possible that the tax cuts gave the market some fresh legs into what may soon be considered the longest bull market ever.

Corporate leverage is creeping in.

Companies have taken advantage of low borrowing costs to finance projects, stock buybacks, pay out dividends, or refinance existing debt. Corporate debt to GDP is currently very high (Exhibit 6). Companies that borrowed significantly at variable rates could be squeezed as short-term borrowing costs continue to rise. One mid-sized company we discovered has the majority of its debt in variable rate issues. A 1% increase in rates will translate into an additional $155 million in interest expense.

Exhibit 4 - Total US Stock Market-to-GDP

Exhibit 4 – Total US Stock Market-to-GDP

Exhibit 2 - S&P 500 Earnings

Exhibit 5 – Growth vs Value

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Exhibit 6 – Corporate Debt to GDP

Stock intra-correlation is low.

The problem with intra-correlations being so low while average valuations are high is that a macro shock to the markets can impact all the stocks together, including those that have good fundamentals and valuations. A large increase in correlations while valuations are high can mean a larger magnitude of a drawdown.

Summary

With so many conflicting signals, how should you proceed?

First and foremost, make sure your portfolio matches whatever your objectives, constraints, and risk tolerances are. If you are overly aggressive, now may be an excellent time to take some chips off the table and move into a more appropriate portfolio.

View the markets with a wide-angle lens, not a zoom lens. If you are a long-term investor, it is probably best for you to not follow all of the day-to-day moves up and down. The majority of this will likely be merely noise, which doesn’t contribute significantly to long-term performance.

Don’t waste time trying to predict which signals will or won’t be right and when. Some of the signals will prove prescient while some obviously won’t. The markets will eventually correct and there will eventually be another recession. Ensure you have a diversified portfolio across several asset classes. This won’t remove all the downside risk, but it should mitigate a significant amount of it.

Don’t rely too much on history as a predictor. Records were meant to be broken. The current market could continue to go higher and higher for a lot longer. Or the market could drop precipitously starting next week. Anything is possible. Remember, never let someone convince you that your portfolio is guaranteed, or that your investments are with companies that are too big to fail.


Source: The charts and data referenced here come from Bloomberg.
The S&P 500 Index is a broad based unmanaged index that consists of the common stocks of 500 large capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange. You cannot directly invest in an index.
Past performance does not guarantee future results. Any stock market transaction can result in either profit or loss. Additionally, the commentary should also be viewed in the context of the broad market and general economic conditions prevailing during the periods covered by the provided information. Market and economic conditions could change in the future, producing materially different returns. Investment strategies may be subject to various types of risk of loss including, but not limited to, market risk, credit risk, interest rate risk, inflation risk, currency risk and political risk.
This commentary has been prepared solely for informational purposes, and is not an offer to buy or sell, or a solicitation of an offer to buy or sell, any security or instrument or to participate in any particular trading strategy or an offer of investment advisory services. Investment advisory and management services are offered only pursuant to a written Investment Advisory Agreement, which investors are urged to read and consider carefully in determining whether such agreement is suitable for their individual needs and circumstances.
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August 21, 2018

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