Good times in U. S. are about to stall
Risk of excessive valuations back on the radar
October was the best month for U. S. stocks in four years, putting the six- year bull market in most global assets back on track, but perhaps not for long.
Investors are unlikely to experience a repeat of the market weakness seen in August and September, but there are signs another pullback may be coming later this month.
The risk of excessive valuations is back on the radar as a result of the sharp bounce- back, and forward earnings estimates are declining across most sectors.
“Although many companies have exceeded quarterly earnings expectations, we have seen very little follow- through with higher forward 2016 consensus estimate revisions,” said Chris Dutton, a quantitative analyst at TD Securities.
He estimates that just 13 per cent of S& P 500 companies posted upward revisions ( defined as a positive change of more than two per cent on a three- month basis) to 2016 earnings estimates.
As a result, recent share- price gains coupled with reduced analysts’ earnings estimates for 2016 have expanded the S& P 500 multiple to 16.3x. That’s higher than the peak of 16x before the AugustSeptember correction.
Dutton also highlighted other consumer- related data points that have come up short recently, including retail sales, new home sales and consumer confidence.
“If the deteriorating consumer data trend continues through November, we believe that stocks would be at risk of a multiple contraction once again,” the analyst said.
But it’s hard to ignore the positives, especially since the equity rebound has gone global, as macro and market conditions in emerging markets have stabilized.
The Stoxx Europe 600 Index climbed eight per cent in October ( its strongest gain since July 2009), Japan’s Nikkei rose 9.7 per cent ( the best showing since April 2013), and China’s Shanghai equity market index is up 20 per cent in dollar terms from the August lows, giving it a gain of nearly three per cent on the year.
David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates Inc., noted that retail investors are also showing confidence, suggesting the rally is about more than just short covering. Investors put US$ 14.6 billion into equity funds during the week ending October 28, marking the largest inflow in six weeks.
Uncertainty has also faded as the CBOE’s market volatility index ( VIX) plunged 42 per cent in October. The U. S. Federal Reserve is more confident about the outlook, having left the door open to a December rate hike, and, despite rather tepid headline GDP growth, U. S. private domestic demand is above three per cent annually.
Earnings once again modestly beat analysts’ estimates and the equity market also happens to be in a strong seasonal period, which typically lasts through the early spring.
Despite these positives, Rosenberg highlighted some of the rally’s shortcomings, most notably the lack of breadth.
Only two of the S& P 500’ s 10 equity sectors ( tech and consumer staples) are above their mid- August highs and 52 per cent of the index’s stocks are trading below their 200- day moving averages.
The rally has also been concentrated in mega- cap growth stocks, primarily from the technology and consumer discretionary sectors, as the small- cap Russell 2000 index has lagged by approximately 800 basis points during this market rebound.
A rotation to large- cap stocks is normal during periods of market volatility, partly because exchange- traded funds buying is weighted toward bigger companies.
Dutton pointed out that the rotation towards large caps exists in Canada, but there is also a more concentrated rotation into specific large- cap stocks within each sector.
“The divergence between winners and losers within each sector is becoming dramatic,” he said. “Although we would argue that we are in a stock- pickers market, it is difficult to explain the reason for such wide divergences.”
Investors are also recognizing that the cycle is likely in its later stages, since most asset classes are generating significantly lower internal rates of return, and many equity investors are already fully invested following the long rally.
“The message we get for investors is that the six- year long rally in global assets has produced great returns, but has brought prices to levels where they are now unlikely to produce great returns in the future,” said J. P. Morgan chief market strategist Jan Loeys. “So the years of simply riding the unrelenting bull market in all asset classes are likely behind us.”