Market momentum? 3 signs the stock rally is running on fumes
The S&P 500 may still have its mojo, but it comes with a caveat, says Martin Pelletier.
It has been one heck of a year in U.S. equity markets with the S&P rallying nearly 15 per cent. A falling U.S. dollar, strong revenue growth from the heavily weighted technology sector, the potential for substantial tax cuts, and an accommodating Federal Reserve have all helped push the S&P 500 to record levels.
As someone who has been in the market for nearly two decades this latest run has been rather remarkable with any dips on the open almost algorithmically bought up leading to the “buythe-dip” (BTD) catchphrase.
Interestingly, other markets have not followed suit with the S&P TSX only now just slightly returning to above its decade ago levels while other developed markets outside of North America still roughly 20 per cent below their 2007 pre-financial crisis highs.
There have been many who have tried to call the top in U.S. markets but few remain after getting steamrolled by investors jumping in with both feet following Donald Trump’s election win. While on the surface there appears to be a lot of momentum left in this market, we think there are three indicator lights showing an engine running on fumes.
1 No cash
According to J.P. Morgan research, only during the tech bubble in 2000 did U.S. households hold more equities and this latest run is fast approaching those levels. As a result, private client cash as a per cent of total investable assets have now fallen to an all-time record low, according to Bank of America Merrill Lynch data.
It isn’t that much different among the investment pros. As reported by Business Insider citing INTL FCStone data, the cash balance sitting in mutual funds is also at an all-time low of 3.3 per cent. Citigroup survey data indicates similar levels among institutional investors with cash now down to only 2.25 per cent of assets under management.
Then you have corporations themselves, who have been the largest buyer of equities via buybacks, running out of money. According to Cornerstone Macro, U.S. corporations generated $1.9 trillion from cash flow and net borrowing but spent $2.2 trillion on capex and buybacks from Q1 2016 to Q1 2017. This $300 billion of net cash outflow is the largest deficit on record.
2 No risk
With all of this buying, it has sent volatility levels crashing down. Specifically, there have been 39 times since 1990 when the Cboe Volatility Index (VIX) has closed below 10, with 30 of those this year and 15 in the past month. Add this to the high returns being generated and the Dow Jones Industrial Index’s Sharpe ratio, a measure of return per unit of risk, is at 4.5 — statistically higher than 99.7 per cent of all readings since 1900 as cited by Bloomberg.
3 No deals
The S&P 500 is up 70 per cent over the past five years while earnings are up only 10 per cent. This is because investors have mostly focused on the high-flying tech sector that has grown to represent a quarter of the index while the traditional sectors such as energy and financials have fallen from a quarter to only a fifth of the index, Forbes reported.
Many are now willing to pay more than 60 times earnings for certain tech firms while applying a more modest 15 times multiple for energy companies and 20 times for banks. On a combined basis, the S&P 500 is trading at 22.3 times trailing 12-month P/E well above the 10-year average of 16.9 times, according to Factset.
We don’t think this is sustainable unless the tech sector can start to transform revenue growth into actual earnings.
In conclusion, while the S&P 500’s gasoline tank is fast approaching empty it does have some momentum to carry it forward — for the time being anyway. The only caveat in all of this is the Federal Reserve, which was supposed to start tapering last month but in reality continued to expand its balance sheet. This means both low rates and readily available debt could allow for a refuelling of the market continuing to drive it higher.