Per Stirling Capital Outlook – December 2019
Renowned value investor, Sir John Templeton, coined one of the most insightful of all investing idioms when he observed that, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
His observation applies to a psychological process that normally takes years to unfold, as market gains over time and improving economic fundamentals slowly and begrudgingly cause bears to convert into bulls, and it is that conversion that traditionally draws new money into the markets and powers the next bull market higher.
However, in stark contrast to historic norms, this time the markets appear to have managed to compress much of a market cycle, with sentiment swinging fully from pessimism (despair even) to optimism in just the past twelve months.
Perhaps even more remarkable is the fact that the global stock market’s very impressive 2019 gains were not attributable to the traditional transformation of bears into bulls. To the contrary, this year’s dramatic move higher in equities took place despite investors pulling a record amount of money (more than $156 billion) out of equity mutual and exchange traded funds, according to Refinitiv Lipper, with much of the market’s gains driven instead by companies buying back their own shares en masse.
It would be a gross understatement to say that pessimism was rampant one year ago. The domestic stock market was in the midst of a vicious bear market and the worst December since 1931. Bearish sentiment was reaching extreme levels, as illustrated by the American Association of Individual Investors (AAII) Survey, which implied that only 20.9% of individual investors thought that the stock market would be higher in six months, and domestic stocks were selling at the lowest valuations since the financial crisis.
Further, according to analyst Mark Hulbert, tactical market timers were more pessimistic a year ago than they had been over 97% of all time since the year 2000. That is in very sharp contrast to where tactical investor sentiment is today, which is more optimistic than it has been in 97% of daily sentiment readings since the year 2000, albeit arguably not yet at the point of “euphoria”.
So severe and so global was late last year’s decline that there were only four stock markets in the world (Israel, India, Qatar, and Russia) that finished positive on the year, with the average global stock down by 8% for the year and by over 15% since the highs of the year. If you remove the domestic markets from the calculation, you can appreciate the severity of the carnage in the overseas equity markets, with the average foreign stock down by over 16% for the year and by over 22% from their most recent highs.
The predominant catalyst for the decline was the sharp divergence between the Federal Reserve’s views on the economy and inflation, on one hand, and the market’s perception of these issues on the other.
At the time, the Fed was concerned by the latent inflationary implications of what they perceived to be a potentially overheating economy. The Fed viewed inflation-related risks as being particularly elevated due to 1) the advanced age of the economic expansion, 2) the fact that the economy was already running near full capacity, 3) the trade war and the potential impact of tariffs on inflation, and 4) the U.S. economy being stimulated by over $4 trillion of monetary stimulus (quantitative easing) and $1.5 trillion of tax cuts. At least historically, such a combination has created a very fertile environment for unwanted levels of inflation.
On the other hand, investors were panicking as they had a very different (and ultimately much more accurate) perception than the Fed of both the strength of the economy and the potential for inflation, and were convinced that the Fed was on the verge of causing an economic recession through its overly-restrictive monetary policies. Not only had they raised interest rates four times, but had also recently announced that they had placed quantitative tightening on “auto-pilot”, thus suggesting that they were going to keep shrinking the size of their balance sheet (i.e., the amount of stimulus) without regard to the status of the economy.
Indeed, the perception was not only that the Fed was on the verge of causing a recession, but that they were doing so at a time when, with interest rates already so low and central bank balance sheets already so large, they did not have the tools necessary to stimulate the economy out of any recession that they might cause.
These investor concerns manifested themselves in a variety of ways, above and beyond the sharp declines in the equity markets, including a surge in the level of negative-yielding debt, on a global basis, and an inversion of the domestic yield curve (with short-term rates moving higher than longer-term rates), which has historically been a very accurate predictor of impending recessions.
As it turned out, the Fed’s concerns about the potential for a growth-catalyzed period of inflation were unwarranted, as the depressive impact of the trade war proved to be much more damaging than had been anticipated, and was more than sufficient to overwhelm the inflationary impact of the tariffs.
This led to the so-called “Powell Pivot” whereby, instead of the promised hikes in short-term rates to “above neutral” levels, and “auto-pilot” reductions in the size of the Fed’s balance sheet, the Fed lowered rates three times this year, and even recently re-engaged in the expansion of its balance sheet.
The $300 billion of liquidity injections to-date is growing domestic money supply at a 12% annual rate and, since lending activity is growing much more slowly than is money supply, much of this Fed-related liquidity is going straight into the capital markets instead of into the real economy. Importantly, the Fed has already reversed almost half of its entire quantitative tightening balance sheet reduction.
Perhaps equally important is Chairman Powell’s October guidance that “We would need to see a really significant move-up in inflation that’s persistent before we would consider raising rates.” This dovish perspective was just further reinforced by the most recent Fed “Dot Plot”, which shows that short-term rates are expected to remain at current levels through 2020 with a singe 0.25% increase expected by the end of 2021.
Taken together, the message is that the Fed is likely to remain accommodative for as far as the eye can see. Indeed, the Fed is so comfortable with the current lack of inflation risks that they are reportedly on the verge of adopting a so-called “make-up strategy” under which they will try to maintain inflation above their 2% target for a time, in order to make up for inflation’s extended stay well below the Fed’s 2% target level.
The Fed’s shift from a hawkish stance to a dovish one combined with news of renewed monetary stimulus in Europe, expected fiscal stimulus in Germany and Japan, and prospects for a “Phase One” trade deal with China to change almost entirely expectations for global economic growth. This is perhaps nowhere more evident than in the level of negative yielding debt, on a global basis, which has plummeted from over $17 trillion to less than $12 trillion based upon these shifts in trade and monetary policy. We view negative yielding debt as nothing more than a bet on a prolonged period of economic stagnation, and any reduction in such debt as a sign of renewed global economic optimism.
This sea change can also be seen in both the shape of the yield curve, where short-term rates have now moved back below longer-term rates, which suggests that the previously inverted yield curve may have given a very rare “false positive”, and that the recession that virtually everyone was expecting a year ago may be pushed off into the future.
Indeed, there has been a dramatic swing in sentiment that has taken place over the past two months, which most recently evidenced itself in the latest Bank of America survey where a net 68% of global money managers now believe that a recession is unlikely in 2020. That represents the largest drop in recessionary expectations since May of 2009 (the penultimate month of the Great Recession).
That same survey, which was conducted between Dec. 6 and Dec. 12, and which polled 247 managers running $745 billion in assets, showed that global growth expectations have jumped by 22 percentage points over the past two months to a net 29% of those surveyed saying the world economy will accelerate next year. This represents the biggest 2-month jump in growth expectations in the history of the survey . There was also an accompanying jump in expectations for future inflation, along with the largest two-month increase in profit expectations since May of 2009.
It is no surprise, in light of this dramatic shift in expectations, that these managers increased their allocation to equities by 10% in December (to a level that is 31% above their benchmarks (the highest level in a year), while their cash levels dropped to 4.2% (tied for the lowest since May 2013) and their allocation to bonds fell one percent (to a net 48% underweight), which is the largest underweight in a year.
We believe that the single biggest factor in this sentiment reversal was clearly the improved prospects for a U.S./China trade deal (albeit one that is very light on substance).
If you want evidence of just how depressive the trade war has been, you need look no further than the fact that the domestic economy has been unable to sustain even a 2% growth rate despite $1.5 trillion of tax cuts, three rate cuts by the Fed in 2019, the renewal of quantitative easing, and what is still an absolutely massive balance sheet being maintained by the world’s central banks. The impact of the trade conflict on overseas economies has been notably even more severe.
It is difficult to quantify exactly how depressive the trade war has been to the global economy, although there are volumes of circumstantial evidence that it is quite significant. For example, the Business Round Table has downgraded its outlook for the domestic economy for the seventh straight quarter as a result of trade angst, and we believe that it is no coincidence that the trade was started exactly seven quarters ago with President Trump’s assurances from March of 2018 that “trade wars are good, and easy to win.”
According to a recent National Association for Business Economics survey, 72% of economists expect a recession by the end of 2021, and this is due primarily to the trade conflict. The trade war is also primarily responsible for the US manufacturing sector contracting in November for the fourth month in a row, according to the Institute for Supply Management, although it is noteworthy that 90% of managers interviewed for the aforementioned Bank of America survey believe that the manufacturing sector is now in the process of bottoming.
In general, both markets and corporate leaders deal much better with certainty than uncertainty, and would generally even prefer “bad news” to uncertainty, because they at least know how to price-in bad news to investment and business decisions, whereas you cannot efficiently price-in the uncertainty related to macroeconomic issues like trade wars.
The trade war aside, there were 2.2 million new jobs created in the U.S. in 2019 and, when you combine this with an average inflation rate in wages of 3%, it translates to almost $5 billion of additional income that can be spent by the American consumer, which already accounts for approximately 68% of the entire domestic economy.
While it may be difficult to assign a nominal value to the economic damage that has been done thus far by the trade war, it is somewhat easier to gauge its impact on corporate earnings. Indeed, according to JP Morgan’s Head of U.S. Equity Strategy and Global Quantitative Research, Dubravko Lakos, tariffs reduced S&P 500 profits by between 7% and 8% in 2019.
Whether you blame 2019’s poor profit growth on the trade war or on other causes, like monetary policy being too tight in 2018, the fact is that almost all equity market gains were due to multiples expansion. In other words, stocks become much more expensive in 2019, specifically when compared to the earnings of the underlying companies. A year ago, the market was selling at 16 times trailing earnings. Now it trades at a very expensive 21 times earnings. Moreover, valuations have jumped dramatically during the year from 13.6 times forward (next year’s) earnings to 17.9 times forward earnings.
All of this is against a backdrop where, according to Morgan Stanley, more than a third of all S&P 500 companies have reported a year-over-year decrease in earnings this year. Of course, the silver lining is that such poor earning growth in 2019 should make for very favorable earnings comparisons in 2020, which could be a significant positive catalyst for the equity markets.
That said, there is little doubt that much of this year’s gains in the equity markets were due almost entirely to reduced trade frictions with China and the dramatic dovish shift in monetary policy. Importantly, markets rarely go up on the same news two years in a row, which suggests that much of the good news is already discounted into domestic equity prices.
However, that is not to suggest that markets will not respond positively to what we expect will be an improving economy in 2020. That said, domestic equity prices are already quite expensive, particularly in comparison to the equity markets in Europe, Japan, and even the emerging markets like China, India, and Brazil. Moreover, we would expect for any improvement in the global economy to benefit most foreign markets and economies more than they will benefit domestic ones, simply because that trade war has done much more damage overseas than it has done domestically.
The level of underperformance by foreign equity markets has been extraordinary over the past decade, with the domestic S&P 500 Index up by more than 180%, while the exchange-traded fund (ACWX), which represents the world markets excluding the U.S., is up by just 18%. Emerging markets have faired even worse since 2010, with a total return of only 4% over the period.
The result of this dramatic and prolonged period of underperformance is that these markets are very inexpensive on both a nominal and relative basis, with domestic stocks selling at over 20 times earnings, while international stocks, on average, sell at only 14.7 times earnings. We believe that this difference in relative value may allow for a potentially extended period of international stock outperformance over their domestic peers.
It is also noteworthy that the foreign markets will not be dealing with the angst associated with a contentious election (unlike the U.S.), and may finally benefit from some weakness in the U.S. dollar, the consistent strength of which has, until quite recently, hurt U.S. investors who are investing overseas.
While we do expect at least some element of mean reversion to further benefit foreign equities, particularly if we see any significant and sustained reduction in trade tensions, we should emphasize that we would also expect for the resulting improvement in global growth to improve the breadth of the U.S. markets, which have largely been driven over recent years by a very select group of primarily large-cap growth stocks.
Under such a scenario, we would expect for value and cyclical stocks to benefit, at the modest expense of defensive stocks, which should still hold their value relatively well due to their dividends. We would still expect for growth stocks to perform relatively well, but for the best risk-adjusted returns in the domestic markets to be found in cyclical and value stocks.
With the Fed on the sidelines, we expect for the election to join the seemingly-ever-expanding trade war as next year’s most important macroeconomic considerations, primarily because markets and investors hate uncertainty, and because, unlike in most years, the differences between the current presidential candidates is simply extraordinary. No longer is it just different shades of the same color. There are potential outcomes of this election that could theoretically change forever America’s entire economic and capital markets system.
It is therefore no surprise that there is a significant premium in the prices of options and futures contracts that would benefit if the stock market were to suffer a significant decline shortly after next year’s election. That said, we suspect that the markets would be fine with either a Trump re-election or the election of a moderate Democrat. However, if it starts to look like either Bernie Sanders or Elizabeth Warren will be the Democratic candidate for president, the equity markets are not likely to take it well, and if it looks like either of them will actually occupy the White House, we have no doubt that investors will start changing how and at what multiples they will value stocks going forward.
That said, prediction market odds are pretty good that the Democrats will keep the House majority (74%) and that the Republicans will keep the Senate (66%). If correct, the checks and balances inherent in divided government should hopefully keep things from getting too extreme in any direction. Remember how equity markets hate uncertainty.
It is noteworthy that the reaction to the impeachment process is more reminiscent of Clinton than Nixon. The stock market is setting new highs, public support for impeachment is waning, and the President’s popularity is actually climbing, as are his poll numbers and odds of being reelected.
In the meantime, we still like the outlook for the global equity markets. While we do have some concerns about domestic equity market valuations, bull markets normally do not end until the individual investor is fully invested in them, and the individual investor is still overwhelmingly a net seller of equities.
That’s why we think that the market cycle has already experienced pessimism and skepticism, and is currently in a state of optimism. However, there are few, if any, signs of euphoria, and euphoria has historically almost always been a requisite for a market top.