A pesar de las continuas voces de que esto se desploma, el que sigue se muestra optimista y cree que todo va a seguir subiendo más… No, no cede ni a tiros. Se llevan equivocando quien desde hace tiempo pronosticaba salirse del mercado… No hay alternativas y esto sube y sube. Y si hay recortes, saldrá dinero más abajo.
Third Quarter 2017: I’m All Right … Don’t Nobody Worry About Me
The reports of the coming economic demise continue to prove premature. For much of the past few years, we have filled these pages with our data-driven retort to the constant noise about the next impending economic and market downturn. One year ago, after United States gross domestic product (GDP) fell to 1.2% year-over-year from a recovery high of 3.8% in early 2015, we titled our commentary, “To Every Season Turn, Turn, Turn.” We expressed our belief that the conditions for rising future U.S. and global economic growth were in place. After a weak first-quarter 2017 U.S. growth report caused many to doubt the accuracy of our prior forecast, we reiterated our position in a commentary titled, “It’s More Than a Feeling.” Why? Because we noted that even with the weak first-quarter GDP report, the forward-looking economic leading indicators – notably business and consumer confidence – pointed to stronger growth ahead.
Consider it done. Indeed, second-quarter U.S. economic growth recently clicked in at a robust 3.1% quarter-over-quarter rate, which pushed the year-over-year number to 2.2%. And we note during the third quarter that these same leading economic indicators leading us to forecast rising economic growth in the second quarter kept expanding. Indeed, both the Institute for Supply Management’s Manufacturing and Non-Manufacturing Index reports on business continue to post extremely strong readings in the third quarter, with the leading indicator of new orders at expansion highs and at levels that have historically led to strong future economic growth.
On a more granular basis, consumer confidence during the quarter remained near levels last witnessed during the strong expansion in the late 1990s. The same can be said of business owners who are finally expressing their belief that it is a good time to expand their companies. Regardless of whether the proposed tax reform becomes law, we believe that business owners must invest to improve the productivity of the millions of workers they have already hired, substitute for the workers they can’t currently find and replace aged plant property and equipment. The confluence of these factors plus a global economy that is accelerating continues to shape our forecast that the U.S. economy is all right and primed for the above-trend growth in the coming quarters.
Does Economic Expansion Have Ample Time To Run?
With the economy having turned the corner, the chorus of naysayers has shifted the conversation to a question of how much longer this aging expansion can last. My answer to this is the same as it was to my children for most of our long summer vacation, when they continually asked “Are we there yet?” from the backseat: Be patient; the journey is not yet over.
The conditions that have historically marked the end of an economic cycle are an out-of-slack U.S. economy with rising inflation and a Federal Reserve rushing to tighten interest rates to snuff it out. During the third quarter, inflation remained at moderate levels. While we believe that it will begin to rise in the future, all indications remain that the Fed will not be in any hurry to stomp on the brakes this time. Our current analysis remains that both the U.S. and global economy have further room to expand; and as history has shown, this means the economy will drag the U.S. and global equity markets higher.
Overly Protective
The Fed is an entity that wants to be overly sure everyone is all right. They can’t just let it be. The last sentence of the prior paragraph is exactly opposite of recent history. Quite the contrary: Over the last 10 years, the Fed has prodded the financial markets higher first with a goal of dragging the economy into expansion. Their prescription was to 1.) Lower short-term interest rates. 2.) Buy large amounts of intermediate- to longer-term Treasuries to push their prices up and yields lower. 3.) Make promises (forward guidance) to solidify their actions and reassure investors to take risks in equities and the economy.
The big event of the third quarter was the Fed’s announcement of the commencement of the second step in the process of unwinding the application of their above prescription. While they have previously begun raising short-term rates, at their September 2017 meeting, they announced they will begin shrinking the $4.5 trillion balance sheet of U.S. Treasury bonds and mortgage-backed securities they have accumulated to push long rates lower. The adjective they used to describe their planned process was “gradual.” You may ask, why? Because, as Fed Chairwoman Janet Yellen mentioned during her last press conference, the Fed’s latest research estimates that its actions have lowered bond yields by around 1%. Yellen added this color to the importance of “gradual” when she said, “By limiting the amount of securities that private investors have to absorb as we reduce our balance sheet, the caps will guard against outsized moves in interest rates and other potential market strains.” In my opinion, this translates into layman’s terms that the Fed wants to keep financial markets elevated because it fears any market volatility (stocks or bonds) could cause a financial market shock, which could spill over into the real economy and cause a recession. The Fed remains supportive of financial markets in the nearer term.
While the past few years have led the Fed to more aggressively backstop financial markets as described above, we believe this is a culmination of a path the Fed has been on since the 1980s. Many long-term Fed watchers and investors have likely heard the following terms: the “Greenspan/Bernanke” and now “Yellen Put.” These are terms investors have used to express their belief that the central bank stands ready to bail them out in times of need. Perhaps the Fed of the future will just let the markets be and focus their actions on the U.S. economy; however, as of now, the Fed appears to be fully behind keeping financial markets and the economic cycle afloat.
The Bottom Line
Given the confluence of the above observations, we continue to believe that in the nearer to intermediate term, equity markets, even at elevated levels, will continue to rise. While we’re certainly not near equity exuberance highs, we do worry that there are increasingly fewer people willing to give us a fight on our positive market outlook. We also note that while we believe the economy has time left to expand, we must acknowledge that we are lurching toward the end of the economic cycle. These two realities are beginning to shrink the margin of safety in our equity call. Therefore, we want to take the closing moments to reiterate the merits of our old friend – diversification.
Diversification pays the most near the end of business and market cycles. While we worry about a rise in bond yields and continue to express our desire to favor equities, we encourage investors to own bonds for the great qualities they possess. Bonds provide an asset class that has a high probability of maturing at par and ballast portfolios if our economic outlook is incorrect, and most importantly, they help fund an investor’s nearer-term liabilities.
We must also acknowledge that the Fed’s action that has pushed bond yields lower has also helped support equity markets. Therefore, if bond markets have difficulty, equity markets could have a nearer-term hiccup. However, equities retain their long-term, attractive proposition. To give an extreme example, October 2017 marks the 10-year anniversary of the U.S equity market peak of the prior expansion. The unlucky investor who bought at that peak in October 2007 would have had to ride through a harrowing downturn of nearly 57% during the Great Recession. However, the recovery that has unfolded over the past eight years would have pushed that investor’s return to over 100%, or 7% plus per annum, since 2007.
We remind that we continue to direct equity investors to diversify across the globe to take advantage of cheaper valuations. Both emerging and international developed equity markets, after years of languishing relative to U.S. equity markets, have recently provided strong relative outperformance. While we spent 2015 and 2016 worrying that investors were abandoning these markets and trying to persuade them that better days were ahead, recent data shows that the average investor fell prey to their emotions and lessened their diversification. A recent Fidelity study noted that investors who had 21% in international markets in 2009 had shrunk that level to 13% by year-end 2016.
This brings us to our last worry. After years of underperforming, there is an asset class that we are gradually warming up to as a potential future portfolio hedge or diversifier. A key lynchpin in the above economic and Fed calculus is that inflation remains low. If it doesn’t, the Fed’s gradual plan may speed up, which could disrupt both bond and stock markets. As such, we are seeking out a third asset class that will provide a hedge if inflation ticks higher than expected. The asset class that is at the top of our list is Commodities. After all, it is highly correlated to inflation.
Abrazos,
PD1: Lo mismo opina Morgan Stanley, que dice que a pesar de haber riesgo de unos días malos, deberá subir todavía otro 15/20% más, ya que saldría dinero rápido en cualquier consolidación:
Morgan Stanley Sees "Greater Risk For A Correction Than We've Seen In A While"...But There's A Catch
As U.S. equity markets casually melt up to all new highs with each passing day, Morgan Stanley Equity Strategist Michael Wilson, whose 2,550 year-end price target from back in August was just breached in a matter of months, says he's getting somewhat concerned given Fed tightening, tax cut legislation that looks increasingly unlikely to pass, USD strengthening and extreme levels in pretty much every economic indicator which will make future improvement nearly impossible.
Given that, Wilson says he now sees "a greater risk for a correction than we have seen in a while..."
With the S&P 500 reaching the lower end of our short term price target (2550-75) we put out in August, we think there is a greater risk for a correction than we have seen in a while. If stocks follow the pattern they have been all year, actual earnings season will be a sell the news event and we could have a decent pull back or consolidation. Other things we think warrant concern include the Fed's balance sheet reduction, uncertainty around Fed Chair nomination, negotiations on tax legislation, and the scope for a counter-trend US dollar rally.
Six weeks ago we went out on a limb with a shorter term target of 2550-75 for the S&P 500 to reach before 3Q earnings season as the market would realize consensus expectations were once again too low. Having breached that lower bound 9 days ago, we believe it is appropriate to respect the pattern we have been witnessing all year for stocks to rally into earnings season and then fade as the numbers actually get reported. Year to date, this has led to a max 3% drawdown which is not worth trying to play when there is still 15-20% upside. However, with less than 10% upside to our target, the risk reward isn't as attractive to just ignore the potential for such a move. We also think it could be bigger than 3% this time given other factors at work. Specifically, we must acknowledge:
+the Fed is reducing its balance sheet this month for the first time since QE began,
+tax cut legislation is trickier than tax cut promises, the negotiations begin this month
+we are going to get the next Fed Chair nomination later this month which could disrupt financial conditions
+The US Dollar appears to be in the midst of a countertrend rally, and
+given the extremes in leading economic indicators like the purchasing manager surveys, the chance of a peak rate of change looks more likely than not.
Of course, 'the catch' is that he also sees any pullback as just another short-lived opportunity to BTFD!
To summarize, we believe the cyclical bull market that began in 2009 is very much intact but we are more confident than ever that we are in the latter stages. As we noted in our initiation, returns are typically very strong at the end and investors cannot afford to miss such moves given the likelihood of lower returns than normal over the next 10 years.
We believe the next month offers a higher likelihood for a 5%+ correction than we have seen since the summer of 2016. With only 1 percent upside to our short term target of 2575 and 5%+ potential downside, this is not the time to be aggressive like it was in August. Rather than a 5%+ correction we could simply trade sideways for a month.
In either case, we will be buyers of that pullback or consolidation as we believe it will set the stage for the next leg higher, toward our 2,700 target on the S&P by 1Q. Our focus remains on small/mid caps, Financials, and late cycle sectors including Energy, Materials, Industrials, and Tech
So, what evidence does Wilson offer up to support his thesis that equity markets will continue to push higher for the foreseeable future? Well, apparently he's encouraged that, after a shift to value stocks earlier this summer...
...investors have returned to cyclical stocks in a big way since August signaling that "Part II" of the reflation trade has commenced....to summarize, if we understand it correctly, what goes up will necessarily continue to go up.
So, what tangible "fundamental" evidence does Morgan Stanley offer to support their thesis that stocks have a ways to go to the upside? Well, none really...just a relative multiple chart suggesting that a basket of "reflation" equities trades at a P/E discount to "deflation" equities.
The key fundamental drivers of our thesis are still very much in place, allowing these nominal GDP / inflation-levered sectors and styles to lead. Exhibit 5 below shows that the median relative forward P/E for "reflation" vs. "deflation" stocks has re-rated higher over the past two months. The relative multiple of this pair remains depressed since the Financial Crisis which makes sense given the persistent deflationary pressures—we would expect a continuation of the recent re-rating of reflation levered equity valuations higher as deflationary pressures fade and re-flation emerges. As further fundamental support, Exhibit 6 shows that relative earnings revisions breadth for the aforementioned pair also appears to have bottomed.
Of course, in our ETF-driven world it's probably not surprising that Morgan Stanley chooses to only focus on relative valuations and completely dismisses absolute valuation levels that look increasingly unsustainable...alas, the chart below was also dismissed in 1999 as irrelevant but by 2001 it was suddenly relevant again...
PD2: Muchos están convencidos de tener ya el “billete” para el Paraíso solamente porque piensan que son buenos. Cristo ha pagado el precio de nuestra salvación sin excluir a nadie, pero hay que observar unas condiciones básicas. Y, entre otras, está la de no pretender que Cristo lo haga todo y nosotros nada. Esto sería no solamente necedad, sino malvada soberbia.
