We show that equity markets are stretched (e.g., more than 80% of the S&P rally since last year is due to re-rating), but we also find that the fixed income market has become quite rich (we have been overweight European peripherals for more than a year on valuation grounds, we show that this argument no longer holds), and the same is true of the credit market. Second because capital has been flowing rapidly into risky assets, we document that argument and here too find evidence that the market might be ahead of itself. We read the market reaction last week to the Portuguese news as a sign that the market is indeed too complacent and could correct rapidly.
"If you're not concerned, you're not paying attention" say Axel Merk, founder and Chief Investment Officer of Merk Funds (and former President of the Federal Reserve Bank of St Louis and a former FOMC member). Like many, he sees today's excessive high-price, low-volume, zero-volatility markets as an unnatural and dangerous result of misguided intervention by the Federal Reserve... "Now, the capital base and the equity of the Fed is very small. Odds are that the losses would wipe out the equity at the Fed."
While Janet Yellen is bust ignoring "noisy" inflation and dismissing low volatility as indicative of any complacency, Goldman is a little more concerned. The decline in economic and asset market volatility this year from already low levels in 2013 has been striking, which as Markus Brunnermeier states, means "the whole system is more prone to a financial crisis when measured volatility is low, which tends to lead to a build-up of risk in the background – the so-called 'volatility paradox'."
Now, for the first time, we have empirical proof that hedge funds are indeed on the verge of extinction. In its hedge fund quarterly note (which it clearly ripped off from Goldman), Bank of America has concluded what we said in the beginning of the decade: "Hedge Funds are less attractive post the financial crisis with lower alpha and less diversification benefits." Or, in other words, hedge funds (for the most part: this excludes those extortionists also known as activists who successfully bully management teams into levering up in order to buyback record amounts of stock, in the process burying their companies and employers when the next downturn arrives) no longer provide a service commensurate to their astronomical fees.
With 97.5% of the S&P 500 having reported earnings, as of May 29, 2014, we can take a closer look at the results through the 1st quarter of the year. Despite the exuberance from the media over the "number of companies that beat estimates" during the most recent reported period, operating earnings FELL from $28.25 per share to $27.32 which translates into a quarterly decrease of 3.4%. The ongoing deterioration in earnings is something worth watching closely. The recent improvement in the economic reports is likely more ephemeral due to a very sluggish start of the year that has led to a "restocking" cycle. This puts overly optimistic earnings estimates in jeopardy of being lowered further in the coming months ahead as stock buybacks slow and corporate cost cutting becomes less effective.
Considering that both key overnight news reports: the Chinese HSBC PMI (printing at 49.4, vs 49.7 expected) and the Eurozone CPI print from a few hours ago (print of 0.5%, down from 0.7% and below the 0.6% expected), we find it odd that futures are red: after all this is precisely that kind of negative data that has pushed the market to record highs over the past five years. And speaking of odd, considering the ongoing non-dis-deflation in Europe, the fact that Bunds and TSYs are being sold off today makes perfect sense in a New Normal bizarro world.
Bizarro market got you paralyzed with inaction (and unwilling to generate trading commissions for Goldman) as you try to make sense of an insane world in which first rising (but not too much) bond yields were desperately spun as positive for the economy and thus stocks because it means inflation is finally on the way, only for the same spinners to turn around and now allege that plunging bond yields are great for the Equity Risk Premium so you must, you guessed it, buy stocks? Fear not: you are not alone: according to the following note from FBN, what JPM, Citi and Goldman are lamenting, this era of a new permanently high equity plateau, and a permanently low vol and yield ravine, is driving pretty much everyone insane.
The US and UK markets may be closed for holiday today but that doesn't mean that US equity futures can't spin this weekend's resurrection of anti-EU sentiment in Europe, coupled with the just confirmed resumption of the "anti-terrorist" operation in Ukraine (more on that shortly) following its anticlimatic presidential elections in a positive light. They can and they have, and even though the USDJPY low volume ramp is oddly missing overnight, and 10 Years appear bid, spoos are set for another record high, and are already trading up 0.2% at 1901.3, above 1900 for the first time ever. European shares remain higher with the autos and bank sectors outperforming and food & beverage, basic resources underperforming. The Italian and German markets are the best-performing larger bourses. The euro is little changed against the dollar. Greek 10yr bond yields fall; Italian yields decline.
Despite two desperate attempts to juice stocks overnight via JPY, US equities opened red and got redder. The selling climaxed when Europe closed and stocks rallied handsomely "off the lows" proving Tepper wrong and the rest of CNBC right (right?) The S&P ramped back up perfectly to VWAP (thank you Michelle) as 330ET BTFD'ers ensured it closed back above the all-important 50-day-moving-average. The Dow did not bounce like its higher-beta short-squeezing cousins and dropped back into the red for 2014. Away from stocks, bonds just kept rallying - but everyone said that couldn't happen - to new multi-month low yields for 10Y and 30Y (-13bps on the week). Commodities lost ground with gold back under $1300 as the USD ripped and dipped to close unchanged on the day. VIX popped back over 13 with its biggest rise in 5 weeks.
Cruising through earnings, it is now time to revisit certain indicators that speak to the underlying health of the economy and that of the US equity and Treasury bond market.
The "Shiller P/E" is much in the news of late, and, as ConvergEx's Nick Colas suggests, with good reason. It shows that U.S. equity valuations are pushing towards crash-worthy levels. This measure of long term earnings power to current price is currently at 25.3x, or close to 2 standard deviations away from its long run median of 15.9x. As Colas concludes, the writing is on the wall and we must all read it. Future returns are likely going to be lower. Competition for investor capital will get even tougher. That’s what the Shiller P/E says, and it is worth listening.
From Goldman's David Kostin, who first looks back: "S&P 500 began 2014 with a pullback of 6%, repeating its 2013 trend, but then rallied 8% to reach a new high of 1885. The market has not had a drawdown of 10% since the summer of 2012, rallying nearly 50% during that time. Gold and bonds have outperformed stocks YTD" and then forward: "S&P 500 rises 2% in 1Q to hit new high; we expect 3% appreciation during next 12 months" In other words, by the end of this week the Market should hit Goldman's 12 month forward price target.
Netflix isn't as expensive as it appears. Be cautious getting caught up in the latest fear frenzy over net neutrality.
With The White House proclaiming Russian stocks a "sell" today (and in the meantime Russian stocks and the Ruble strengthening), it is clear, as Citi's Steven Englander notes, that the Russia/Ukraine crisis may be the first major political conflict that is played out in international financial markets. The difference, Englander points out, between this and standard imposition of sanctions is that both sides have some options that can inflict damage on the other side; and this has significant implications for investors in the short- and medium-term.