Earlier today, when Bank of America said that "panic is building" in the market and asked, rhetorically, "how bad could it get", it listed what it thought are the five core pillars [14]in the bailed out bank's wall of worry:
- slowing US and global economic growth (US 4Q GDP tracking 1%)
- collapsing commodity prices (oil prices averaged -42% y/y in 4Q)
- renewed fears about China (Shanghai Composite -38% since last June)
- heightened geopolitical tensions (Middle East, North Korea, etc.)
- the first transition to Fed policy tightening (in a decade).
We were very surprised that one thing missing, perhaps the most important thing, was fundamentals. And, as SocGen's Andrew Lapthorne conveniently points out, as he has been pounding the table on this issue for years, it is fundamentals - stretched to ridiculous levels - that are finally being appreciated by the market, and the result is the dramatic repricing we have seen.
As Lapthorne says, whilst the focus has been on China, where the CSI 300 fell 10% last week and at time of writing is off another 5%, "China and its accompanying devaluation is just another domino to fall, in what has been a long process of investor realisation that all is not well in the global economy. For us the real problem remains the lack of growth, a problem QE sought to disguise, but did not solve through higher asset prices."
So having deferred growth for years and years, hoping central bankers would magically conjure it out of thin air eventually, suddenly the market is realizing it the most important component to justify valuations isn't coming, "and now after four long years without any profits growth, the risk is that MSCI World mean-reverts to its original 2011 PE multiple, which would imply a further 50% decline from here. Even decline back to average would imply a 15% drop."
So what does this valuation disconnect mean? Lapthorne explains:
This gap between equity prices rises and actual profits means that despite recent price declines, obvious pockets of value are still quite rare. Median valuations remain elevated, especially once huge debt piles are included and EV/EBITDA metrics are used and valuation dispersion (the choice of valuations available in the market) is still below average in Europe and the US. However from what was a very low base, the number of deep-value names (a la Ben Graham) has risen from 43 at the end of November to 73 as of close Friday, with the bulk of these new names coming from Asia ex Japan, Japan and the US. Quality Income names with a 4% yield however remain rare.
So could the long, long overdue great rotation from growth and momentum names to value finally be starting? If so, some of the upcoming flame outs, not just among the FANGs but across the entire market leadership, if such a thing exists, in the coming months will be stuff financial horror stories are made of.
