JPM Still Hates The Market Rally: Here Are Its Reasons

In the past month, not a day has passed without some major sellside firm (yes, that also now includes traditional bull Goldman Sachs) releasing its bearish take on deteriorating fundamentals, and urging clients to not only not buy the rally but sell into it (and as both retail and "smart money" flows indicate, this advice ha been heeded). Today it's JPM's turn. In the latest note is out of JPM's Mislav Matejka, the equity strategist presents five reasons why "upside for stocks is limited" due to numerous reasons but mostly because "global activity momentum is failing to pick up."

Here are his five reasons not to chase the rally in the short-term:

Equities have seen very large outflows for a number of weeks now, vs bonds which have enjoyed significant inflows.

This could be interpreted as a positive, as one could say that equities appear underowned, vs bonds which might be overowned. US EPS revisions have managed to stay in positive territory for the last 3 weeks. Given these and the fact that stocks have been consolidating the Feb/March gains for two months now, the question is should one look for another leg higher, such as the 10-15% tradeable rally we called for on 15th Feb? Our view is that risk-reward is not attractive for equities, as:

  1. Activity remains sluggish. The latest business expectations reading within US services PMI is the lowest on record. The latest output reading within US manufacturing PMI is the weakest since Sep ‘09. The gap between CESI and SPX continues to be significant.
  2. Chinese backdrop remains worrying. Activity rolled over again, iron ore price is down 30% from highs, A-shares are down double digit ytd, policy support is waning and Renminbi is very close to making new lows vs the USD.
  3. US EPS revisions will not likely be in positive territory for long. The hurdle rate for the rest of ’16 is very optimistic – S&P500 EPS are expected by consensus to accelerate from $27 in Q1 to $32 in Q4, which would be a new all-time high. Even using these lofty consensus EPS projections, P/E multiple for S&P500 is at the top of the range, at 17.8x for ’16e, not offering much upside.
  4. Bond yields are staying put. We need these to move up for equities to perform, in our view. Furthermore, the move has to be for the right reasons, i.e. growth turning up, and not just inflation. Yield curve is the flattest in eight years, which was typically not a good sign.
  5. Tactical indicators are mixed. Retail outflows suggest positioning is light, but HF beta is in fact elevated, and speculators are net long SPX futures. Seasonals are not attractive and some of the upcoming event risks might end up being more of a problem than the equity market gives them credit for currently. VIX trading near lows is perhaps a sign of complacency.

In terms of equity allocation, we are UW equities in balanced portfolios for ’16, our first UW equity allocation since 2007. We cut our multi-year, structural OW stance on 30th Nov and this year have a preference for credit vs equities.

It's not just the near-term. JPM also adds that over the medium term "we think the upside for equities is limited, and we advise to keep using rallies as opportunities to reduce."

  • Equity valuations are not offering much room for error. Global P/E multiples have moved back to outright expensive territory. The P/S metric is higher today than it was at any time in the ‘07-’08 period, also outright expensive. Peak P/S on peak sales? Bond yields staying low might not result in ever higher P/E multiples - low bond yields will over time spill over into ever-decreasing nominal growth rates.
  • US bank lending standards have tightened for three quarters in a row – supply of credit is worsening. The gap between credit spreads and equities remains significant, despite some stabilisation in credit spreads in 1H. At the same time, median US net debt-to-equity ratio is at the top of the historical range, much higher than it was in ’07.
  • US profit margins are deteriorating. Profitability improvement was one of the key drivers of the seven-year long equity rally. This is likely finished, as the profit margin proxy – the difference between corporate pricing and the wage growth – turned outright negative in Q4, for the first time since 2008. Buybacks have flattered earnings for a while now. As a share of EBIT, buybacks are near historical highs, similar to the levels seen in 2007. We would be surprised if they stay a potent support. Indeed, announced buybacks have slowed down sharply recently.
  • Growth – Policy trade-off is poor. Global economic activity remains subdued, and at the same time, the Fed is not injecting liquidity into the system anymore. Any spell of better dataflow is met with the Fed opening the doors to hikes, which brings stronger USD and puts CNY under renewed pressure, acting as an automatic dampener for equities. On the other hand, weaker dataflow puts in question the earnings delivery. Not a great combination.
  • Structural Chinese backdrop remains challenging, in particular in terms of credit excess. Given these shaky foundations, it is difficult to extrapolate any pickup in Chinese activity with much conviction.

All that said, as of this moment - with stocks at 2016 highs and just why of all time highs - it is clear that correlation algos do not really care about JPM's puny "fundamental" reasons.