"What Has Kept The Rally Going": Some Thoughts From Deutsche Bank

The relentless, steady, monotonous levitation to all time highs keeps chugging along: while last week saw the S&P experience its first 1% intraday move in nearly two months, there has yet to be a comparable move on the downside. As Deutsche Bank notes, pull backs of 3-5% in the S&P 500 are typical every 2 to 3 months historically. The last such pull back occurred just prior to the US presidential election. The 4 month uninterrupted rally since is now well above average and if it continues for another 2 weeks will put it in the top 10% of rallies by duration. At 14%, the size of the rally is also somewhat larger than the historical average between such pullbacks (+10%).

Incidentally, sell-offs of 5% or more occurred on average every 5 to 6 months. With the last one occurring after the Brexit vote, the 8 months since is also well above the historical average. If the rally continues past mid-April it will be in the top 10% by duration. In size, the 19% rally since then is also well above the 14% historical average

So while it is clear that the recent move is an outlier, the next question is what factors have kept the rally going. Here, Deutsche Bank offers several possible answers:

Strong equity inflows following large outflows and massive under-allocation. After stalling at the beginning of the year, US equity fund flows have resumed over the last 5 weeks. US equities have got $80bn of inflows since the election but from a slightly longer term perspective, under-allocation remains massive. Over the last two years cumulative outflows from US equities still stand at a large -$230bn compared to inflows of +$250bn to other developed market equities and +$310bn into bond funds. The direction and pace of equity inflows remains tightly tied to macro data surprises.

US equity fund positioning moved from under- to over-weight though has been pared since. From slightly underweight positioning at the start of the year, positioning rose steadily through January, then leveled off and over the last two weeks has been trimmed even as data surprises which tend to drive positioning have moved up, suggesting funds may already be anticipating a modest slowdown in data surprises

Buybacks remain solid but seasonal slowdown during the earnings blackout period is approaching. After a slowing in Q2 and Q3 last year, buybacks ramped up again in Q4 and the 2016 annual total ($460bn net) was in line with our forecast (Buybacks: Myths, Realities and the Outlook, Jan 2016). We see net buybacks rising in line with earnings growth and forecast $500bn in 2017. Our demand-supply model for equities points to buybacks continuing to provide steady support and by themselves imply 10% upside for the S&P 500 in 2017. However, the buyback blackout periods starting in two weeks should see the pace slow temporarily again.

DB then points out that from a fundamental perspective, the rally has kept going as data surprises skipped typical negative phase. With equity inflows and positioning both tending to follow data surprises, the fundamental reason for the long duration of the equity rally has been the unusually long period without sustained negative surprises. Data surprises generally alternate between positive and negative phases. This time around, however, they skipped a negative phase. After falling to neutral by the end of last year, DB's index of US data surprises, the MAPI, hovered around neutral for the first 6 weeks of the year, then rose sharply again and moved back up to near a 4 year high. The MAPI has consequently been neutral or positive for the last 3.5 months.

Finally, while rates futures positioning remains very short an upside risk is that bond outflows resume on strong data and rising rates. Leveraged fund shorts in bond futures remain very large albeit off extremes while real money bond funds are already neutral their benchmark. Bond funds have received steady inflows this year but the historical relationship with rising data surprises and rates suggests outflows to come.

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That said, as Deutsche Bank pointed out recently, the global "economic surprise" rally is finally poised to roll over after hitting near record highs...

... primarily as a result of a loss in Chinese momentum and the slowdown, or in some cases outright drop, in commodity prices:

Deutsche also added the following warning:

We believe global macro momentum is likely to roll over from current elevated levels:

  • Global macro surprises have only been higher 5% of the time since 2003 (when the data series starts), typically roll over from these elevated levels and have shown first signs of softening over the past week;
  • Global PMIs are already consistent with global GDP growth 50bps above our economists’ 2017 growth forecasts of 3%, despite the fact that the latter incorporate aggressive assumptions for fiscal stimulus in the US;
  • Chinese PMIs are already close to a six-year high, having rebounded by 7 points over the past 15 months. They point to quarterly annualized GDP growth of 8%+ (above the government’s target of 6.5%) and the credit impulse (a key driver of SoE fixed asset investment) is set to turn negative. This suggests the risk to Chinese growth momentum is now to the downside;
  • Our model of global PMIs suggests global growth momentum has rebounded because of the easing in financial conditions due to tighter HY spreads and a reduced drag from USD strength as well as lower global uncertainty. However, it also implies that the rebound in growth momentum should start to fade, as the lagged benefit from falling commodity prices is wearing off.

So whether it is any of the above factors, or simply the influx of retail investors as JPM showed last weekend, coupled with an aggressive selloff by institutions and hedge funds, or an even simpler explanation - a relentless short squeeze - it is clear that while everyone has a theory to "explain" what is going on, nobody really knows, even though everyone can admit the duration of this latest market surge is anything but normal.

As such perhaps the best indicator of what to expect in terms of future returns may be the good, old Shiller CAPE. At 30x, the market has been at these valuations only 2% of the time in history, with future returns without fail being negative in the medium to long-run.

Of course, it is the short-run that everyone obsesses about these days, and as such, those betting on further upside may be wiser to just put their money in "Millennial momentum favorites" like Snapchat. At least there nobody pretends to even bother with such anachronistic concepts like "valuation."