During the Cold War, US and Soviet submarines tracked each other across the world’s oceans, often following their adversary very closely to avoid detection. The Soviets developed a tactic to determine if they were being followed: a sudden and sharp turn meant to give their sensors a chance to pick up any trailing US subs. It worked well, unless the two boats collided. Which happened more than once.
The Americans had a term for this maneuver: “Crazy Ivan”. If you’ve seen/read “The Hunt for Red October”, you heard it before. Here is the history from the Russian side, if you are a fan of military history.
Global equity markets are in the middle of their own Crazy Ivan at the moment, swerving to see if inflation is hiding in their wake. After years of peaceful sailing they now fear, well, everything. More aggressive central banks, rising wage inflation, higher organic volatility, valuations… Everything.
What has struck us most starkly are the dramatically different narratives used to explain – or explain away - the Crazy Ivans of the past week, all using the same term: “Fundamentals”. Here are three:
#1. Equity Analyst “Fundamentals”
Anyone who follows corporate earnings in isolation is scratching their head at the recent selloff. From FactSet’s most recent Earnings Insight:
- Corporate earnings for Q4 2017 looks like they will show 14% growth versus prior year once reporting season is over. This is higher than at the start of the year, when expectations called for 11% growth.
- Revenue growth is strong, with 79% of companies reporting top lines that beat estimates. If this holds through the end of the reporting season, it will be a record back to 2008.
- Wall Street analysts are increasing their earnings expectations for the remainder of 2018 and looking for very strong earnings growth overall: Q1 (+16.9% comps), Q2 (+18.7%), Q3 (+20.3%), and Q4 (+17.3%). Yes, much of this is due to lower corporate tax rates, but analysts still looking for 10% earnings growth in 2019 after we anniversary that change.
- Earnings estimates for 2018 for the S&P 500 have been rising all the way through the market selloff, up from 12.2% on December 31st to 18.5% last Friday.
- The bottom up price target for the S&P 500 based on analysts’ price targets is now 20% higher than current trading levels. On January 25th, the S&P 500 was trading at just a 6% discount to these targets.
Conclusion: “Equity Analyst Fundamentals” do nothing to explain the selloff, and in fact make it much more worrisome. A falling stock market in the face of good/great earnings news is a sign of a top in both earnings and profit margins. Or, at least, a robust fear of that outcome…
#2. Cross-Asset “Fundamentals”
During equity market dislocations the first thing we do is look at every other capital market to see where else volatility is rising/falling. The next item on the to do list: assess which markets are moving in line with historical patterns, and which have taken on a life of their own.
This approach gets us closer to the truth about how markets are repricing risk. It isn’t just the rise in Treasury yields that are flashing yellow. For example:
- Options markets. The price of hedging an S&P 500 portfolio, as measured by the CBOE VIX Index, has not fully recovered from its melt-up on Mondayand sits at 29 (one standard deviation from its long run average).
- Fed Funds Futures. We have been closing tracking Fed Fund Futures, particularly the odds that the Federal Reserve increases rates 4 times or more this year, rather than most investors’ expectations of 3 moves. Futures gave 4 increases (or more) a 28% chance on February 2nd, up from 24% the prior day and 11% at the start of the year. Not a coincidence in our minds: that US stocks began their decline on February 2nd, just as Fed Funds Futures topped a 1:4 chance the Fed would raise rates more than consensus expectations.
- Oil markets. Crude markets are complicated, but the price action in the current equity market decline is dead simple: it is awful. Over the long term, oil prices correlate positively to both equity prices and economic growth. The fact that WTI closed below $60/barrel even as stocks rallied isn’t a good sign.
Conclusion: flashing warning signs everywhere (not just bonds) that equities aren’t out of the woods yet. Volatility remains elevated, Fed Funds Futures still give 4 or more bumps a 17% chance in 2018, and oil prices remain under pressure.
#3. Portfolio Manager Fundamentals
Many portfolio managers see the world through this lens: their job isn’t to find assets they like right now – rather, it is to find assets that other PMs will like in the future.
Here is the problem they face using that paradigm in the current environment:
- There is a new pattern for both equity and fixed income volatility that is a sharp break from the norms of the past several years. Stock volatility is at multi-year highs; bond volatility is close to one-year highs. Challenge: PMs must decide if last week’s price action is the “New normal” or an overreaction after a long run of extreme calm. If it is a blip, they will make their year by buying this week and waiting for others to realize things are fine. If it isn’t a blip, they need to sell more of their holdings and wait for a bottom.
- If inflation is really staging a comeback, interest rates have to rise further. Challenge: what will other money managers decide is the “Right” level of US equity valuations? We know earnings are rising, but will multiples contract further to offset the risk that long-term interest rates are heading much higher? Many portfolio managers may well choose to sell and wait for the price action to tell them valuations have bottomed.
- How will very large asset managers – pension and sovereign wealth funds, for example – choose to reallocate their very large portfolios in the face of rising interest rates and incremental equity volatility? Challenge: this question is the source of much of the capital market’s turmoil, and it will not have an answer for a while. In the meantime, portfolio managers will do their best to guess what the really “Big Money” is thinking.
In the end, it is “Portfolio Manager Fundamentals” that set asset prices just now. And since their game is to forecast future sentiment among other asset managers, we don’t expect volatility to come down materially until they feel they have a grip on these three questions.
But we will end this section with our own Crazy Ivan thought: “PM Fundamentals” have a short half-life since they are based on sentiment rather than the fact/market based approaches of the other approaches.Portfolio managers may well decide in a few weeks that asset prices have been beaten up enough, and will once again fear that other PMs will start viewing stocks as attractive.