Stock market valuations have moved significantly higher. This is especially apparent in South Africa, where the current price earnings multiple of 17.5 times has only been exceeded five percent of the time over the past 50 years. The readings are far less ominous in the US, where the current multiples of 19 times are merely breaking into the top third of historical readings. But we also know that profit margins are historically high in the US, implying that the moderate valuation may be masking some of the potential capital risk.
The chart below, generated by GMO, provides fascinating insight into the high profit margins currently being experienced by US listed companies. The so called Kalecki profit equation disaggregates profit margins into its component parts. The key observation for the purposes of this article is that the largest current contributor to elevated profit margins is the record fiscal deficits run by the US government (grey shaded area). This cannot continue indefinitely and therefore a reasonable assumption must be that unless the household sector re-leverages aggressively, or there is a dramatic increase in investment spending, profit margins are at unsustainable levels.
The importance of valuation
Starting valuations are the most reliable predictor of future returns. The lower the valuation at the time of investment, the better the likely outcome. The challenge for investors is that this relationship tends to be predictive only over long time horizons. Consider, for example, the South African stock market over the past 50 years: our research suggests that the starting price earnings multiple has statistically explained 67% of the subsequent market return over the next seven years (a remarkably high number), but only 12% of the subsequent market return over the next 12 months. In other words, valuation is not a particularly effective predictor of returns over shorter time horizons. But caution is warranted because market corrections tend to be more severe when their inception coincides with high valuations, as is currently the case.
Investors are therefore faced with a choice. Take heed of the lessons that history has provided, accept that longer term equity returns are likely to be muted, and position themselves for this outcome. Or continue to ride the wave of liquidity that has been instrumental in pushing valuations (and the profits on which those valuations are based) higher. After all, the best advice over the past couple of years has certainly been captured perfectly by the old adage: ‘Don’t fight the Fed’.
It therefore seems like an opportune time to assess whether there are any additional indicators (over and above valuation) that investors should be taking heed of to help reduce the chances of a nasty drawdown.
We are not suggesting that bear markets can be predicted or that there are any indicators that have individually had a perfect record in predicting a drawdown. However, there are some indicators that as a group have often been co-incident with impending poor market returns. And because these factors should all fundamentally impact market returns, they are worth paying attention to. These indicators include valuation (already discussed), economic conditions, monetary conditions and levels of investor optimism. We discuss each of these in more detail below:
Recessions tend to be anticipated by stock markets and markets tend to drop in advance of economic downturns. In other words: the stock market is often a good leading indicator of economic activity. Therefore, any indicators that point to a looming recession should be noted. The heat-map below shows that global economic activity has generally been improving and is at healthy levels (a number above 50 indicates expansionary conditions). South Africa and China are notable exceptions, both having been ‘stuck in neutral’ for some time.
In summary the economic backdrop remains positive for most developed markets, but neutral to negative for South Africa.
In the developed world, liquidity remains abundant. Although the US Federal Reserve has begun to taper its quantitative easing program, it is still injecting large amounts of liquidity into markets; just a bit less than before. The UK, European and Japanese authorities are still going at it full speed. This excess liquidity has kept real rates at artificially low levels, which has been stimulatory for asset prices. Continued elevated liquidity conditions bode well for market prospects.
Although in South Africa there are no deliberate large-scale measures to either add or remove liquidity from the market, domestic assets have certainly been the beneficiary of the global liquidity glut.
Rising interest rates impact equity markets in a number of ways. Firstly, higher interest rates can stifle economic activity and negatively impact the operating performance of the companies themselves. Secondly, higher interest rates reduce the attractiveness of stocks, as the yields on bonds and cash become relatively more appealing. In developed markets, interest rates are at or close to all-time lows and look set to remain low for the immediate future. In fact, bond markets are only pricing in initial interest rate increases in 12-18 months’ time.
In South Africa and a number of other developing nations, interest rates have already moved off their lows, in some cases substantially. And things seem set to get worse: the SA bond market is currently pricing in a substantial rate hike over the next two years. The potential impact on the economy and companies dependent on it is clearly negative.
There are a number of indicators that help quantify the level of investor optimism. A high level of investor optimism is a contrarian signal as investors tend to get most optimistic when things have gone well for a long time. Flows into equity funds, levels of margin debt, the put/call ratio, market breadth and price momentum all provide clues to levels of optimism.
Citi Research has developed a ‘Panic-Euphoria’ model for the US market that measures many of these factors and some additional factors to try and determine the current level of investor euphoria. They call this measure the ‘Other PE’. From the chart below it can be seen that the most recent reading (light green line) is at its highest level since the end of the dot.com boom, and is well into the ‘Euphoria’ zone. It is interesting that this model, which dates back to 1987, has had some explanatory power (an R2 of 36% exists between the Other PE and the 12-month subsequent market return). The current reading for the Other PE ‘predicts’ a 12-month return for the US market of -6%.
Similar research by Bank of America Merrill Lynch on South African fund managers highlights that this grouping is relatively bearish and cautiously positioned. This potentially reduces the likelihood (and impact) of an imminent correction in the SA market.
In the table below, we ascribe a positive (+), neutral (o) or negative (-) rating to the US market today, and also at the onset of the previous three bear markets (defined to be a market correction of 15% or more, lasting three months or more). It is interesting to note that current conditions are generally broadly neutral (two positives and two negatives) and are in fact better than at the onset of two of the previous three market corrections. The exception is the bear market precipitated by the worries over the Eurozone collapse in 2011, which could perhaps be argued to be an exogenous (i.e. non-US) event.
The picture for the South African market is less rosy. Three of the four factors are being rated negatively, with the exception of Investor Optimism which is assigned a positive rating due to the pessimism of local fund managers.
Predicting the next bear market is a fool’s errand. But the data provided suggest that a number of indicators, particularly in the South African market context, are flashing as warning signs. It is with this in mind that investors should decide if they still want to be ‘all-in’ for the ride that has been so good for so long.