I took some time out recently to describe the extent to which the journey to new record highs for U.S. equities has morphed from an all-out, wind-at-our-backs sprint in January to a slow, arduous grind higher, reminiscent of trudging warily uphill on a hot, breezeless summer day.
If you like short stories or are otherwise inclined to appreciate good writing from the finance bloggers you read (I know, what a concept, right?!), I recently framed this discussion using a vignette about an aborted Sunday journey to a local fish market. You can read that post and some accompanying color from JPMorgan’s Nikolaos Panigirtzoglou here.
Ultimately, this is a push and pull dynamic with, on the one hand, various geopolitical risks weighing on sentiment, credit signaling something might be amiss and the withdrawal of central bank liquidity removing perhaps the biggest tailwind for global risk assets, and on the other, fiscal stimulus, record earnings, re-risking by systematic strats and a deluge of buybacks arguing for a final leg higher for a U.S. equity bull whose place in history is already cemented.
Rising rates add another wrinkle, as everyone seems to change their story about what level on 10s actually matters for stocks depending on where 10Y yields actually are at the time (and yes, that’s funny). Take this amusing visual from the latest installment of BofAML’s Global Fund Manager survey for instance:
Well, for their part, Barclays thinks “It’s Late, but the Party’s Still Going”.
That’s the title of a new equity strategy piece that finds the bank slapping a 2,900 year-end target on the S&P.
This is a lengthy note, but the gist of it is captured in the executive summary (which is a good thing because you know, that’s what executive summaries are for), in which the bank breaks things down into five questions. We’ll just excerpt four of those and the short answers here (needless to say, the full piece has exhaustive discussions of all points mentioned). To wit:
Q1: When will higher rates become a headwind for Equities?
Answer: History says 5% in 10y Treasury yields but this time it could be 3.7%.
Q2: Where are we in the business cycle?
Answer: We think we are just entering the late stage despite 9+ years of expansion.
Q3: Can the strong expected earnings growth and elevated valuations be justified?
Answer: We forecast strong earnings growth of 19% for 2018 but expect a further modest decline in valuations.
Q4: What are the fundamental cross-currents buffeting equities?
Answer: Trumponomics and Disruptive Innovation are creating strong winners and losers.
Obviously, question 3 (and the accompanying answer) calls for a bit more in the way of explanation, even if we’re just giving you a summary of the longer discussion.
So, here’s Barclays’ approach to their year-end target which really isn’t as complex as they make it sound:
For SPX our projected one-year-out P/E ratio is a weighted average of the current P/E ratio and long term P/E “fair level,” which itself is dynamic and depends on a range of macro factors. This explicitly acknowledges the reality that the P/E ratio can deviate from its fair value for extended periods of time and only slowly mean reverts to a fair level. After examining a range of variables, we find that a parsimonious set includes interest rates, inflation, inflation volatility, and industrial production. The one-year-out P/E ratios for each sector are modeled as a function of the one-year-out SPX P/E ratio and the current level of the sector P/E ratio. Thus we assume that SPX P/E ratio effectively captures all the macro effects and our sector P/E ratios are best viewed through a relative value lens.
So that’s a pretty conservative estimate and I guess what’s so amusing about these forecasts now (and by “now”, I just mean in light of everything that’s happened since the halcyon days in January) is that if you think back to the first three weeks of 2018, U.S. equities were routinely blowing through analysts’ year-end targets on a near weekly basis. Remember this chart?…
In any event, Barclays’ forecast entails more multiple contraction from here which I suppose means you’d better hope earnings hold up.
Take it all for what it’s worth.
Well as a bond and equity investor who has always preferred a higher bond allocation, I would shift over a large allocation to bonds at 10 year treasury @ 4%. This would put baa 10 year corporates at close to 5.5 – 6% (assuming same compressed spreads, which might actually widen). This would offer some stiff competition to historical long term equity yields.
The crossover threshold is much lower than 10 years ago, before the interest rate drought. Interest rate sensitivity increases the longer a drought lasts. I think in general this is true for many fixed income investors.
Unfortunately, A 10:year treasury at 4% won’t be happening any time soon……:(