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In Markets, Summer Melt-Up To Meltdown?

You can hardly blame anyone who's nervous

“Inauspicious” probably isn’t the right word considering how far stocks have run since the end of May, but “uninspiring” will work to describe US equities’ performance as earnings season got rolling in earnest.

Stocks had their worst week since the May selloff as folks digested big bank earnings, heightened tensions in the Strait of Hormuz and a rather unfortunate communications debacle from the New York Fed.

Nobody would blame you if you’re betting this week’s 1.2% decline presages a steeper selloff. After all, the usual laundry list of concerns are still in play. Friday’s events in the Mideast underscore the risk of miscalculation even as rhetoric from both sides (i.e., the West and Tehran) seems to suggest nobody really wants a serious escalation.

On the domestic political front, Donald Trump has infuriated half the country with increasingly vitriolic attacks on four congresswomen of color, rankling Democrats just days before Robert Mueller is set to testify for five hours on Capitol Hill.

Expectations for corporate profits are muted and investors remain concerned about the global economic outlook. BofA’s latest Global Fund Manager survey found 41% of investors saying global profits will deteriorate in the next 12 months. Last month saw the second-largest ever plunge in profit expectations over the 23-year history of the survey question. Meanwhile, 79% of respondents are bearish on both the growth and inflation outlook for the global economy over the next 12 months.

(BofA)

The trade war is still simmering, with Congress angling to enshrine Trump’s Huawei ban into law just as the administration looks to roll it back. Talks with Europe to resolve the Airbus subsidy spat and, more importantly, avert auto tariffs, haven’t even begun in any real sense.

And on and on.

Some pundits are fond of saying there’s always risk in the market and there’s always uncertainty. That’s true (in fact, it’s a truism, which means you aren’t saying anything that’s worth saying by uttering it), but considering Trump is in the Oval and stocks are loitering near record highs in a late-cycle environment, you can hardly blame anyone who’s nervous. Indeed, YTD cross-asset returns border on the absurd.

“Flow-less” is still a word many observers use to characterize the equity rally. $144 billion (net) as come out of equity funds in 2019, while more than $250 billion has been plowed into bonds. That only muddies the waters further. It suggests there’s “dry powder” out there for stocks, but it also conveys how nervous people still are after the Q4 2018 rout.

(Goldman, EPFR)

As BTIG’s Julian Emanuel told Bloomberg’s Sarah Ponczek, “I talk to people that are having fantastic years and they’re miserable [because] they don’t know whether they should be taking their chips off the table, or even if they would be taking their chips off the table, whether you cut back your winners or cut back your underperformers”.

While forward multiples may be stretched, it’s not clear that stocks are mispriced. “Based on the 45-year historical relationship between trailing Price/Book valuation and return on equity, S&P 500’s current P/B multiple of 3.5x is consistent with the index’s ROE of 18.9%”, Goldman’s David Kostin wrote on Friday evening.

(Goldman)

At the same time, hedging or waiting on dips to buy has been frustrating of late. The average drawdown for the S&P is now virtually non-existent as it was last summer and in January of 2018, after Trump’s tax cuts catalyzed a melt-up.

And maybe that’s more cause to worry. After all, “melt-up” has become the base case for many on Wall Street, and you don’t have to be a market historian to recall what happened just weeks after January 2018’s “blow-off” top…

Read more: Looming Catalysts And A Bad Macro Picture Are ‘Incongruous With Very Low Volatility’

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6 comments on “In Markets, Summer Melt-Up To Meltdown?

  1. I don’t think we should take that P/B-ROE regression at face value. First, the statistical relationship does not look that strong, and it’s definitely influenced by a few outliers. There’s also clear heteroscedasticity. Second, there really is not that much data represented—there are a few market cycles chopped into tiny pieces to produce a larger number of observations that arguably aren’t contributing much real information. Those few outliers might really represent a single period in time. Third, and most importantly, the theoretical relationship makes little sense. ROE is high right now because of low debt costs, an increased debt portion of many corporate capital mixes, and late-cycle profit margins, not because of intrinsic and enduring performance excellence. When the cycle ends, that leverage will come back to bite investors, with relatively small revenue decreases tanking ROE. I actually think that if you threw up a chart of corporate debt to (name metric) next to that one, the opposite point would be made: investors are paying heavily for highly leveraged companies. I would be curious to see the time labels on Goldman’s data. My guess would be 1999 and 2007 would be in the upper right corner, and 2003 and 2009 would be in the lower left, which would make the conclusions Goldman draws from the chart pretty disingenuous. A really cool chart would be 3D and show 12-year forward returns as well…ok, rant over.

    • Help me out here. What is a 3D chart? Are we not talking about price? Prices go up and down. That is adequately described by x and y. So what z are you talking about? 12-year forward returns? Returns that are fantasies? Pardon my opacity.

  2. PaulMiller

    ” There’s also clear heteroscedasticity”. Chris, that’s easy for you to say.

    • Dana Newman

      Reading about this stuff makes my variance not uniform. It makes me deviate from normal, and then I go all heteroskedastic on everybody.

  3. PaulMiller

    Reader Chris made an excellent point that today’s “normal” ROE and P/B relationship may only appear normal in that it falls within abnormal data points which probably occurred at previous market tops or unusual market conditions.

  4. market is going where ever earnings are going. Given the current interest rate forecast and earnings forecast, the SP 500 is on the upper end of fair value with forward P/E of around 17.5. Even though one could argue that the “risk/reward ratio” is skewed to the downside, that does not mean the market is going to drop 10% either. There is unlikely to be an even 10% drop unless earning forecasts get cut substantially (which seems unlikely in the short term since the forecasts are actually going up for Q2 2019 and also 2020) or unless the fed somehow screws up royally again. The feb 2018, oct 2018 and dec 2018 selloffs were all reactions to fed. Feb 2018 – projected 3 or 4 interest rate hikes due to rising inflation (huh? seems funny now) and no end to balance sheet runoff. Oct 2018 – october surprise “long way from neutral”. Dec 2018 – december disaster rate hike and “autopilot” in the face of the shutdown and slowing data.
    Until there is are substantial cuts to forward earnings forecasts, all dips are going to get bought. I am putting my money on a slow grind toward 3200 by year end. but i expect every 1 or 2% gain to be met with .75 to 1.75% selloffs. the wall of worry is very strong and is likely to keep a lid on any substantial upside (like a 5% straight up move followed by a 4.75% down move).

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