(Nov 11): US stocks reached fresh record highs last week, boosting sentiment for the rest of the world’s markets. Wall Street remains the best-performing equity market globally this year.
Notably, though, its rise has been dogged by investor scepticism every step of the way. Does the rally have legs or is it overdone?
In absolute price-to-earnings ratio (PER) valuation terms, the Standard & Poor’s 500 is currently trading at 17.2 times future earnings, which is above both the five-year (16.6 times) and 10-year (14.9 times) averages.
However, the difference in yields between equities and bonds is hovering well above the 10- and 30-year averages.
Chart 1 shows the yields for the S&P 500 and 2-year US Treasuries over the past three decades. Table 1 shows the prevailing spread (difference in yields) between the S&P 500 and 2-year Treasury securities as well as the historical averages.
Why is there such a huge yield gap in favour of equities and what does it imply? There are two distinct possibilities:
• Equities are today significantly cheaper, relative to bonds, than they have been in the last 30 years, on average. This scenario suggests that stocks have more upside, especially taking into account the US$17 trillion ($23.1 trillion) invested in negative-yielding bonds globally; or
• Recession is coming. That means corporate profits have peaked and are primed to contract. When profits decline, earnings yield will fall and the spread will narrow towards the historical average. Therefore, the current spread is actually reflecting a higher-than-normal risk premium.
Probability prediction for an imminent US recession was high at the start of this year. After all, the current expansion cycle is the longest on record, so a recession is seen to be long overdue. The US Federal Reserve was raising (normalising) interest rates and uncertainties over President Donald Trump’s trade war with China were affecting business confidence and global trade.
But the world’s largest economy has held up far better than most expected, with the latest 3Q2019 GDP growth exceeding market consensus at 1.9%.
Robust consumer spending on the back of a strong jobs market is fuelling the US economy. Unemployment is at the lowest levels in five decades and real wage growth remains healthy, if somewhat subdued. This has more than offset the drop in business investments. In addition, the Fed has reversed its tightening policy and cut rates by 75 basis points so far this year. Falling mortgage rates have, in turn, revitalised the housing market.
These statistics have gone some way towards alleviating recessionary fears. Notably, the US Treasury bonds yield curve has resumed a normal positive slope, where long-dated bonds yield higher than those with short maturities. A few months back, the yield curve was inverted, a signal that has, historically, preceded recessions (see Chart 2).
Corporate earnings too have come in better than expected. Analysts now believe profits will return to growth in 2020, following a flattish 2019 performance.
If true, then it would support the case for further gains for the stock market — taking into account the attraction of a wide spread (compared with bonds) and positive earnings outlook.
We believe the market outlook is positive in the near term.
As the rally gains steam, we may well see more investors pulling back from low-yield bonds and into higher-return equities. In fact, we are already seeing returning interest in cyclical stocks such as banks and industrials.
Recent reports indicate that fund managers are, on average, holding 27% of their portfolios in cash, near the highest levels in nearly a decade. There is plenty of cash on the sidelines and investors are far from exuberant, even though stock market indices are at record highs. A partial deployment of this cash pile could spur stocks higher.
The big question is whether the rally is sustainable. In particular, will the slump in business investments eventually affect (limit) corporate profits, hiring and, finally, consumer spending and the broader economic growth?
Chart 3 shows that gross capital formation as a percentage of GDP has been trending lower compared with the long-term averages in the US and, even more so, in Europe and Japan.
A fall in capital formation is expected to translate into a fall in future production. This leads to a drop in consumption or a rise in price levels. That is, capital formation is always closely watched for its predictive usefulness.
How worried then should we be over this downtrend? We will explore this issue in greater depth next week.
The Global Portfolio was marginally down for the week, paring total portfolio returns to 10% since inception. By comparison, the benchmark MSCI World Net Return index is up 11.5% over the same period. We added 140 shares in The Boeing Co and are looking to rejig the portfolio further to reflect our positive expectations for cyclical stocks.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
