The stock market continues to trend higher as earnings growth remains lackluster. This has caused valuations to get very expensive, signaling a stock market that’s becoming increasingly due for a sharp sell-off.
Everyone is flagging this anxiety-inducing pattern, and yet the market continues to rally arguably nonsensically.
“The S&P 500 has advanced 6.8% YTD (8.4% including dividends) despite a more modest improvement in the earnings outlook (+1.4%),” RBC’s Jonathan Golub observed in a note to clients on Monday. “Put differently, the market’s move higher has been fueled almost exclusively by multiples.”
Most analysts argue that these record-high stock prices are unsustainable without a significant pickup in earnings growth. Unfortunately, there isn’t much hope for that.
“Since EPS trends have typically been associated with S&P 500 index patterns, a sharper-than-expected uptick in profits would be a necessary prerequisite for additional upside,” Citi’s Tobias Levkovich said on Friday. “[A Citi survey suggests] new positive developments would need to emerge to justify more in terms of net income generation. With outstanding issues such as the impact of Brexit and/or fiscal policy post the US elections, it seems challenging to come to any powerful conclusions at this juncture.”
The Fed wants to hike, and the S&P fell 10% after the last hike.
Economic data in the US has been positive, highlighted by notably strong labor market and housing market data. This has put pressure on the Federal Reserve to tighten monetary policy with an interest rate hike sooner than later.
In fact, three members of the Fed have signaled that a hike will come sooner in just the past week. Last Tuesday, NY Fed President William Dudley said“we’re edging closer towards the point in time where it will be appropriate to raise rates further.” On Thursday, San Francisco Fed President John Williams said every meeting, including the one coming in September, should “be in play” for a rate hike. On Sunday, Fed Vice Chair Stanley Fischer said “we are close to our targets.”
“A more hawkish Fed could trigger a return of volatility if financial conditions (USD, credit spreads) start to deteriorate again,” Societe Generale’s Patrick Legland said on Monday. “The S&P 500 fell 10% following the first rate hike last December.”
In that same breath, Legland warned of the importance of earnings to the stock market.
“US company earnings were better than expected in Q2,” he acknowledged. “But the sharp increase in valuation ratios (S&P 500 forward P/E 17x, P/B 2.9x) puts the onus on EPS growth at a time when global GDP growth remains uninspiring” (click on image).
Could fund flows save the day?
The sad thing about the current stock market rally is that it comes at a time when retail investors are spilling out of the stock market.
“US equity funds saw outflows deepen to a new 6 year low in July,” Credit Suisse’s Lori Calvasina observed on Thursday (click on image).
Perhaps this trend is set to turn around. Indeed, with bonds and bond funds offering little yield, no yield or even negative yield, perhaps we’ll finally witness the so-called “Great Rotation” of money out of bonds and into stocks.Not everyone is convinced of the "Great Rotation" from bonds into stocks. Akin Oyedele of Business Insider reports, The 'great rotation' isn't happening:
“One way that share prices could surge would be to anticipate a new flow of money towards the fairly despised equity asset class,” Citi’s Levkovich posited.
Stocks are susceptible to a pullback in September, according to UBS chief equity strategist Julian Emanuel.But is there something else driving the volatility (fear) index to cyclical lows? Saqib Iqbal Ahmed of Reuters reports, Focus on VIX futures shorts hides the real story:
Emanuel wrote in a note to clients on Wednesday that this trouble is because a likely seeming and recently touted source of fund inflows may not materialize: The so-called great rotation from bonds into stocks.
This idea first gained traction early in 2013, when investors started a massive shift in their asset allocations away from bonds and to stocks.
That prompted calls that bond funds would experience a mass exodus as investors moved to equities.
The rotation was meant to boost the stock market at a time when some pundits believed that the 30-year bull market in bonds was ending. However, investors kept pouring into bond funds. And the bull market in bonds is still going.
"While a number of bull market peaks (2000 in particular) have been accompanied by enthusiastic public buying, such exuberance catalyzed by a rotation away from cash and bonds seems unlikely in 2016," Emanuel wrote.
There won't be any great rotation because it has already happened, as stocks rose to record highs and bond yields slid to record lows (click on image).
Additionally, the rally to all-time stock market highs has largely been supported by companies repurchasing their own shares, or buybacks. Buybacks — not retail investors — have been the biggest source of demand for stocks since 2009, according to HSBC.
"In this context, set against VIX trading near cycle lows after a parabolic S&P 500 summer rally, ahead of more US and European political and Fed uncertainty, stocks appear vulnerable to a pullback into the seasonally weak September period," Emanuel wrote.
Judging by the way hedge funds have been betting on Wall Street, they see U.S. stock market volatility remaining low, but it may not be that simple.Is volatility cheap? Is the VIX index (VIX) ready to rip higher? Sure, if stocks plunge, the VIX will soar but I personally think the bigger risk now is stocks continue grinding higher and volatility will remain historically cheap.
CBOE Volatility Index (VIX) futures contracts allow a play on implied volatility in stock prices and can provide a hedge on equity returns, but big speculators are currently net short 114,088 contracts in VIX futures, just under the record level set earlier this month, according to U.S. Commodity Futures Trading Commission positioning data through August 16.
After trading in a range for most of the past year, U.S. stock prices recently broke out to record highs and hedge funds have reluctantly bought into the rally. Their net long/short exposure has increased to 22.8 percent, a top quartile level, but still shy of the 5-year peak of 24.5 percent set last December, according to Credit Suisse data.
On the face of it, the CFTC data could be seen as evidence that speculators strongly believe in the lasting power of the recent rally in equities and expect the CBOE Volatility Index (VIX), which is near historic lows, will remain subdued.
"That's not exactly right," said Maneesh Deshpande, head of equity derivatives strategy at Barclays.
Deshpande and other derivatives market experts say speculators are to a large extent just selling VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility.
With the S&P 500 stock index (SPY) near a record high, demand for these is quite strong.
For instance, money flows into the iPath S&P 500 VIX Short-Term Futures ETN (VXX), the most heavily traded long volatility ETP, are the strongest in three years, according to data from Lipper. In turn, that's creating steady demand for VIX futures that the hedge funds are only too happy to supply.
"Strong inflows into long VIX ETPs means the issuers of these products have to go and buy VIX futures," Rocky Fishman, equity derivatives strategist at Deutsche Bank.
Even in the absence of those inflows, the way these ETP products work means that as market volatility declines it requires these product issuers to buy more VIX futures contracts.
It is in response to this strong demand for VIX futures that speculators have ramped up the selling of VIX futures. Essentially, these funds are acting as liquidity providers, not making outright bets.
THIRST FOR PROTECTION
Over the last month and a half, as stocks rallied, investors have been loading up on ETPs that profit from a jump in volatility. Roughly $1.73 billion has poured into long VIX ETPs since the start of July, according to Deutsche's Fishman.
Investors may be looking to protect recent gains, or simply betting that stock market volatility has drifted too low and the CBOE Volatility Index (VIX) is ripe for a rally.
Friday was the 13th straight session when the VIX closed below 13, the longest the index has lingered so low in about two years.
With less than three months to go before the U.S. presidential election on November 8th stocks may fall and volatility may rise as investors assess the political risk to equities.
Speculators selling VIX futures may suffer if volatility rises too quickly but much of their short position is likely to be hedged, analysts said.
"They might be selling the front one or two month VIX contracts but then they are buying the (further out) contracts as a hedge, or they might be short S&P 500 and short VIX futures simultaneously," said Nitin Saksena, head of U.S. equity derivatives research at Bank of America Merrill Lynch.
"They are not as exposed to a rise in volatility as you might think," he said.
The risk is if the market moves violently, leaving those with short positions with little time to monetize their hedges.
In the event of a decline on the S&P 500 index like the one seen in August 2015, when it lost as much as 11 percent over the course of four days, the large short positioning could trigger even more volatility.
Of course, if investors start moving away from exchange-traded funds back into actively managed funds, then there will be less selling of VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility. That too can trigger more volatility but so far nothing suggests there's a massive shift out of ETFs into actively managed funds (quite the opposite).
So what is driving the demand for US equities? GFC Economics posted an interesting tweet showing the drop in real estate arrears is supporting the rally in US equities (click on image):
But it's not only US equities that are outperforming. Good old US bonds (TLT) have been outperforming equities, a point underscored in several tweets put out by Charlie Bilello of Pension Partners (click on image):
As you can see, over the last 15 years US bonds outperformed stocks (7.5% annualized vs 6.3% annualized), especially on a risk-adjusted basis, which goes to show you "stocks for the long-run" is a bunch of nonsense.
Admittedly, over the last 20 years, as Charlie Bilello shows in his tweets, the performance of stocks vs bonds is equal at 7.9% and over the last five years stocks have vastly outperformed bonds (16.2% vs 7.1%) but with a lot more volatility (Charlie should show risk-adjusted figures too).
Charlie has done a very interesting analysis on Valuation, Timing, and a Range of Outcomes, showing stocks were “overvalued” in September 1996 and from there, they would go on to become much more overvalued, rising for another three and a half years to their peak in March 2000. After that, a nasty bear market ensued, taking the S&P 500 down over 50% from its peak.
The point being just because stocks are overvalue, it doesn't mean they can't become a lot more overvalued, especially when global central banks are still pumping massive liquidity into the financial system (John Maynard Keynes was right, "markets can stay irrational longer than you can stay solvent," especially these high-frequency algorithmic, schizoid markets).
Sure, stocks valuations that aren't supported by earnings growth are doomed to collapse at some point but when exactly that some point is is tough to predict. It can be months or even years away. In the meantime, if you're not playing the game, you're missing out on huge gains.
So, is it time to plunge into stocks and hope that liquidity gains will continue even if there are some major pullbacks along the way? That all depends on your risk tolerance. Mine is very high, so I got whacked hard when biotechs got slaughtered over the last year.
Still, I don't regret recommending to load up on biotech shares last August as that is exactly what I've been doing, loading up on them whenever they got clobbered. And after today's Pfizer deal to buy Medivation for $14 billion, you'll see momentum continue in the biotechs (with crazy volatility, of course).
These days, I'm busy trading and buying biotech shares I like (click on image):
Do I recommend you buy individual biotech shares? Not if you want to sleep well at night, you are better off sticking to the biotech ETFs (IBB and equally weighted XBI) but even they are volatile. I must tell you, however, from a trading perspective, I like the way a lot of names have been performing lately, including Valeant Pharmaceuticals (VRX).
This is why when I read a lot of smart money is betting against stocks, I can't understand why they're so confused, the real smart money is making a killing snapping up Medivation and many other biotech shares at the right time.
Are these elite hedge funds worried about Janet Yellen or Stanley Fisher? No. Am I worried about the Fed? No, I haven't been worried about the Fed because I know the real threat out there remains global deflation, not inflation, so if the Fed raises rates, it will trigger a crisis in emerging markets and risk importing deflation in the US.
And I don't think the oil rally is going to end well because I take the bond market's ominous warning very seriously. Having said this, I expect the stock market rally everyone hates will continue a lot longer than most people expect but you've got to pick your stocks and sectors a lot more carefully and always remember, in this environment, bonds are the ultimate diversifier.
All I can tell you right now is what I've been telling you for a while, I see no summer crash but given my bullish US dollar views, I remain highly skeptical of a global economic recovery and would take profits or even short emerging market (EEM), Chinese (FXI), Metal & Mining (XME) and Energy (XLE) shares on any strength. And despite huge volatility, I remain long biotech shares (IBB and equally weighted XBI) as I see great deals in this sector and momentum is gaining there.
Below, "Fast Money" trader Tim Seymour and Simeon Hyman, ProShares Advisors, share their take on dividends stocks. I agree with those that think valuations in dividend stocks are out of whack but this doesn't mean they can't gain further in a deflationary world where investors are starving for yield.
Also, the market leadership appears to be shifting with lower-quality stocks are leading the rally. Eddy Elfenbein of the Crossing Wall Street blog and Craig Johnson of Piper Jaffray discuss with Brian Sullivan.
Third, Timothy Ng, Clearbrook Global Advisors CIO, and Joe Tanious, Bessemer Trust Principal and Investment Strategist, discuss the current market environment and what investors are looking for within passive and active management.
Lastly, Ken Kamen, President of Mercadien Asset Management talks with Bobbi Rebell about what he believes will drives stocks higher and which candidate the markets believe will win the Presidential election.
On that note, please remember to plunge into your pocketbook and subscribe and/ or donate to this blog on the top right-hand side. I thank all of you who graciously support this blog via your dollars.