Depression moving in from the east
Markets remain by and large in a depressed state, following on from a sell off on Friday after the Non-event, Non-Farm Payrolls. Whilst it's not entirely clear what the catalyst was for the US sell off, we can surmise that the low ball Non–Farm number gave investors pause for thought, as they considered the possibility that the Fed has raised interest rates prematurely.
With many Asian markets closed or on short working for the Lunar New Year the baton passed from the US close straight to the European open. European markets initially rallied on Monday morning but then turned tail. That negative price action fed back into US index futures and US equity markets opened lower once more. As I write, 10 minutes into Mondays US session, the Dow is off by 1.5% or some 240 points, whilst the tech heavy Nasdaq Composite index (which was hard hit last Friday) is down by a further 1.9%.
These type of downside moves, followed by short sharp countertrend rallies are typical of a bear market. Which as I noted in late January, in what are the markets telling us? , is where many equity indices find themselves. At that time we characterised the market moves as a correction rather than a crash and I think we can still consider that to be the case. Although the longer the downtrend continues the more tenuous the distinction becomes.
Of course as equity markets and other financial assets sell off from their peaks, traders and investors naturally start to consider at what point these same instruments might be considered to be " good value " or put another way are approaching a bottom , from which they could bounce.
Chart shows the 6 month % performance of selected Futures contracts (source Finviz.com)
As we can see European stock indices have been particularly hard hit over this time frame with the Dax and Euro Stoxx 50 indices down by 21.7% and 22.67% respectively. By comparison the S&P 500 and Nasdaq 100 (a more concentrated measure of tech stock performance than the Composite index mentioned above) are down by 10.10% and 12.3% as of the close of the 05/02/2016.The narrower Dow 30 industrial index has fallen by just 7.17% during this time. The exception to the out performance of US equities has been the Russell 2000 small cap index, which has slumped by 18.73% over the last 6 months. I also note that the VIX Index, effectively a measure of the levels of fear and greed in the market, has rallied by 73%. A clear indication that for now at least fear has the upper hand.
Why are we correcting?
We could explore many different reasoned arguments to try and answer this question. However it is said that a picture speaks a thousand words and in this case two pictures can do that very eloquently indeed. The pictures in question are two charts prepared by analysts at the French bank Societe Generale.
Chart one plots global equity prices against global equity earnings since Dec 2011.
Chart two plots the level of global corporate debt against global profit growth (EBITDA)
It's quite clear that equity prices have run well ahead of earnings since the summer of 2012 it's also clear that earnings peaked, if we can call it that, around December 2014 and have moved lower on a shallow incline since then. The gap between the two lines in chart one could be said to represent the unrealistic expectations about equity valuations, which investors and traders have held since the summer of 2012.
What's more as we can see in chart two, profits have effectively moved sideways since January 2011, whilst at the same time levels of corporate debt have risen sharply. Despite the fact that many corporates have been stockpiling cash in this period. In summary equity investors had been prepared to pay more to own less. Both in terms of earnings streams, profitability and residual valuations.
Investors haven't had some kind collective hysteria over the last five or six years but their heads have been turned by Quantitative Easing and the flows of cheap money that have artificially boosted many asset values to levels well ahead of their historical averages.
New challenges ahead
Now that US QE is a distant memory and the Fed has, for better or worse, began to tighten rates. Investors that chased valuations in haste, have the opportunity to repent at their leisure. They must also wrestle with the prospect of a double whammy over the cost of debt servicing going forward. Higher US interest rates will make dollar debts more expensive to service, this might be offset by negative interest rates in the Eurozone and Japan. However the spectre of deflation can't be ruled out in either economy. Deflation works in the opposite way to inflation and actually raises the real value of outstanding debts. Making them more expensive to pay back. Falling expectations about global growth in 2016 /2017 have also weighed on investor sentiment and will have a trickledown effect on analysts' earnings forecasts for both Developed and Emerging Markets.
Dividends under pressure
One of the reasons that investors own equities is to receive dividends, which are if you like are their share of the company's success or the reward for ownership. The reinvestment of dividends has been the cornerstone of success for many long term investors. In an environment where decent returns available from bonds are few and far between equity dividends also take on an added importance for income investors too.
When we consider that 25% of all government bonds in the JP Morgan Government Bond Index had a negative yield as of the end of January and just this morning, the yield on Japanese Government 10 year bonds went negative for the first time. We can see that dividends matter.
Against this background then it's worth noting comments by the Economist magazine in a recent series of articles on the importance of dividends. They note that dividend reinvestment has accounted for two thirds of the real returns seen in US equities since 1900 and that 70% of the dividends paid in Australia, Britain, France, Germany and Switzerland came from just 20 companies in each country.
That may not be an issue in and of itself. Save for the fact that these dividends are under pressure in key sectors such as Mining, Oil & Gas and Industrials (this is particularly true for the UK & Australia).
The Banking sector was thought likely to be able to make up any short fall as it emerged from a multiyear restructuring. But in Europe that now looks unlikely to be fulfilled over the mid-term. Which will place additional pressure on and concentrate investment (risk) in sectors such as Healthcare and Pharmaceuticals.
Chart shows the concentration of Dividends across selected markets (source Economist/ Soc Gen)
Global Macro (top down) factors will dominate the investment outlook in 2016/2017. But bottom up issues such as those outlined above will also play an increasingly important role .Traders should not try and pick bottoms.But rather should wait for the markets to tell them they have found support. And when in the market, traders should exercise caution and discipline in relation to order sizes, stop losses and unattended positions.
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