Some Alternate Views

Greetings from Memphis in May BBQ Fest!  As we try to cut through the pork-induced food fog, we figured it might be interesting to check in on a few charts showing some trends that might provide some different perspective on recent and future market moves.

First, we want to take a quick look below at the historical S&P 500 price relative to spot Gold.  We see this chart from time to time among various pundits and analysts.  The interesting aspect of this chart over the past year or so is the significant trend change that has taken place.  When the ratio moves higher, S&P 500 prices are outpacing Gold, and vice versa.  We have the ratio’s 200-week moving average represented on the chart.  As you can see, going back to the late 1970’s, major movements through the 200-week moving average have coincided with major, long-term turns in the secular bull/bear equity market trend.  For instance, the ratio moved solidly through the moving average in 1982/1983 just as the market began a nearly 20 year run towards highs in 2000.  Conversely, this ratio broke down through the 200-week in early 2001 just as the decade long secular bear in equities was beginning to take hold (with Gold moving in the opposite direction, ever upward).

Lo and behold, the ratio made a decisive break higher through the 200-week at the beginning of 2013.   The 200-week moving average is moving higher for the first time since the last bull run.  We don’t want to make a decisive call that a 15 to 20 year secular bull is on the way, but it does show us that market dynamics and attitudes have changed in an eye-opening way.  Though sentiment surveys still show healthy skepticism towards equities, in practice markets have become much more comfortable with risk and more skeptical of safety trades.

Next, we’ll keep Gold prices in the equation by showing Gold price relative to the trade-weighted dollar index.  Once again, we see another significant shift through the 200- week moving average after a massive move higher over the past decade.  Like the ratio above with the S&P 500, this ratio burst out to the upside in the early 2000s, but has tumbled downward over the past year and a half as gold tumbled and the trade-weighted dollar showed strength, confounding many prognosticators.  Perhaps this trend shift after such a long run higher means that, intermediate-term, calls for the death of a dollar-based global financial system are premature?  

Moving back to equities, another interesting perspective below is the so-called Fed Model.  This model shows the relationship between earnings yield (the inverse of P/E: the lower the P/E ratio, the higher the earnings yield) and long-term Treasury yields.  Theoretically, higher levels in the ratio indicate an undervalued equity market and vice versa.  We’re very aware that the traditional Fed model has performed very poorly from a predictive market-timing standpoint.  Most Fed Model representations use trailing 12-month P/E, which can be quite volatile, especially during major shifts in the earnings cycle.  We’ve substituted the Shiller 10-year CAPE P/E in place of trailing 12-month to provide more stability to the indicator.  

As you can see, extreme movements above or below the +1/-1 standard deviation band have been associated with market lows and highs since the early 1960s.  For instance, the move above the 1 standard deviation band in mid-1962 marked the beginning of a equity market run into the late 1960s during which the S&P 500 doubled in price.  A similar spike in 1974 marked the bottom (though not the absolute end) of the 70s secular bear market.  Markets moved meaningfully higher off those ’74 lows.  Fast-forward and the move below the bottom of the band in the late 1990s coincided with the end of the massive 80s/90s bull run.  Look at the amazing moves above the band in financial crisis and post-crisis months and years.  Combine a devastating equity market selloff and P/E compression cycle with super-low Treasury yields, and you get moves several standard deviations above the norm. Even with the substantial equity market move higher since 2009, the ratio is just now approaching the top portion of the standard deviation band.

Of course this situation could play out several different ways if we assume that the ratio will eventually work its way back into more normal territory.  For instance, Treasury yields could spike higher while equities remained neutral.  Equity markets could continue to move higher while Treasury yields did the same.  Or, equities could continue to move ever higher (P/E expansion) while Treasuries continue to meander around current levels.  Whatever happens, the chart tells us a few things.  First, we get a great visual representation of the strange market distortions that played out during and after the financial crisis.  Second, looking at the various scenarios, it’s not a major stretch to argue that equity prices could continue to defy the skeptics and move higher via multiple expansion channels.

We’ve also produced an alternate take to this model using corporate investment grade yields instead of Treasuries.  Just like the more traditional Fed Model above, we get a similar picture.  Equities seem to be in a favorable position relative to investment grade debt.  

Is there a thread or theme unfolding through these alternate-view charts?  If anything, we just might be able to draw the conclusion that equity markets could continue to defy the widely held view that the upward trend is significantly long in the tooth.  After all, we think there is a lot of truth to the statement put forward by several of the bloggers and analysts we follow that this is the “most hated bull market in history.”  Trend changes over the past few years in the direction of a risk-on trade are powerful.  Meanwhile, Fed and corporate bond model charts show that one can make a case that equities remain undervalued vis a vis various fixed income instruments.  We know from our work following various sentiment indicators that sentiment among investors remains tilted towards the pessimistic side long-term, favorable for markets from a contrarian standpoint.  Certainly, there are distortions in these charts related to the Fed’s extraordinary help over the past five years.  At some point, though, we have to look beyond Fed-only explanations.  

The Great Small-Cap Freak Out

If you haven’t heard, it’s been a tough year for small-cap stocks here and abroad.  YTD, the Russell 2000 is down over 5% and the MSCI World Small Cap Index is trailing the broader index.  Both indices are down strongly since early March.  The Russell 2000 has fallen approximately 9% and its international cousin has fallen approximately 4% over the past two months.

In our hypersensitive media environment, this of course has invited a number of breathless shotgun reactions as to what this means for markets moving forward.  A popular conclusion among many pundits centers on the story that the breakdown of small-cap indices relative to the broader indices is a massively negative early warning signal for a major market correction or collapse.  In reality, the historical record couldn’t be more different.  Looking back at the historical relationship between the Russell 2000 and the S&P 500 (we’ll go with these US indices because they have longer track records), cycle changes back towards large-cap outperformance have actually coincided with bull market activity.  

Don’t get us wrong, as we’ve mentioned on these pages before, the S&P 500 is overvalued based on several long-term valuation metrics we like to follow.  A US market correction could certainly pop up at any point, and would be a normal part of participating in the equity markets.  Looking at the relationship between small-caps and large-caps, however, it’s hard for us to accept the conclusion that the Russell 2000 breakdown of late is the end-all-be-all canary in the coalmine.

Here’s the chart going back to 1978 on Russell relative strength vis-a-vis the S&P 500.  The black band represents the +/- 1 standard deviation band around the long-term average.  

As we can see above, the Russell 2000 has experienced a sustained period of outperformance since the end of the 1990s.  This, in turn, followed a 20-year secular downward trend that began in the early 1980s.  What’s interesting about this?  The last time the Russell/SPX relative strength chart peeked its head above the +1 standard deviation bar and reversed (beginning the long secular small-cap underperformance trend through the 80s and 90s), the broader US markets were beginning 20-year secular bull market.  Conversely, the major trend-reversal towards small-cap outperformance that took place in the late 1990s happened to coincide with the beginning of terribly frustrating secular bear market that was in place from 2000 onward.  These trends contradict the conclusions out there that small-cap underperformance means major trouble in the near or intermediate term.   We’re definitely not making a prediction that this we’re in the beginning stages of a multi-decade secular bull market.  But, we think relying on small-cap stock index reversals as a warning indicator for broad market activity is misguided based on the record over the past 35 to 40 years.

So, what explains the reversal in small-caps?  The answer is very simple.  After approximately 15 years of sustained outperformance, small-cap stocks have become very expensive relative to their large-cap compatriots.  Matter of fact, they’ve become historically overvalued on a relative basis.  As of this week, the Russell 2000 is trading at 16x on an EV/EBITDA basis vs. 10.6x for the S&P 500.  We’ve looked at the ratio of the Russell valuation to the S&P 500 valuation over time.  That ratio is currently 1.5, slightly off the all time peak of 1.53 observed a few weeks ago.  Historically, the average ratio between the two multiples is 1.05.  The median is 1.05 as well.  Standard deviation for the weekly data going back to 1978 is approximately 0.145.  Therefore, the ratio of the Russell EV/EBITDA multiple to the S&P 500 multiple is currently a whopping 3.1 standard deviations above the norm.  This is a big, big outlier, which suggests that small-caps could and should be relative underperformers for a while.  If we use EV to Sales multiples, we see a similar picture.  The relationship is over 2 standard deviations above the norm.  

Therefore, we believe it’s premature to flip-out about the small-cap breakdown of late.  As shown, over the past four decades, Russell underperformance has actually coincided with broader secular bull performance.  Whatever the situation, the bigger story seems to be that if you have all your eggs in the small-cap basket, it may be time to start heading back towards the larger-cap space.  These secular shifts between small and large cap seem to take place every 15 to 20 years.  It looks like we could be on the cusp of one of those major shifts.  It doesn’t mean the end of the world is at hand.

Relative Strength Overview

Since the beginning of the year, there have been a number of changes taking place underneath the surface of the market.  We like to glance at the global sector relative strength charts regularly to get a visual on these changes and general sector performance over time relative to the MSCI World.  These simple relative strength charts often tell some interesting stories.   

Let’s run quickly through some of the standout shifts in the below charts:

• Consumer Discretionary, a big outperformer off the 2009 lows and a big outperformer last year, has broken down meaningfully versus the broader market.  The sector has experienced the first significant break of the 30-week moving average since the ‘06/’07 rollover.  Consumer Staples names began breaking down last year.  
• The hook upward for utilities, not to mention the longer-term chart for Utilities, mirrors the Consumer Discretionary chart.  The Utilities sector happens to be the best performing sector year-to-date.  Is this a sign of the apocalypse?  Not necessarily.  Just because Utilities are trending higher and Consumer Discretionary is trending lower doesn’t mean markets are ready to dive into dark places.  Last decade, the Utilities sector began a long period of sustained outperformance in early 2004, while the Consumer Discretionary downshift occurred around the same time.  Markets continued to rise for another three and a half or four years.     
• Energy and Materials are showing signs of life after a tough stretch.  Energy has underperformed since early 2009.  Materials names have been underwhelming for the past three years.  
• Global Financials have remained yucky.  At best, the Financial space has matched market performance over the past five years.  One of these days, the sector will have another run of outperformance.  Right now, they continue to have a hard time finding breakout velocity versus the broader market.
• Global Information Technology captures the investing public’s imagination and captures more headlines than less exciting areas of the market.  Yet, we see that coming off the big boom and bust in the late 1990s and early 2000s, IT has basically followed the broader market relative performance-wise.  The past four or five years have shown the same pattern.  Meanwhile, the Telecom space has also been a very, very tough place to find relative performance since the bust over a decade ago.
• Health Care has chugged along quite nicely over the past three years.  There was some movement downward for HC during Q1, but the sector has recovered of late.  While there haven’t been any major trendline breakdowns here, this is a sector to watch.  During the back half of last decade’s market uptrend, HC demonstrated relative underperformance.
• Industrials names have provided a mixed bag in recent years, though they’ve acted better of late.
• Overall, the picture seems to be of a market that is shifting into a more mature, “mid-innings” phase.  Again, in 2004/2005, the middle of the last upward cycle, the Consumer oriented sectors and Health Care began underperforming while boring “stuff” like energy, materials, and utilities began exhibiting strength.  We seem to be seeing signs of a similar shift this go-round.  The shift wasn’t a death-knell for the overall markets then.  We don’t believe that massive market disruption is in the cards right now either.  The above sector shifts fit in well with some of the other work we’ve presented on this blog during the past several months indicating that global markets could be moving towards a period of solid, not spectacular, maybe a bit frustrating returns over the next few years.  Looking forward, will IT, Telecom, and Financials break out of their relative strength doldrums?