GDP Q2: Looking Under the Surface

It’s been a while since we looked at some of the numbers within the US GDP report and what they might say about the underlying trends in the American economy.  This morning, the US government released the final revision for Q2, and the numbers overall proved solid.  GDP came in at 4.6% on a Q/Q annualized basis, a vast improvement over the Q1 negative print.  Y/Y, real GDP came in at 2.6%, solid but not spectacular, continuing the pattern observed since 2010.  Average Y/Y real GDP since Q1:2010 has been about 2.2%.  This compares to an average Y/Y real GDP number of 1.6% from Q1:2002 through Q4:2009.  Thus, all in all, growth is mediocre, but it’s been mediocre for more than a decade.  The “New Normal” really isn’t particularly new at all.

Underneath the headline numbers, there are some interesting trends among the GDP aggregates, Consumption, Investment, Net Exports, and Government, as a percentage of GDP.

Consumption spending continues its pattern of growing in-line to slightly below overall GDP on a Y/Y basis.  As such, Consumption, which reached a high point of 69% of GDP in 2011 has retrenched a slight bit to 68.5% of GDP.  Nonetheless, Consumption still remains near the very high end of the historical range.

A bright spot in the report appears to be growth in Investment.  Real investment growth in Q2 was 7.7% Y/Y, the best showing since 2012 and comfortably above the historical median of 4.7%.  With the improvement, investment as a percentage of GDP continues to move closer to the middle of the long-term range and has reached levels not observed as a % of GDP since the pre-crisis days.

Defying conventional wisdom, total government expenditures continue to probe the low end of the historical range as a % of GDP.  Y/Y real growth in government expenditures came in at -0.7%, the 16^th straight negative year over year print, by far the longest negative streak in the history of the GDP series.  The last period with negative real Government expenditures was the 1993 to early ’94 period.  Prior to that, you have to go back to the early 1970s.  Y/Y nominal government expenditures growth was under +1% for the 14^th straight quarter.  Of note, prior to the current run, nominal government expenditures hadn’t fallen below 1% on a Y/Y basis since a brief negative run in the mid-1950s during the Eisenhower Administration.

Finally, net exports, which have been in negative territory as a percentage of GDP since the early 1980s, remain comfortably higher than levels observed in the years preceding the Great Recession, but near the lower end of the historical range.

Taking Investment + Net Exports as a proxy for “national savings,” we see that the picture has improved significantly since the Great Recession, but remains below historical levels.  It’s currently in-line with the levels observed in the mid-2000s, pre-crisis.

All in all, we continue to believe that consumption growth will underperform relative to the other aggregates, perhaps keeping some longer-term pressure on the consumer oriented segments of the US markets.  Conversely, we believe overall investment will continue moving higher as a % of GDP, as will government expenditures, mainly due to the renewed health of state and local government finances.

Market Tidbits

Dollar En Fuego

Several months ago, we pointed out that the US dollar index relative to gold had breached long-term moving averages to the downside.  After some sideways churning, sure enough, the dollar has resumed its march higher while gold moves back towards multi-year lows, keeping the ratio on the downward slope.  Since the end of 2009, Gold is essentially flat while the dollar index is approximately 15% higher.  Conventional wisdom has been completely turned on its head over the past four to five years.  Three rounds of QE, political turmoil in Washington, and a muddle through economy had many investors convinced a significant dollar collapse was on the way and gold would outpace equities.  The opposite happened, a not so atypical situation in markets.  What happens going forward?  Considering the intensity of the recent moves, we wouldn’t be surprised to see a short-term technical reversal.  Longer-term, there’s still plenty of space to the downside on the below chart, especially in light of the massive upward move in the ratio from 2003 to 2011.   

Source: Bloomberg and IronHorse Capital

Inflation Expectations: Tame

Meanwhile, as always, Fed watchers gnashed their teeth over the future Fed Funds rate trajectory and the Fed statement ahead of this week’s meeting.  After the meeting, the “dot chart” showing Fed members’ predictions on the future rate path showed that the median projection for 2015 has moved slightly higher, from 1.125% after the June meeting to 1.375% today, suggesting rate hikes earlier than projected in 2015.  Two Fed Presidents dissented.  Dallas Fed President Fisher remains preoccupied with heading off phantom inflationary pressures before they spiral out of hand.  Next month should represent the final month of QR.

We remain baffled by the rush for accelerated rate hikes in the US.  We pointed out early in the summer that inflation pressures are completely benign at this point and that contributors to inflationary episodes, such as labor costs, remain subdued.  This week, markets received word that year-over-year CPI came in at a paltry 1.7%.  Year-over-year CPI hasn’t exceeded 2.2% since early 2012.  Around the world, there’s a real risk of outright deflation in Europe and Japanese economic momentum has dropped off dramatically in recent months, perhaps putting some of the price stability gains at risk there as well.  

Market participants are voting.  Looking at the yield spreads between Treasury bonds and TIPS, we see that market expectations for future annualized inflation are rolling over again back into sub-2% territory over the next five years.  We remain of the view that it’s much easier to tame inflation after it appears than it is to reverse the insidious deflationary trends associated with sub-trend economic episodes.  The US remains far below potential.  The worries about “overheated” economic growth seem ridiculous.  If anything, the Fed, ECB and others may be too timid when it comes to pushing economic growth back towards long-term potential.

Source: Bloomberg and IronHorse Capital

Europe and Japan: The Feeling’s Gone

With recent updates to the OECD leading economic indicators for Europe and Japan, we see that the economic momentum that kept markets hopeful throughout 2013 and early-2014 has dropped off considerably.  In Japan’s case, Abe may have a big problem on his hands, with the smoothed Japan LEI moving back into negative territory for the first time since the ‘08/’09 global recession, suggesting that the probability for a Japanese recession is significantly elevated.  Japanese citizens may be getting the worst of all worlds: higher prices, and dim economic prospects.  Europe isn’t terribly far behind in terms of entering negative economic territory.  As discussed above, outright EU deflation could be in the cards; the ECB recently felt compelled to enhance monetary stimulus programs within legal bounds, though indicators this week show that some of the measures had disappointing results.

Source: OECD, Bloomberg and IronHorse Capital

Source: OECD, Bloomberg, and IronHorse Capital

US: P/E’s Creeping Higher:

The S&P 500 index has moved comfortably above the 2000 level again.  Long-term valuation ratios have moved in lock step.  As of today, the 10-year CAPE P/E, using adjusted, pro-forma earnings to satisfy those concerned about accounting changes over time, stand at approximately 22.3x, approximately 0.8 standard deviations above the norm.  Valuations in the US are roughly back to levels observed in ‘06/’07 and during the mid-1960s.  As we’ve mentioned in the past, we’re not suggesting that a big market maelstrom is imminent.  Instead, we want to point out that valuations near these levels have regularly produced sub-median real and nominal annualized market returns over the subsequent seven to ten years.  In other words, it might be a bad idea to count on double-digit US returns over the next several years when thinking through the kids’ college funds.  That doesn’t mean there isn’t opportunity elsewhere around the world, however.  Many individual countries/regions’ index multiples are trading in the low teens and single digits.  As such, we remain convinced that longer-term equity returns will come from overseas stock markets and that the US will be a long-term laggard.  In addition to the P/E chart below, we’ve included a handy-dandy rundown of markets from cheapest to most expensive across several valuation metrics produced on Mebane Faber’s World Beta website.  As you can see, the US is among the five most expensive in the world.  Eastern European emerging markets and peripheral European developed markets hold many of the “cheap” spots.  Much of the European malaise mentioned above has already been factored into equity market outlooks.

Source: Bloomberg and IronHorse Capital

Source: Mebane Faber World Beta Blog. mebfaber.com

The Sunk Cost Fallacy and The European Dilemma

It’s déjà vu all over again.  Three years on from the meat of the European sovereign debt crisis, and two years on from then-new ECB President Mario Draghi’s “whatever it takes” rescue program, which spurred across-the-board European asset price rallies, European economic data is showing strains again.  France remains stuck in neutral.  German GDP growth actually contracted last quarter.  Unemployment rates across the Eurozone, especially in the periphery countries, remain disturbingly high; Eurozone-wide unemployment remains at 11.5%, but localized numbers can appear much more harrowing.  Core and headline inflation remains dangerously close to stall speed.  The latest annual CPI numbers for Europe in July showed overall Europe-area inflation below 1%, with outright deflation (the naughtiest of naughty economic terms) still observed in Greece, Portugal, and Spain.  Italy is on the cusp.

A simple fact: potential Euro-area GDP remains upwards of 20% below potential and economic activity, unlike the US and others, is nowhere near pre-crisis levels.  The way things are going, economic activity won’t make up significant ground anytime soon.  As such, the blame game has begun ramping up again.  On one side, the hawkish types continue to bemoan the fact that structural economic reforms haven’t proceeded as quickly as liked in periphery countries and that further budget cuts and reform are necessary to secure economic prosperity.  On the other side, economists and policy-makers argue that current ECB measures are too timid and that aggressive monetary stimulus should be accompanied by aggressive fiscal stimulus to kick-start activity.  In their eyes, European austerity policy, though softened somewhat over time, is a “penny-wise, pound-foolish” endeavor.  Likewise, the Euro-currency-area structure can be equated, in their eyes, to the shackles of a gold system that undermined flexibility and exacerbated European economic problems during the Great Depression era.  

There’s merit in both of these arguments.  Without a doubt, closed, protected economies like Greece and Italy require much more work to achieve long-term competitiveness.  On the flip side, while no one in the US is claiming economic victory, aggressive Fed action in conjunct with other aggressive moves by US policy makers helped keep the US on a growth trajectory, however uneven.  Yes, policy-makers have made mistakes along the way in the US, but on balance our system found a path to a viable support structure.  We in the US complain about the state of economic affairs, but the general state of economic affairs here is much better than experienced in the bulk of Europe, or even a number of former high-flying emerging economies.  

While the issues at play on the European continent are far more detailed and complicated than could ever be examined in a simple blog post such as this, we tend to sympathize with those calling for a more aggressive European response and a move away from the shackles and restraints the Euro union place on the weakest nations.  Frankly, we’re curious why peripheral nations have chosen to remain in a structure that allows them nearly zero flexibility in terms of monetary/currency policy response.  Sure, economic growth has stabilized to a certain extent in the periphery during the years following the ECB’s 2011/2012 actions, but not enough to move the proverbial “needle” in any major way.  Overall, it’s arguable that monetary stimulus remains woefully inadequate in these countries in terms of providing proper air cover for the demand destruction associated with the massive strides many have made in collapsing primary budget deficits.  It’s not crazy to think that these countries could remain well below potential GDP for decades into the future.  Again, what keeps policymakers (and citizens) beholden to a quasi-depression track?

A version of the “sunk-cost fallacy” remains in play among policy-makers and citizens alike.  The sunk-cost fallacy is an economic problem under which individuals, organizations, or policy-makers make forward-looking decisions erroneously based upon the time, money, or other resources “sunk” into a project in the past.  Time, money, and effort expended in the past should never be a consideration, only the future “profitability” or “viability” of an effort.  What’s done is done.  If a project is going to be a proverbial money-loser going forward, it should be stopped no matter what’s been invested in the past.  

A version of the sunk-cost fallacy is playing out in the European sphere, in our estimation.  For years, we’ve heard politicians, economists, and individual citizens across Europe express their commitment to a monetary union solely on the basis of the immense amounts of political effort that have been expended over the past six decades.  This has been particularly true of politicians in the economically depressed countries.  The structure of the EU can’t be significantly questioned because “We’ve dedicated so much time and effort to the project and the notion of European solidarity.  If we change course, we sacrifice our significant past investment in a Pan-European identity.”  Yes, there have been reasonable qualitative and quantitative economic arguments put forth to defend the status quo, but more often than not, the pursuit of the status quo is justified solely by the simple notion expressed above.  

Just as in running a business, this can be a dangerous notion, and create much bigger problems down the road.  Dumping the rest of one’s life savings into a money-losing venture to justify the past investment, for instance, would lead to full financial devastation and the even bigger problems associated with being completely wiped-out financially.  Continuing this project in the periphery nations simply on the notion of a large historical investment in the European “project” without some serious soul-searching regarding future policy options could lead to devastating effects at the national level over the coming decade.  

Already, younger generations entering the workforces in these countries face bleak future prospects.  Despite progress made on budgets, debt-to-GDP ratios continue to rise because of stagnation.  The best and the brightest continue to emigrate to other nations.  Birth rates are down, exacerbating negative demographic trends.  Extremism has increased, evidenced in recent years by organizations like Golden Dawn in Greece, as marginally attached individuals seek outlets for their discontent.  If European growth at-large stalls out again meaningfully, and broader deflationary trends become a part of broader European economic life, there are few pathways for these countries to exit their depression-like conditions, especially if they remain in the currency union with its current slate of policy options and prescriptions.  These problems will become significantly magnified.  A blow-up of that pressure cooker down the road would make today’s dilemmas look like small potatoes.  

Does this mean that breaking off portions of the currency union is desirable or fait accompli?  Not necessarily.  But with economic growth stalling again, it’s time for the periphery nations to break the shackles of sunk-cost thinking and engage in some serious self-examination in terms of what type of economic growth is achievable within or without the binds of the union.  Band-aids and European solidarity proclamations are no longer acceptable or sufficient.  Likewise, it’s in German and ECB leaders’ interests in the long-run to meet the periphery countries further in the middle before centrifugal forces move beyond their control.  A broader Japan-esque “lost decade” experience with pockets of depression has dangerous implications on a fractured continent like Europe.  Old solutions and old ways of thinking based on past investments in the European project will ultimately lead to violent economic problems.  These countries must find sustainable economic growth.  If that means a controlled exit, so be it.  Exit and/or radical economic policy measures should be on the table.  

Fundamental Free Lunch: Update

Periodically, we like to update a back-test that uses a single fundamental factor, EV/EBITDA, to demonstrate how successfully a ultra-simple value portfolio can play out favorably over a number of years.  Now that we’ve crossed the halfway point for 2014, we thought this would be a good time to revisit this back-test and update it with year-to-date numbers.

As in past iterations of the back-test, we begin by ranking all the components of the S&P 500 at the end of each calendar year from 1992 (earliest data) to the present day by EV/EBITDA multiples, taking the 50 cheapest stocks in the S&P 500 and rebalancing on 12/31 each year.  Companies are equal-weighted.  Once a portfolio is set, there’s no trading over the course of the year.  Companies involved in M&A transactions over the course of any given year go out at the takeout price; we do not replace the acquired company with a new position.   Finally, in a new twist, for comparison purposes we use total returns for the S&P 500 benchmark (i.e. include dividends) but exclude dividends for the back-tested portfolio.  Since annual dividend yields for the S&P 500 are generally 2%+, this is a back of the envelope way to account for performance draining factors like slippage, commissions, and other fees.  All data comes via Bloomberg.

Why do we like to do this?  As you’ll see below, a super-simple portfolio using EV/EBITDA multiples for stock selection once per year without any other work produces outsized returns over the index over time.  It’s a powerful reminder that fundamentals work over the long run.  And, it’s a reminder that complexity can be the enemy as well over time.  As an aside, it’s incredibly interesting to go back over the past few decades and look at the names that pop up along the way, many of which no longer exist.

Here are the results through the end of trading today, 7/25/14.  

The back-tested portfolio outperforms the S&P 500 by over 4% annualized during the approximate 21.5-year period.  Because of the power of compounded returns, this is a very big deal.  $1000 invested in the model portfolio using the single valuation factor is worth $15,972 today versus $6,939 for an index tracker.

As we’ve pointed out in the past when conducting this exercise, there is a catch.

Pretend you are a portfolio manager launching this simple value based strategy on 12/31/1992 knowing that value works over the long run.  You invest the portfolio and look like a rock star the first two years.  Then, the value-manager killing late-1990s growthy stock bubble takes off leaving you in the dust for five straight years.  By the end of 1999, you’re losing by over 40% to the index with investors abandoning the portfolio (at the worst possible time, by the way) in droves to chase the newfangled internet stock dreams.  For the next 14½ years post-1999, the portfolio crushes the index, but you may not be there with a product to take advantage.

The moral: true value investing can be incredibly streaky and requires significant patience.  Over the first 21 years of the back-test, the model portfolio underperforms in eight. Though the long-term rewards are substantial, it is enormously difficult for investors, whether individuals or institutional, to stay the course, stick to plan, and take advantage.  Furthermore, it’s easy in hindsight to look at the names that pop up along the way and think that some of the moves were obvious in hindsight.  In real-time, many of the companies included in the portfolios were wounded and down on their luck at the time for rebalancing.  Apple, for instance, shows up in the early 2000s when few gave it much of a chance to do anything.  At the very least, the vast majority of the names included in the portfolio over time were far from being considered the sexist names in the investing universe.

Ultimately the value “free-lunch” continues because no matter how much the collective investor universe understands that value ultimately wins, very few are actually able to exhibit the patience, consistency, and discipline to take advantage.  A pesky thing called emotion intervenes over and over.  Investors can’t help chasing the shiny object, nor can they help ignoring the names that are trading cheaply but happen to carry some baggage. 

More On the US P/E

Debate over the “Shiller CAPE” normalized P/E ratio, popularized by Nobel Prize winning economist Professor Robert Shiller, has been particularly pointed this year.  As we’ve discussed in the past, this measure takes the average of 10-year trailing earnings for the “E” in the P/E ratio in order to smooth out and eliminate the volatility present in typical expressions of simple trailing 12-month S&P 500 earnings.  Supporters of the widely followed valuation measure correctly point out that future 10-year total index returns have a statistically significant relationship to CAPE valuation levels.  Detractors have leveled a number of charges varying from complaints that 10-year trailing earnings unfairly capture the massive, and in their view highly unusual earnings cliff dive that occurred in ‘08/’09 (but ignoring the fact that earnings were overly inflated ahead of the crisis), to the fact that the supposedly mean reverting ratio has remained above mean for the vast majority of the past two decades undermining the credibility of the indicator.  

A particularly interesting argument against Shiller’s version of the normalized P/E came from a blog by the name of Philosophical Economics back in December.  The blogger pointed out that changes to the treatment of “goodwill impairment” when calculating GAAP earnings had created real problems in terms of the consistency of Shiller’s earnings data over time.  The blogger demonstrated this issue by comparing GAAP earnings since the early 2000s (when the rules changed) with Bloomberg’s S&P 500 earnings calculation of scrubbed non-GAAP earnings from continuing ops and showing that the deviations between the two series since the early 2000s had increased dramatically since the shift.  We thought this was a particularly compelling argument and therefore used the alternate Bloomberg earnings data series in the same manner as the above blogger to reconstruct a historical normalized P/E ratio to create a more consistent measure.  

First, we’ll take care of a few housekeeping items.  Since the Bloomberg pro-forma data only goes back to 1952, and considering that deviations between pro-forma and GAAP are much, much small prior to the goodwill changes, we took a bit of “artistic license” and added Shiller’s publicly available data for the period from 1925 to 1952 so we could get a longer term view incorporating the bubble of the late 1920s and the subsequent depression years.  Now that that’s out of the way, here is the chart:

Now that we’ve addressed inconsistency due to GAAP changes, what do we learn from the current normalized P/E levels using the alternate “pro forma” data?  We see that the real (inflation-adjusted) P/E ratio currently sits at 22x versus the 25x level of the traditional Shiller P/E.  This compares to a long-term average of approximately 17x and a long-term median of 16.5x.  While not as overvalued as the traditional Shiller P/E, we see a market that’s still decently above historical levels.  How does this translate into a prediction for future returns?  The 10-year future annualized return forecast comes in at 3.54% for inflation-adjusted total returns (i.e. with dividends), 6.38% for non-inflation-adjusted total returns, and 4.47% for non-inflation-adjusted returns without dividends.  This compares to historical averages of 5.71%, 8.85%, and 6.63% respectively.  These numbers, therefore, look better going forward than those produced by Professor Shiller’s calculation.  Still, we’d say at current levels, even with the GAAP adjustments, there’s a good chance that market returns over the next 10-years will be substandard relative to historical averages.  

Regarding the criticism by some that the ratio has remained above median for a good part of the past 15 years, we see looking over the future returns streams that the above average P/Es resulted in sub-average returns.  The massive spike associated with the late 90’s tech bubble?  That spike resulted in outright negative 10-year annualized nominal and real returns.  How about those elevated P/E ratios observed in the period from roughly 2003 to 2007?  So far, the 10-year annualized returns that have been realized from 2003 and 2004 onward have been roughly in-line with the sub-par results P/E ratios would have predicted.  Take September/October 2003, for instance, when the normalized P/E was trading at approximately 22x, the current observed level: 10-year future total real returns were 4.5% per annum, over a percent lower than historical averages and nominal total returns were 6.9%, approximately 2% lower per annum than historical average.  The pattern has continued.  And, don’t forget that there was one heckuva wild, dangerous ride during that 10-year period, with the S&P 500 falling over 60% peak to trough at one point during the financial crisis.  

There are some other interesting historical observations worth pointing out, in our opinion.  Look at the Great Depression period and the secular bear market associated with that era.  Leading into the ’29 crash, valuations were extremely elevated.  At the beginning of the Depression, valuations dipped into the single-digits at a velocity similar to the velocity of valuation compression we’ve observed at various points over the past 14 years.  Over the five-year period from 1932 to 1937, however, markets recovered materially and valuations actually pushed back above 20x to a level almost exactly where we currently reside.  Sure enough, a relapse sent markets and valuations tumbling from overstretched highs back towards cycle lows.  

Of note, the next single-digit valuation low in 1942 proved, though, to be one of the better buy-points of all time.  Buying at the valuation low in 1942 would have produced double-digit annualized returns over the next 25 years.  Further showing how important starting valuation is, buying the market at the height of the Depression in 1932 when valuations hit a modern low produced double digit total returns over the ensuing 33 years until the next valuation peak was reached in 1965.  Similar observations and outcomes arise out of the valuation lows of the 1970s and early 1980s.

What’s the point of all this?  Set expectations appropriately for US returns and make sure you’re keeping your eye open for opportunities elsewhere.  They do exist.  Again, at current valuations, we’re hard-pressed to believe that US returns will be able to approach or exceed long-term historical averages over the next decade.  On the flip side, many other markets overseas hold much more attractive valuations in the low to mid teens.  In fairness, just because US valuations are elevated doesn’t mean that total market Armageddon is around the corner.  There are a lot of breathless, hyperbolic bears out there right now.  But, thinking that a decade of 80’s and 90’s like equity returns are in our future isn’t a very prudent way to approach US markets under current circumstances.

Scattershot Summer Thoughts:

EAFE: Waiting for Godot

As we’ve discussed in the past, since the beginnings of the 2007 to 2009 financial crisis, the MSCI EAFE, an index comprised of developed market companies from Europe to Australia to the rest of Asia, has significantly trailed the performance of US markets.  Of course, the sovereign debt crises spreading across southern Europe from 2010 to 2012 hurt European equity markets and held back performance.  And, Japan has been a multi-year economic mess, though Abe’s moves since late 2012 have ignited strong recent upward moves in Japanese equities.  Looking over the first six or so months of 2014 though presents a similar relative performance picture despite the fact that attitudes towards international equities, and Europe in particular, seem to have perked up considerably.  Through yesterday (7/10), the EAFE total return is 3.79% vs. 7.44% for the S&P 500. 

Long-term relative performance analysis shows that the back and forth battle between US and International stocks has been cyclical in nature, with long periods of EAFE outperformance followed by long-periods of US outperformance.  In the past, major turns in relative performance have occurred when the relative strength ratio between the EAFE and S&P 500 has reached extreme levels, generally either +1 or -1 standard deviations from the average.  We’ve passed that threshold recently, with the EAFE performance relative to the S&P 500 falling below -1 standard deviation from the average in recent weeks for the first time since late 2001 and early 2002.  Here’s a chart of long-term relative strength.

The last time the EAFE crossed this threshold to the downside, the EAFE index outperformed the S&P 500 significantly over subsequent years.  From 12/31/2001 to 12/31/2007, the period roughly corresponding with the minor uptrend in the chart coming after the last threshold breach, the EAFE was up 132% (total) vs. 42% (total) for the S&P 500.  Interestingly, even with all of the economic and political troubles outside the US over the past 13 years, the EAFE has matched S&P 500 performance on a simple basis and actually outperformed the US when taking dividends into account.

Investors like us have been waiting for our international developed brethren to re-take the performance mantle from the US for a few years now.  The above suggests that the winds may shift in coming quarters and that the EAFE may soon become a strong relative performer.

Emerging Markets Emerging?

Speaking of relative performance and downtrends, there’s no denying Emerging Market equities have been performance dogs when compared to the US and even developed Europe and Asia over the past several years, defying all sorts of conventional wisdom coming out of the Great Recession.

Year-to-date, the MSCI Emerging Markets Index has shown some vigor, matching the performance of the S&P 500 for the first time in what feels like ages.  Is this the beginning of another long period of outperformance or another short-term reversal?  The evidence seems mixed at this point.

Like the EAFE/S&P 500 comparison above, Emerging Markets performance relative to US stocks has been just as cyclical.  The recent underperformance comes after a long period of outperformance following extremes similar to extremes observed above in the EAFE chart.  Even with underperformance over the past 3 or 4 years, relative strength is stuck in the middle of the 2 ½ decade range as seen below:

Using relative valuation, Emerging Markets are clearly undervalued on a long-term basis, with various CAPE P/E ratios hovering in the low-teens versus the low-20s for US equities.  At some point, those wide valuation differentials will converge.  When though?  We also look at the 200-day moving average for the relative strength ratio between the S&P 500 ETF, the SPY, and its Emerging Market counterpart, the EEM.

At this point, the downtrend remains in place as shown below:

At IronHorse, we’re seeing more and more emerging-market stocks pop-up as targets for consideration; we’ve even added a small amount of single-stock emerging markets exposure in recent months.  We’ll become more comfortable, however, with large amounts of emerging markets exposure when the above trend starts moving the other way.

Sentiment:  The Song Remains the Same

The past few years, we haven’t ceased to be amazed by the quickness with which broader market sentiment deteriorates at the first hint of correction.  This is a very good thing in our estimation.  Take recent market action.  Granted, the S&P 500 and global markets have pulled back in recent sessions.  Nonetheless, the S&P 500 is still slightly up for the month of July at this writing and the MSCI World is down less than 1% for the month.

What’s happened to various sentiment indicators?  Fear has jumped.  It’s not extreme, but the jumps higher for fear gauges seem disproportional relative to the magnitude of actual equity market moves, a condition that’s persisted for much of this equity market cycle.  For example, the put/call ratio has jumped from a roughly neutral level to approximately 0.6 standard deviations above the long-term average.  The 10-day average for the ISES option indicator has fallen from an extended level over 1 standard deviation above the norm to a neutral level over the past two weeks.  Meanwhile, individual investor sentiment as represented by the AAII bull/bear/neutral survey remains below long-term averages.

As we mentioned a few weeks ago, there seem to be several pockets of serious complacency out there, but nothing that warrants deep pessimism.  Corrections, minor or not-so-minor, are healthy recalibration agents for up markets.  Investors broadly seem to still think, though, that every little hiccup is the beginning of the end of days.  Until this behavior changes significantly, we’ll remain encouraged.

Inflation: Little Sound, Little Fury

This week, the back and forth continued among various Fed officials, Fed watchers, and market gurus about the future path of inflation, and hence Fed rates.  Some of this back and forth has contributed to some of the recent market hiccups.  James Bullard, St. Louis Fed President, suggested this week that the Fed Funds rate could increase sooner than the markets expect. 

Of course, there remain a number of pundits and analysts out there sounding the inflation warning signals, as they’ve been doing for five years now.  To this, we say, “Where’s the Beef?”  Looking at 5-year and 10-year TIPS/Treasury spreads, a way to gauge the broader market’s expectations for future inflation, inflation expectations remain well grounded at this point and have barely budged in recent months, even with improving labor market numbers and other indications that economic growth has regained its footing.  The following charts provide a visual representation of this benign pattern:

 

Furthermore, it seems to us that the biggest driver of sustained inflation problems in the past (take the mid to late 1970s for instance) has been strong increases in unit labor costs.  At this point, there’s no sustainable evidence that unit labor costs are increasing materially in the US.

Look at the below chart showing year over year unit labor cost moves.  As you can see, the green line, the 24-month moving average for year-over-year unit labor costs, began increasing in 1967 and didn’t stop until Volcker broke inflation’s back over a decade later.  Of course during this time period, Americans experienced the infamous double-digit inflation that affects attitudes to this day.  What’s happening now?  Actually not much.  There’s always statistical noise in this series.  Focus on the 24-month moving average which remains in a downtrend.  Wage data in the recent strong employment reports remains unremarkable.  We’ll begin to worry about long-term inflation trends when labor costs begin to uptick in a meaningful and sustained way.  

The VIX and Company Risk

Keeping with a few recent posts dealing with volatility and the market’s overall opinion on market stress, we thought it might be interesting to examine the connection between equity market volatility and market participants’ ideas on corporate risk.  

The VIX, an index that quantifies the market’s views on forward 30-day volatility, has historically been very closely related statistically to past/recent realized market volatility.  In other words, the levels of recent market volatility heavily color the market’s view of volatility in the near future.  This makes sense.  There’s a strong amount of “recency bias” among investors.  Taking the view on market volatility one step further, though, shows that percentage changes in the VIX are significantly correlated to percentage movements in Markit’s 5-year Investment Grade Generic CDX Index, which measures credit default swap prices for 125 investment grade companies across all sectors.  Higher levels in the CDX index show that the cost to insure against bond defaults in these companies is rising, meaning that the market’s view on corporate risk is increasing.  Lower levels in the index show that the market is less worried about corporate risk.  The VIX/CDX relationship is interesting, and shows the direct connection between individual company risk (or perceived risk) and overall market jitters.  

Here is a chart going back to the beginning of 2006.  Values for the VIX and CDX indices have been normalized for comparability.

Sharp rises (declines) in the VIX have been accompanied by sharp rises (declines) in the CDX index over the past decade.  In percentage terms, the moves from peak to trough have been almost completely in sync.  Accordingly, the weekly correlation for the percentage co-movements in these indices is approximately 0.65.  

We’ve obviously gotten geeky here.  What does the above chart convey in our view?

• As one would expect, stock market volatility is related to underlying corporate risk.
• Just as the realized volatility and the overall VIX index have hit multi-year lows, the market’s view on corporate risk is falling to the lowest levels since 2007.
• In 2007, the VIX and the CDX index began creeping higher nearly a year before global equity markets began experiencing significant convulsions.  
• While there are no guarantees, we’ll surmise there will be a similar deterioration in market attitudes towards risk decently ahead of the next market snafu.  
• We’ve seen this play out with deterioration in leading economic indicator indices over time.  Significant downward moves in the leading economic indicators have occurred well ahead of major market calamities.  Of note, the beginning of the move upward in the VIX and CDX indices in early 2007 coincided almost perfectly with signals from leading economic indicators that recession probabilities had increased significantly.  This makes intuitive sense that perceptions of corporate risk, and hence volatility, would increase with increased recession probabilities.  Because…What happens during recessions?  Earnings collapse and earnings volatility significantly increases.  In other words, corporate “risk” jumps through the roof.
• Therefore, while corrections, sometimes very uncomfortable, come and go, we maintain our view that a major market calamity isn’t on the immediate horizon.  As with some of the other early warning indicators we’ve discussed such as financial market stress, until we see indicators like the CDX index begin to creep higher on a sustained basis in sympathy with recession warnings, we’ll stay involved in markets.  As seen above, the CDX index is still trending down.  And, despite a noisy and discouraging Q1 GDP print in the US, leading indicators here and abroad haven’t budged to the downside whatsoever.  The probability for recession over the next 8 to 12 months remains very low.  We’ll stay vigilant though!