The Days Ahead: Earnings season over and it’s a light data week.
Plenty of action on the politics, less on the investment and economic side. We were in Washington early in the week and the economic talk was about how much the President’s budget would cut programs and how unlikely many of them would survive a House and Senate overhaul. Markets are cold-blooded beasts. For now there’s nothing tangible coming from Washington other than pro-business-speak. So at worst, it’s no change and at best, it’s all the tax cuts, spending, deregulation we, and everyone else, has spoken about. We don't believe the market has much of the “reflation” trade baked into prices. It’s been more of a story about earnings growth, lighter regulation, higher loan demand and momentum in global growth and trade.
We think this explains the sideways action in 1) the S&P 500, which has gone nowhere since early March and 2) the 10-Year Treasury, which has ambled around 2.2% to 2.4% for several weeks. Meanwhile, European markets continue to catch up. Eurozone stock (so Europe less U.K. and countries that don't use the Euro) had a good week although there was a bit of “sell the fact” going on when the French election news came though. The broad European market is now up 17% (for a dollar investor) year to date compared to the S&P 500 at 6.7%. European bond yields have also drifted up. In the case of the ultra-haven Swiss Ten-Year bond, from -0.23% to 0% and German Bunds from 0.2% to 0.4%. That means signs of growth and a probable end of deflation risk. Right on cue, German GDP reported on Friday at +1.7%
1. Let’s talk risk: There has been much commentary on the low levels of volatility in U.S. stocks. And indeed, the only real measure of this has been the VIX. Here it is with its European counterpart thrown in for good measure. The black line is the 12-month moving average of the U.S. VIX.
The folks over at Deutsche Bank put out a note explaining that there have been only nine days since 1993 that the VIX closed below 10. Last week was one of them. We also put a chart out last week that showed shorting VIX over the last five years would have returned nearly 800% whereas being long would have lost 99.999% of your money.
So why is it so low and should we worry?
On the first, we must remember the VIX is implied volatility. It estimates how prices should move not how they actually move. Market dynamics are changing. ETFs and passive investing means there is more price discovery going on in the market, which means quicker price response and so lower expected volatility. The prevalence of covered call and risk parity investments strategies– also tends to flatten out expected volatility. We also know there’s an interest rate effect on options. If rates increase, the value of options increase. Those paying attention will see that there’s a bit of a circular argument going on: stock prices move so options move so stocks move. But it doesn't surprise us that volatility is low.
On the second, we’d argue that complacency is never good but we have strong signals from nearly every major central bank, that rate tightenings will be ultra slow and cautious. So stock volatility should be lower because it’s dealing with one less important variable.
So, bottom line? We don't think the VIX is much of a leading indicator of anything. It’s a good coincident indicator but we don't need any more of those. And we certainly don't think about it until the VIX is in the 20s. Then you can worry about it.
2. Japan: We've talked (and invested) about the merits of international stocks for a while even as domestic stocks outperformed for most of the post-crash period. That’s changed now and one of the reasons has been the Japanese market, which is up around 20% in the last year. Here we show the Enterprise Value (which is the market value of a company’s equity and debt less its cash) over earnings excluding interest payments and non-cash expenses for U.S. and Japanese stocks.
This shows Japanese stocks trading at 8.5x compared to the U.S. at nearly 11x. And U.S. stocks have risen from around 8x to 11x in the last few years (so 40% more expensive) while Japanese valuations have not changed. The Abenomics policies (low rates, structural reform and spending) remain in place so Japanese companies should operate under benign conditions for some time yet.
We’ve never invested on just one metric but it’s heartening to see that Japanese stocks appear reasonably valued even after a strong run. Big h/t to FT Alphaville.
3. The U.S. economic numbers: another week of not-so-great reports. Retail sales were disappointing and below expectations. The Fed is always focused on inflation numbers and there wasn't much to grasp with the PCE number (the one the Fed follows) coming in at below the 2% target again. Here’s the consumer inflation numbers with the core inflation (so ex-food and energy) rolling off.
Inflation is not hitting the Fed’s target and growth isn’t exactly hitting on all cylinders either. This leads us back to why the threat to bonds seems vastly overrated. We're growing at 2%, with inflation at 2% and the 10-Year Treasury at 2.4%. We're not going to go into depth on the natural interest rate debate (but here’s a good summary) but we do know the rate is lower than it was and not heading higher. Our view is for the 10-Year to remain well under 3% for the remainder of the year.
That bottom black line? That’s your wireless services in the middle of a price war and new carriers coming into the business. Enjoy it while it lasts. It’s about 1.6% of the CPI index.
Bottom Line: U.S. stocks are at a high but stable level. The S&P 500 is on a P/E of 17. We were curious how many companies were trading above 30 times. The answer: 124, and many are the mega cap names like GOOG (32x), AMZN (178x), FB (40x) and even XOM (34x) and CVX (70x), which are 15% of the market. The point is that there are many reasonably priced stocks away from the headlines.
--Christian Thwaites, Brouwer & Janachowski, LLC
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.