Yesterday the US equity market (S&P 500) reached all-time highs. Indeed so far in 2019, many major equity markets are up between 10% and 20%.
This has caused much confusion; it runs contrary to what seems to be a very negative backdrop for the global economy, with warnings of more to come:
As one Bloomberg article put it yesterday: “the list of reasons stocks should be down is much longer than the one for why they should be up.”
How can we think about this apparent disconnect, and how valid are some of the other arguments being put forward?
Our view: the importance of rates and starting point
We don’t see moves in equity markets as the puzzle that some commentary has suggested. Readers of this blog will be very familiar with our arguments on the importance of US (and global) rate expectations for the valuation of all assets, and particularly the role that rate pressure played in driving asset returns in 2018.
In 2019, that rate pressure has abated in a big way, providing support for equity markets:
This can seem confusing. For one, it shakes the mental model that many have whereby bonds and equities are always negatively correlated. It is also a dynamic that can seem counterintuitive and circular: the very pessimistic views that some see as inconsistent with 2019’s equity gains are the same views that have driven rate expectations lower.
What squares the circle is that the impact of this move in discount rates has swamped news of lower profits.
The starting point of valuation
Just as important has been the starting point of the 2019 journey. From October 2018, markets had seen significant weakness, initially on US rate pressure, and then what looked like episodic panic.
With valuations reaching attractive levels and investor myopia prevalent, it is perhaps not surprising that equities were set up for a strong recovery, particularly when one source of concern (rates) was removed:
The longer term context also reveals that many markets are little changed over twelve months. Even the US and Europe, which are above those October levels, have only got there relatively recently.
Rather than suggesting a euphoric rise in markets, this longer term perspective suggests that investors were right to be concerned about returns on a twelve month horizon, but that by December 2018 were pricing in scenarios that were more negative than subsequently transpired.
Another argument: investors aren’t as pessimistic as commentary suggest
Of course it is possible that the pessimism suggested by journalists and economists isn’t shared by investors, and that market participants are actually highly optimistic, or at least wilfully ignorant given the distortion provided by QE.
We won’t revisit the QE argument here, except to note that it is not clear from a chart of European equity markets this year that new ECB stimulus had notable impact. However, it does seem that simply looking at aggregate equity returns and seeing them as indicative of optimism is overly simplistic. A deeper look certainly seems to reveal deep pessimism with regards to the economic cycle.
Within equities, the underperformance of ‘value’ stocks has been well documented and has continued this year, despite a recent improvement. We can add to this the outperformance of companies with less volatile earnings streams (often less cyclically exposed and more ‘bond-like’) and the underperformance of small cap stocks (often considered beneficiaries of healthier growth environments):
This is mirrored across assets: from the preference for less liquid alternatives and fear of equity correlation, or the fact that lower-rated (more cyclically exposed) US corporates have seen spreads widen this year, while safer bonds have rallied:
Each of these examples will have idiosyncratic, bottom-up drivers (US energy credit for example) and won’t only be a feature of growth pessimism. However, taken together they at least cast doubt on the notion that, just because aggregate equity markets are up a lot, investors are optimistic about the world.
There is a tendency for the investment industry to overemphasise the importance of the calendar ‘year to date’ as well as all-time highs in price levels.
But such tendencies can overlook context and ignore some important considerations: a price index does not tell you about valuation, GDP is not the same as profits, and profits need not be the same equity returns. A single metric is not enough to assess the landscape.
Investors who have plied their trade throughout ‘the most hated bull market in history’ won’t be surprised to see stocks do well against a deeply pessimistic backdrop. It is when the consensus is most optimistic that we need to be more concerned.