Don't Fight the Fed. Don't Fight the Tape.
Clients of the Firm,
The 2nd Quarter of 2019 brought with it increased volatility both up and down as macro-economic uncertainty ruled the quarter. Markets fell over 8% in May and recovered to new highs in June as trade talks and the Fed dominated market positioning.
Trade Uncertainty in May
On May 5th during Sunday brunch, President Trump dropped a surprise tweet on investors announcing a sudden increase in tariffs to 25% on imports from China with the potential for further tariffs all imports from China. The President also indicated that the Chinese government had reversed course on previously agreed to provisions of a pending trade agreement, thus causing this sudden unexpected action. Markets had anticipated that a trade deal was near after evidence of significant progress as well as positive commentary from the Treasury Secretary and US Trade Representative.
During the rest of May, markets began to teeter on the news and worry of a significant escalation of the trade war between the US and China. A flight to safety began to take place into Treasury bonds and cash and a rotation out of stocks with any exposure to China ensued.
Later in the month, President Trump further escalated the trade concerns with China by banning US companies from doing business with Huawei, a major Chinese telecommunications equipment provider. This action combined with the tariff increases, caused a major reversal in Chinese state media’s depiction of the trade negotiations toward a more aggressive position. Sources on the ground in China also indicated a growing negative sentiment towards the United States due to the President’s aggressive posture and the perceived disrespect of the Chinese leadership, companies and people.
Further, President Trump further upset the apple cart of trade by announcing he would impose 5% tariffs escalating to 25% on all imported goods from Mexico to punish them for not cooperating with his border policies on immigration. Presumably, the intention of such a policy was to pressure Mexico into further cooperation on securing the southern border. Simultaneously, the Chinese announced they were developing an “unreliables” list of companies and persons doing business in China which further enhanced uncertainty with respect to China trade. All of these issues further boiled the pot of uncertainty on trade, sending stocks lower and bond prices higher.
In June, markets applauded the when the administration resolved its dispute with Mexico over immigration and removed its threat of tariffs as a result of a further border cooperation agreement with the Mexican government. In addition, President Trump and President Chi of China met at the G-20 summit and agreed to get trade talks back on track. Further, and perhaps most importantly, the Fed changed its stance on interest rates to dovish, indicating that weakening data from abroad, trade uncertainty and even uncertainty surrounding the debt ceiling were all reasons it would consider a more accommodative stance on monetary policy (i.e. a rate cut).
The result of this trade and economic outlook uncertainty has been a dramatic decrease in interest rates and an inverted yield curve. As we write this, yields have contracted to 2.08% for the 10-Year Treasury and 1.86% for the 2-Year Treasury. The 2-Year rate is now 64 basis points below the Fed Funds target implying we will see two and a half Fed rate cuts over the next two years. This pricing represents market expectations of a dramatic reversal of policy from last September when the Fed had indicated a likely 3 rate increases in 2019.
It is very difficult to price in the implications of such sudden, seemingly unplanned, tariff impositions which are likely to impede American companies and consumers. First order magnitude implications are easier to estimate, but second order effects are impossible to predict with any degree of certainty. Consequently, in May the stock market sold off until a level was reached where fair value seemed appropriate despite estimates of significant second order impacts of the trade wars.
In June, the stock market rallied substantially on interest rate cut expectations and now sits at or near all-time highs. This rally is demonstrative of what we call a TINA (there Is no alternative) phenomenon in stocks. This theory espouses that capital will continue to flow into equities until a competitive return alternative emerges or that the likely return on stocks is at parity with corresponding interest rate risk. As interest rates drop, the discounted value of future cash flows goes up as a result of a lower risk-free rate. Thus, investors are willing to pay more for the same earnings because the alternative of investing in low interest rate investments is so relatively unappealing.
Don’t Fight the Fed. Don’t Fight the Tape.
A mentor of mine and one of the leading head traders in the hedge fund industry left me with two Wall Street adages when we first started this firm over 15 years ago. These were: Don’t Fight the Fed and Don’t Fight the Tape.
“Don’t fight the Fed” speaks to the overwhelming ability of the Federal Reserve to manipulate the flow of capital and short-term interest rates. Currently, the Fed policy shift favors equities as an alternative to bonds with the expected earnings yield of the S&P 500 at 5.87% versus the 2.08% 10 Year Treasury. This 3.79% earnings risk premium is at the higher end of recent ranges and represents the premium one is paid for taking equity risk over the risk-free rate of return. Fighting the Fed on investing strategy has consistently been a losing mission.
“Don’t Fight the Tape” refers to pursuing a strategy that is contrary to market momentum. Indeed, as we have seen over the past few months this adage is not always the correct indicator of what strategy to pursue. Sometimes when markets seem the darkest and sentiment is lowest the best strategy to pursue is to be bullish. By contrast, when markets are at their most optimistic, a bearish or hedging strategy may be advantageous.
While we see most asset classes today at elevated prices, the least expensive of the two primary asset classes in public investing appears to be equities. Bond yields, globally manipulated by central bank policy, are at all-time highs in price and all-time lows in yield. Several trillion dollars of sovereign debt in Europe and Japan have negative yields. With the Fed shifting policy, the short end of the Treasury curve may go to between 1.75-2.00% over the two years, absent a recession.
We have reached a crossroads in investing in stocks where we must decide whether the prices of equities are reflecting likely earnings in the future or are experiencing a valuation multiple adjustment higher due to artificially low interest rates or a combination of both. The latter thesis holds with it a bull case for equities and the former a cautionary tale of temporary overvaluation in parts of the market.
Our considered view is that we are experiencing a combination of multiple expansion and the appropriate pricing of expected earnings. While not the worst-case scenario, we must be cautious to avoid overpaying for future earnings in this type of environment. It is tempting to become overly aggressive during super-bull market moves that often end in crescendo retail buying followed by cascading institutional selling on valuation. These types of markets tend to last longer than they should, reaching new highs that are not based on fundamentals. Typical P/E valuation peaks range from 18-20 times earnings. Based on current estimates that would put the market near-term top projections between 3,163 and 3,515 for the S&P 500 or between 5%-17% upside from current levels. Normalized valuation levels of equities tend to be 15 times earnings. This valuation places projected market levels at 2,636 or approximately 12% below current levels.
Our analysis, of course, assumes that earnings levels will come in as predicted and that the aforementioned trade uncertainty, political upheaval, rate policies and valuation paradigm will not derail corporate profits. This outcome is far from certain.
Our analysis currently assumes that earnings will come in on target and that the aforementioned trade uncertainty, political upheaval, rate policies and valuation paradigm will not derail corporate profits. If some of these uncertainties abate, we may see increases in corporate spending and consumer confidence against the backdrop of record low unemployment and the positive wealth effect of stock market gains. This scenario could drive better than expected profits and thus make current valuation levels justified.
By contrast, if trade uncertainties persist it may cause international growth to slow or even recede. This coupled with the potential for interest rate policy to cause dislocation in bond prices and excessive borrowing, may imply that stock prices are rich at their current levels.
On balance, upside and downside near-term levels are relatively equal for equities. By contrast, we see almost only downside on prices for bonds of longer duration at this juncture. While we should tread cautiously in this environment, we should not abandon the equity market at current levels nor expect a substantial increase beyond the previously discussed valuation levels. In addition, we should not expect a substantial degradation in prices absent a surprise by the Fed, economic shock or deficit in earnings. We continue to monitor market conditions closely and thank you for your confidence in our management of your funds.
Peter C. Wernau
Wernau Asset Management
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