Author: mgyurcsik

How Will Valuation Levels Normalize?

Active U.S. equity managers regularly point out that the stock market looks expensive, and as a result, they are having trouble finding good companies to buy. Our chart this week looks at the median P/E for the S&P 500 Index over the last decade compared to the current P/E (our E is based on trailing twelve months operating earnings). Not only does the broad index look expensive relative to history, but each of the sectors in the index also appears to be overpriced. But how overpriced? The green bars indicate the price correction needed to bring the index back in-line with the historic median P/E ratio. At current valuation levels it would take a full blown bear market (a price correction over 20%) before the market looks reasonably valued again.

However, there is another way for P/E multiples to normalize over time; an increase in earnings without a change in price. The orange bars show the earnings growth needed to bring the index back in-line with historic valuation ratios. While 27% earnings growth for the S&P may seem optimistic, investors should realize that after seven straight quarters of negative earnings growth from 4Q14 to 2Q16, overall index level earnings are growing again. Year-over-year earnings growth hit 21% in 4Q16 and analysts currently expect S&P 500 earnings to be up 22.6% in 2017.

Lastly, astute observers will notice our analysis excludes two S&P sectors. Real Estate is excluded for a lack of historical data, as it just became a stand-alone sector back in 2016. Energy is excluded because energy sector earnings are currently so low the P/E multiple is essentially meaningless. But investors are expecting energy earnings to bounce back in 2017, and play a key role in driving overall S&P 500 index earnings growth.

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The Easter Bunny’s Hopping All The Way To The Bank

The Easter Bunny has a lot to celebrate this holiday as cocoa and sugar prices continue to slump. Both commodities experienced a supply surplus in recent months, largely due to substantial rains during El Niño, which has substantially decreased prices. The Ivory Coast experienced a hearty rainy season and dry winds from Northern Africa were below their historical averages; both trends increased the country’s cocoa yield and led to a 20% reduction in cocoa prices over the past 6 months. Additionally, Brazil benefitted from a very healthy rain season which led to a record production of sugar crops and a global surplus of the commodity. Sugar prices have fallen 18% in the past 6 months.

Americans are anticipated to spend $2.6 billion on Easter candy this season and the Easter Bunny’s haul is a substantial portion of that total which should allow him to increase his margins. Given the uncertainty across the globe, coupled with high equity valuations and the prospect of rising interest rates, we recommend he invest in a diversified portfolio and rebalance as appropriate.

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Will 2017 Bring a Surge of IPOs?

Snapchat (SNAP) — which went public in early March — was the first venture-backed technology company to do so in 2017. The firm sold 200 million shares to raise approximately $3.4 billion, making it the largest tech IPO after Alibaba Group in 2014. As private companies like Uber, Airbnb, and Pinterest continue to use private markets to raise capital, how much longer can they wait before turning to the public markets?

This week’s chart shows total global IPOs going back to 2008. Compared to 2015, 2016 saw 32% fewer global companies entering public markets. As accelerated growth continues among private companies, many market participants expect lower corporate taxes and fewer regulations. These potential changes would likely lead to more IPOs in 2017. According to Renaissance Capital, U.S. IPOs were off to a solid start in the first quarter with 25 companies going public and raising $10 billion. If in fact IPOs do pick up globally in 2017, it will become a much stronger year for venture and private equity investment firms. These firms will be able to monetize investments following the IPOs, creating a financial windfall for investors. A broad market sell-off in 2017 could be the only thing standing in the way of a record setting year for IPOs.

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What Will Drive Real Estate Returns in the Coming Years?

Core real estate investments have flourished since the financial crisis. The NCREIF Property Index (NPI), since returning six consecutive double-digit annual returns through 2015, delivered an 8% total return in 2016. Despite lower projected absolute returns compared to what we have experienced over the last six years, real estate remains an attractive investment relative to other asset classes.

This week’s chart illustrates the historical 1-year trailing total returns of the NCREIF Property Index (NPI) going back to 1979 broken down by the three main components of total return: dividend yield, cap rate shift (also known as cap rate compression / expansion), and net operating income (NOI) growth. As seen in the chart, the slowdown in total returns since last peaking in the third quarter of 2015 has been dominated by the cap rate shift effect as cap rates level off at their current historically low levels. NOI growth, on the other hand, has been relatively stable since the slowdown and will be a critical component of future real estate returns going forward as overall fundamentals for the asset class remain strong. Despite lower projected absolute returns, real estate is still an attractive investment relative to other asset classes and should deliver positive returns to investors again in 2017.

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March Market Madness: No One Knows Who Will Win

Historically, two indices have moved hand-in-hand: the Global Economic Policy Uncertainty Index and the VIX Index. The former is a measurement of uncertainty surrounding economic and political policy on a global scale, while the latter is a gauge of the volatility level for the S&P 500 index. The relationship between the two should not be surprising: as uncertainty increases, equity volatility rises. What is surprising is the recent divergence of the two. While global economic policy uncertainty surged to recent highs, market volatility is close to 20-year lows. Since the late 1990s, the 3-month rolling correlation between these indices has hovered around 60%; a divergence of the two to this extreme has not been seen in recent history. So what has caused this disparity?

One answer could be the election of Trump, which could explain the directionality of both indices. The contradictory nature of White House statements versus direct quotes from Trump himself oftentimes leaves the public unsure of what to expect next, as it relates to policy direction. Meanwhile, markets have climbed from the “Trump Effect,” which reflects optimism about the successful implementation of new business-friendly policies. An alternative explanation could simply be that company earnings have been sufficiently strong to support current valuation levels. Though there is global policy uncertainty domestically and internationally — notably due to the populist movement in Europe — strong earnings have more than offset this policy uncertainty and thus driven markets higher and perceived risk lower.

Can both sentiments concurrently be correct? This trend certainly hasn’t been the case in recent years, however, the divergence has continued since Trump’s inauguration. Only time will tell if one of these indicators is truly victorious.

Diverging Market Opinions (aka The Bears vs The Bulls)

This week’s Chart of the Week examines a recent phenomenon seen in valuations for both bonds and equities. U.S. stock prices rose quickly over the last year and a half with the S&P 500’s P/E ratio climbing to 21.8, surpassing its 20 year average. Meanwhile the Bloomberg Barclays Aggregate Index saw its option adjusted spread (OAS) fall below its 20 year average to .43%. OAS is a primary metric for valuating bond prices and this tightening suggests that bond prices are relatively expensive.

This is a rare situation as it is counterintuitive for both indices to be valued highly at the same time. Highlighted in the gray bars on the chart are the months when this occurred. During the late 90s equity valuations hit historic highs with the tech bubble. Treasury rates during this time were as high as 7%, so even though spreads were low the total yield on the Agg was still relatively high. Today’s environment is much different with Treasury yields around 2%. Excluding a transitory period in 2003 this was the only other time when this happened.

What makes this so unusual is bond and equity prices typically move in opposite directions of each other. Stock valuations increase when investors are confident in the markets and want to take advantage of a strong economy. Bond prices typically rise during “risk off” periods when investors look to be more defensive. The fact that both are rising seems to suggest there is increasing polarization of opinions in the financial markets. Since there is so little precedence for this situation it is difficult to know what to expect, but something almost certainly will have to give. Only time will tell who will win: the bulls or the bears.