We are not usually pessimists but when we see the writing on the wall getting bold redder each week that passes, we can't help but to take serious note.
Just last week, we warned readers that markets might be about to get nastily volatile during the summer. So far so bad. May hasn't started well at all. The S&P 500, as of the week ending this past Friday, posted its first 3-week losing streak since January. The VIX has finally gone above 15, and the U.S. dollar index has been breaking the chain of shorts in the past 2 weeks, wiping out many bears in the process.
As portfolio managers, we have been flipping from short to long repeatedly in 2016. The environment remains markedly difficult to navigate and although the markets are aware of the many known unknowns, the sheer diversity and quantity of these unknowns have led to nervousness in the markets, and that has been reflected in abnormally non-directional price action in various asset classes. Volatility is a given.
Recent macro developments both in the U.S. and elsewhere have however strengthened the bearish case for risk, in our opinion. It might have reached a point where downside skews in risks make a derisking maneuver potentially more rewarding than chasing beta.
We use a series of anchor points for our analysis as directed by our approach to the markets. The "3Ps" of Positioning, Policy, and Profits remains a fundamental cornerstone in our framework. All 3 are currently not in favor for higher valuations, which translates (in typical market sense) to weakness in risk, and strength in liquidity and perhaps even quality/safety.
- Positioning has recently turned slightly negative with institutional players selling rallies in equities, shorting USD, and being very long in precious metals (short USD). Duration has been bid but remains mild compare to the extremes seen in the USD. The capacity for an abrupt turn in prices triggering simultaneous covering of these crowded positions is certainly present and poses a sizable threat for risk.
- Policy measures by central banks might have already been exhausted. Risk markets will likely not react positively to additional monetary stimulus the likes of QE or lower/negative interest rates. See ECB vs. euro & European equities; BoJ vs. yen & Japanese equities. Read more in the next few sections.
- Profits in America Inc. are already in a downturn. There will likely be a dearth of micro drivers to support elevated valuations, leaving multiple expansion and corporate buybacks as the only real bullish forces — both of which have already been running their courses for a good part of 5 years. An earnings recession doesn't equate to higher valuations, absent an exogenous shock which we don't see coming.
As such, we have shifted our bias to the short side of risk. The positions in our portfolio (which we keep private) have partially reflected this change in view and will continue to do so as the situation evolves.
Here are some of the known unknowns the markets currently expect. While the occurrences of these events are a given, the outcomes aren't.
- June FOMC. The Fed is not expected to hike rates during their upcoming June FOMC meeting. FF futures imply a 4% probability of a hike, but according to May's FOMC statement, we believe that there is a sizable risk of a hawkish Fed which, even absent a hike, has the potential to rattle markets. Policy uncertainty here (even if isolated to the U.S.) is impeding on investor confidence. Fed is being seen to remain highly data dependent and sensitive to macro. See next point.
- Uncertainty surrounding U.S. macro. Economic data has generally been atrophying since March with employment and labor market indicators turning lower, catching up to softness in other points of the economy. Manufacturing activity points to much slower growth than what retail activity suggests. Build up in inventories signal a recession, but relative strength in the labor market and pick up in wage inflation partially counters those negatives. Various regional Fed banks have also downgraded GDP growth forecasts for 2016. Market based expectations have likewise been on a decline since the start of the year. Macro reverberates back to policy in a feedback loop. See previous point.
- UK EU membership referendum. Brexit or no Brexit, this is a major event risk that has been confounding European and British markets. The GBP has been most directly affected and volatility could easily spill over to other risk assets. Current opinion polls show an almost neck-in-neck tie between both sides. We note that after Obama's visit to Britain earlier in April, Brexit odds have risen notably. This will remain an uncertainty for the markets until mid-June when the English will take to the ballots to vote on England's future in the EU for the first time since the trade and continental bloc was founded.
- Monetary policies. The BoJ spoke markets and sent the yen rallying (risk tanking) when it failed to ease policy in April. Markets are still expecting a looser stance from the BoJ and have been discounting that possibility after the initial negative surprise. The ECB is also expected to ease when its governing council members convene to decide on monetary policy later in June. The onus is on Draghi to lower interest rates further, but there are doubts that he will do so. especially after having just boosted the PSPP in March. Uncertainty in what the major central banks might do next is a key driver for volatility which limits excess returns. Currencies have also started to react differently to monetary easing.
- U.S. presidential election. This isn't a major event risk for markets but will still be affecting sentiment. Uncertainty builds up as we near Election Day, especially so when the race between Trump and Clinton heats up. More on this at the end of this piece.
Here are some of the known knowns the markets currently face. Consequences from these have likely not been fully reflected in asset prices.
- U.S. corporate earnings recession. We have talked about this in our previous piece on Insight. Investors expect EPS growth to slow significantly for the S&P 500 index as a whole, and valuations to catch down as a result. Micro drivers are few and far between, as we have seen so far this year. Negative surprises by way of earnings misses and lower guidance far outnumbered positive surprises. Apple Inc., once the world's most valuable publicly traded company, has been dethroned by Alphabet Inc. (Google), falling 17% since its pre-earnings cycle highs, and down 30% from 2015's all time highs.
- China concerns. As the world's second largest economy, China remains a heavy weight on the balance of global risks. Said risks are skewed downward for China. Growth concerns, a property market that is still deflating, massive swings in credit creation (the most important factor for growth in our opinion), central bank policies towards the yuan and interest rates. Yuan policy garners reactions from other regional central banks, and they too have started to tighten FX pegs and loosen policy language.
- Higher oil prices. One Risk that has mostly been overlooked by analysts is the 65% surge in crude prices since bottoming out in February. Prices at the pump (and including gasoline, diesel, jet fuel, distillates) have risen more than 30% on average, and have affect U.S. consumer sentiment negatively. While the rollover effects of higher energy prices on the economy are debatable (growth and inflation implications), markets are very late to discounting these potential implications, and their consequences on monetary policy.
- Volatility in FX. Wildly swinging exchange rates are never good for risk markets. The dollar, even after having retraced part of its huge YTD drawdown, is still the biggest wildcard in town. Uncertainty in central bank policies feeds into this via a feedback loop.
Conclusion & analysis from Goldman Sachs
As mentioned in the onset, we have started to be bearishly biased risk. Should technical factors line up well, we will be looking to build a short exposure in equities (general), and possibly in the precious metals complex. What stands between us going outright short on risk, and being on the sidelines by staying in cash/safety are mostly technical factors.
As you will read in the note from Goldman below, there has been, on average, 2 corrections of 5%+ magnitude each year in the U.S. stock market since 2010. U.S. equities experienced only one of such corrections in 2015, and another so far this year. It seems to us that market participants in general have gotten too complacent and have neglected some of the risks aforementioned in the sections above, and have back loaded the nature process of self-correction (in an anti-fragile system).
We would not be surprised to see another of such corrections in the near future, given how the risks have been structured. The event horizon will be busy going forward, and we believe big money remains the most clueless in a long time, as to where they should flow.
"Sell in May and go away" looks appealing to us. For those wishing to ride out the volatility, staying liquid should be the easiest thing to do. For those who still wish to have a net long exposure to risk, hedging via volatility calls might be an alternative. For those, like us, who intend to be geared riding any serious selloff, it is time to pick your weapons.
Of all the major asset classes, and on a beta-adjusted basis, we expect equities, precious metals, and the dollar (USD FX crosses) to be hit the hardest. A highly levered play would be to short the PMs on momentum; not that we will do it but it seems like a logical play. Sell in May, and play it safe!
From Goldman's David Kostin:
Following a tumultuous first quarter, S&P 500 has stabilized in 2Q 2016. Realized volatility averaged just 10 in April, the lowest level since May 2015. Implied volatility as measured by the VIX averaged 23 during the first two months of the year before retreating below 15 in May. Equity investors seem complacent rather than bullish about the near-term prospects for US stocks.
Looking over the horizon for the next few months, we see a variety of risks that lead us to revisit the adage and ask whether investors should “sell in May and go away” and not return until after Labor Day.
A drawdown during the next few months could find the S&P 500 index falling by 5%-10% to a level between 1850 and 1950. 16 drawdowns greater than 5% have occurred since 2009, including the 13% correction that lasted 3 months and ended in February (Exhibit 1). S&P 500 trades at 2047 and has a forward P/E of 16.7x based on bottom-up adjusted EPS of $123. A 5% pullback would lower the P/E to 15.8x, implying an index level of 1950. A 10% correction would reduce the P/E to 15.0x and the index level to 1850.
We continue to expect the S&P 500 index will end 2016 at 2100, roughly 3% above the current level. Not all is bleak, with possible upside arising from the recent trend of positive earnings revisions, as discussed last week, along with the possibilities of investors adding more length and a dovish Fed surprise in June. However, upside/downside risks are not evenly distributed. S&P 500 will likely experience at least one drawdown between now and year-end. We recommend selling upside calls to fund downside protection given the options market prices a below-average probability of a 5%-10% drawdown during the next three months (see Exhibit 2).
The six “known known” risks listed below are currently quiescent but investor perception could easily shift and trigger an equity index drawdown.
- Valuation is a necessary starting point of any drawdown risk analysis. At 16.7x the forward P/E multiple of the S&P 500 index ranks in the 86th percentile relative to the last 40 years. Most other metrics paint a similar picture of extended valuation. The median stock in the index trades at the 99th percentile of historical valuation on most metrics. The most likely future path of US equities involves a lower valuation.
- Supply and demand trends also suggest downside risk. During the first quarter, the lack of investor positioning in domestic equities was the most bullish argument for a share price rally. Even as the S&P 500 index rebounded from its February 11 low, institutional and hedge fund US equity futures positions remained net short and our Sentiment Indicator hovered near 10 (out of 100). A low sentiment reading represents a bullish trading signal for the subsequent 4-6 weeks. Sentiment has shifted sharply during the past few weeks. Since the end of March, investors have bought $23 billion worth of futures positions, lifting our Sentiment Indicator to 32, a less bullish level compared with mid-winter.
- Corporate buybacks represent the single largest source of equity demand but may wane during coming months. Most firms completed 1Q earnings season by early May and have now resumed their discretionary buybacks, providing near-term support for the market. The month of May typically witnesses 10% of annual repurchase spending. However, spending normally decelerates in June and again in July, when just 7% of buybacks occurs as companies enter a blackout window ahead of 2Q earnings reports.
- The fed funds futures market currently implies an 83% probability of zero (41%) or one (42%) rate hike in 2016. Our economists expect two hikes this year. The two upcoming FOMC meetings (June 14-15 and July 26-27) and the July Humphrey-Hawkins testimony to the House and Senate will offer opportunities for Chair Yellen to guide the market in the direction of the FOMC central tendency, which also anticipates two hikes in 2016. Put differently, given current futures market pricing we believe more likelihood exists for an incremental hawkish surprise than a dovish surprise.
- Now-dormant economic growth concerns could awaken at any time and provide a catalyst for a sell-off. Official “total social financing” data shows China credit growth surged by $1 trillion in 1Q but acceleration in credit creation is needed to prevent a slowdown in activity by 3Q. Decelerating growth in China would cause investors to re-focus on the prospect of a US recession, a topic that has receded from client conversations after dominating discussions in 1Q. Our US-MAP index of economic data surprises has slipped back into negative territory and reinforces the risk of a slowdown. The UK “Brexit” referendum on June 23 represents another imported economic risk.
- The US presidential election is now part of every client conversation. The closeness of the race appears to be underpriced by the market given polls in prior presidential elections tightened as voting day approached. History shows that during a typical presidential election year, the S&P 500 index remains relatively range-bound until November (see Exhibit 4). But thus far 2016 has hardly followed a regular election playbook. The upcoming party conventions (Republicans on July 18-21 and Democrats on July 25-28) will almost assuredly raise political uncertainty and weigh on equity valuations.