US10Yr Over 100x P/E, SPX 16x Pricy?; Sanity Check Please
There’s a great deal of consternation that the stock market reacted poorly to the “surprise” Federal Reserve 50 basis points interest rate cut last Tuesday. The cut was said to be ineffective. Well, there are few things wrong with that headline.
First, it wasn’t a surprise to veteran investors or folks who read this newsletter. We pointed out as much the previous Friday. Secondly, because markets are a discounting machine it was the nearly 5% equity rise on Monday which was the “reaction.” Markets already expected the cut Monday. Tuesday was profit taking.
Lastly, as I’ll demonstrate below, the initial stock market reaction is not ultimate market reaction (and given the effect on the yield curve, the effect should be ultimately positive).
The market’s wide swings in both directions each day last week had the effect of focusing more and more investors on the worst case scenario—that either (a) the solution to COVID-19 requires governments to resort to some form of clampdown or martial law, which drives the world in recession, or (b) COVID-19 becomes pandemic and kills consumer confidence sufficiently to drive a recession worse than 2008.
While these are plausible outcomes, they don’t seem to be the central case. In fact, hardly so. Consider other outcomes:
- Vaccine or treatment is developed;
- New forms of hygiene are imposed such as ‘washing stations/disinfection stands’required to enter any public venue, ala how metal detectors are the norm today;
- Social distancing works—in the US, many are taking this proactive measure;
- Spring weather arrives, and the disease could burn out.
The point is that the central case isn’t necessarily pandemic, but investors are increasingly positioned for that. In times of emotional stress, the market often shoots first and asks questions later. But you should be asking questions. For example, what is the history of previous similar sharp and vertiginous stock market declines.
POINT #1: SELLING EXHAUSTION–We are fans of Lowry’s internal market structure data (lowryondemand.com), in part, due to the fact the company has data sets stretching back more than 70 years. One of its daily comments last week caught my eye: the S&P 500 index had as of Tuesday spent six consecutive days where the percentage of stocks above their 10-day moving average was below 10%.
- Lowry’s had previously noted that we have seen 3 (arguably 4) 90% down days, where 90% of volume is down and 90% of stocks are down. This is a precursor to a bottom (exhaustion of selling), and we need to see a 90% up day to confirm the bottom, that is, where 90% of stocks and trading volume are up.
POINT #2: Had a big rally not happened on Wednesday it would have meant the stock market is “extremely” not normal. Over the past 40 years, there have been only 4 instances where stocks spent six days where the percentage of stocks higher than their 10-day moving average is less than 10%. Think about that, out of 10,000 trading sessions since 1989, only four times were stocks this oversold.
The bearish view is that the Fed cuts don’t fix the supply problems about to erupt in the U.S. and a demand surge is not needed. But the 50 bp cut is fixing the yield curve. This is a good thing. It has resulted in normal steepening of the U.S. Treasury 5-yr-1-yr and also a massive steepening of 30-yr-10-yr. The latter is macro sensitive, and the fact that it is steepening is a leading indicator that growth could be accelerating in the months ahead post Corona virus slowdown. This is a reason we are staying structurally constructive on equities.
Thus, this move is not meant to fix demand but rather protect the proper function of fixed income markets. Ultimately, I see the steepening as a relatively positive signal for future economic growth. As I have noted previously, this curve has a very good track record of predicting the ISM level 18 months out (9 mos. change of 30-yr-10-yr). This keeps us structurally constructive, despite near-term risk.
What could go wrong? COVID-19 could indeed morph into a much more dangerous disease, changing the risk profile and the required response of markets. The good news is China’s cases seem to have peaked and are falling. Moreover, US policy makers and central bankers are ready to take necessary action.
BOTTOM LINE: THIS WEEK WAS ARGUABLY A TEST — HAS MARKET STRUCTURE CHANGED OR DOES OVERSOLD REALY MEAN OVERSOLD?
The takeaway, in my view, is that stocks have reached a point where a material and sustained rally historically takes place. We are in a new world where systematic trading, zero commission, ETFs, derivative greater than cash, and virtually frictionless money movement, could make stocks merely a video game. But isn’t valuation a floor? And shouldn’t exhaustion of selling matter? I think it does.
Investment grade corporate bonds have a 40X P/E (2.5% yield) and the US 10-yr has a 110X P/E now (at 0.9% yield). Yet, people think the S&P 500 is expensive at 16X P/E. Sanity check please.
Figure: Comparative matrix of risk/reward drivers in 2020
Per FS Insight
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
More from the author
Articles Read 1/2
🎁 Unlock 1 extra article by joining our Community!
Stay up to date with the latest articles. You’ll even get special recommendations weekly.
Already have an account? Sign In 0d77e4-fab669-a08f8b-de80b7-67c6c7
Already have an account? Sign In 0d77e4-fab669-a08f8b-de80b7-67c6c7
