As Greece continues to make headlines, global markets have shown remarkable resilience throughout the roller coaster ride. US indexes have ended up recovering after each fall, and although the S&P 500 remains up only 1.9% YTD, Greece’s actual neighbors have done pretty well. Overall, the European Stoxx 600 index is up 13.5% YTD, and even Spain and Portugal have delivered 7.3% and 22.5% respectively, with government yield spreads staying relatively calm. Investors seem to have factored in the inevitability of a bailout, amicable negotiations, and the potential restructuring of Greece’s debt – currently at an unsustainable 180% of GDP.
As European leaders figure out the next steps this week, the focus of the financial world is shifting eastward, to China. Here, the skyrocketing market that doubled in value over the past year lost nearly 30% in a month, finally finding support last week. Such a slide is not easy to digest, considering nearly $3 trillion in market capitalization got vaporized in the downturn. Granted, as much research has pointed out, barely 10% of China’s population engages in stocks, and according to UBS, equities only account for 20% of China’s household wealth, against 54% in bank deposits. So, the losses may not be as widespread as feared. However, we feel that the same population that suffered is part of the spending group – the middle class – and therefore, the potential for consumption to reduce there is much higher. China’s market drop was inevitable, and shouldn’t come as a major surprise. However, how the global economy deals with the after-math from such a critical economy needs to remain in focus. More on this in the coming weeks.
At the moment, we’re also watching the US earnings season, which kicked off last week. We don’t have high hopes for results. In our opinion, large caps will have inevitably suffered due to choppy overseas markets (where over half of the S&P 500’s revenue comes from), sustained currency headwinds, an emerging market slowdown, and weak oil prices. As always, analyst estimates will likely be cautious and the bar for companies will be low, so expect weak outperformance, but nothing extraordinary. We prefer looking ahead, as the rest of 2015 points to a much more fundamentally-driven market. Here are the data points we’re keeping in mind for the 2nd half:
– The S&P 500 found itself at a 16.4x forward P/E multiple at the end of June – more expensive than its 25-year average of 15.7x (JP Morgan data). However, note that treasury yields were far higher in the past, above 4% on average, compared to today’s meager 2.3%. As a result, fixed income asset classes yield far lower these days – making stocks a more attractive choice for investors and the ‘expensiveness’ of the P/E ratio less relevant.
– Employment is getting fuller (at 5.3% in June), inflation is slowly rising, and wages are showing an upward trend, at 1.9% YoY as of June. In a tightening labor market, we’re thinking that Main Street stands to benefit in the coming months. Oil prices don’t seem to be going higher anytime soon, and that’s another catalyst for consumption to prosper.
– S&P 500 operating margins find themselves continuing to hover around record levels, at 9.4% earlier this year. So, margin expansion has a limited runway left. The priority for companies will turn to growth and productivity, which we believe should provide the next leg up (via capex). As is, the US capital stock needs serious replacement. Fundstrat’s Thomas Lee has been stressing this point for months. According to his data a few months ago, ‘the average age of consumer durable goods and business capital equipment [was] at the 99th percentile’. So, the need exists. When companies will pull the spending trigger is the only question.
– The US treasury yield curve is showing a pretty resounding upward slope – signaling confidence in the economy via higher rates ahead. A downward curve has been a remarkable leading indicator of recessions in the past. Recessions, therefore, theoretically should not be a worry for the next 18 months or so.
– Debt to equity ratios have historically averaged around 160%, but find themselves at 100% today for large cap US companies. Firms have significantly deleveraged since the crisis, and are showing cleaner balance sheets. Corporate cash, meanwhile, is nearly 30% of assets, at the highest level since 2000. So, the money to invest is around, waiting to be deployed.
– Small cap growth stocks have returned 8.7% YTD, compared to the S&P 500’s 1.9%. A steady Main Street resurgence, shelter from currency headwinds, and an improving business environment have all caused this. Growth, meanwhile, has also outperformed value stocks. We think this is an extremely positive sign from investors, signaling confidence in the economy.
Meanwhile, some watchouts to keep in mind:
– Margin borrowing as a percentage of market capitalization is higher than during the 1990s stock market bubble, according to the IMF and WSJ.
– Employment is improving, but labor participation reached a 25-year low of 62.6% in June. Also, in our opinion, no one is able to correctly measure productivity – which seems to be declining per reports, but doesn’t add up given the advances in technology over the past 2 decades.
– Per Schiller’s CAPE ratio, the market is definitely overheated, at 27.2x, compared to the 25.5x 25-year average.
– $2.15 trillion in M&A deals occurred halfway through the year – a pace which might surpass 2007’s record of $4.3 trillion, according to the WSJ and Dealogic data. Slow organic growth and cheap cash is fueling this trend. Knowing the deal sizes from 2007, it’s worth recollecting what happened in 2008 (the downturn).
– The US homeownership rate is at the lowest level in 25 years, with details highlighted in our June 21st column. The drivers of the US economy are changing – and change sometimes isn’t easy to handle. Also, private valuations in technology remain high, and several recent IPOs have shown a below-par performance in the market.
What it means for you: Markets worldwide have shown remarkable resilience this year in the face of macro events and sluggish growth. The fundamentals, by themselves, remain strong for the US economy in 2015’s 2nd half. Stock downturns, especially due to overseas concerns, should be viewed as buying opportunities for longer-term investors. China’s uncertainty and Greece’s negotiations will define the near term, while the rising rate environment will define everything after. As a result, we’re sticking with our calls on small cap outperformance, a preference for growth over value, and financials, consumer discretionary and a bit of tech to outperform – all ideas noted in the beginning of the year. All in all, we’re focused on staying steady while tuning out the noise as Wall Street navigates the 2nd half of 2015.
