It’s safe to say 2018’s euphoric stage is over. Almost $3 trillion was erased from equity values in six days, volatility surged, and the best start to a year in three decades was wiped out. Now what?
Some, such as Stephen Diggle, who co-founded a hedge fund that made $2.7 billion in the depths of the global financial crisis, said the resurgence of volatility is here to stay as bonds and stocks are both way overvalued.
Markets have been roiled by huge price swings over the past week, punishing investors who were betting on an extended period of calm. Stocks slumped and bond yields surged on concern a stronger US economy will stoke inflation and push up interest rates faster than the market has priced in. The Cboe Volatility Index - known as the VIX - surged to a more than two-year high on Tuesday.
“In the short term I think volatility can remain elevated and the VIX as well,” said Mr Diggle, chief executive of Singapore-based family office Vulpes Investment Management. “There have been so many persistent volatility sellers for such a long time that the market has been seriously out of balance for a while.”
Mr Diggle said he’s gained from the surge in volatility after buying December put options on the S&P 500 two weeks ago at strike of 2,200 as “crash protection.”
“They doubled overnight, so I’m feeling rather pleased with myself,” he said Tuesday.
“All markets must eventually come back to attractive value and this is a very, very long way down for both stocks and bonds. The broad economy and corporate profitability are both strong, and that’s important, but value is what provides the best support and it’s nowhere to be seen.”
Both sovereign and corporate bonds are expensive, though sovereign bonds “set the floor," Diggle said. US yields “have moved off that floor now" but Japan and Europe are still firmly on it, he said.
Vulpes has stayed clear of equity and bond markets for some time, and isn’t planning to buy on the recent dip, Mr Diggle said.
“I’ve no idea how to trade a market like this, equities are as expensive as they have been only three times in the last 100 years: the 1920s and late 1990s and now,” he said. “And bonds are more expensive than at any time in recorded history. Possibly they were this low during the Black Death in the 1340s - data for the period is not great.”
Buy, sell or hold - simple choices, never easy for investors. Is the bull run too old? Should I buy the dip? What about valuations?
Following is a breakdown of the bull and bear case for five different topics, from earnings to sentiment to bond yields:
Valuations
The Bear Case: Equities are pricey. Just this weekend, former Fed Chair Janet Yellen said that US stocks are "high," with price-earnings ratios near the upper end of their historical ranges. S&P 500 companies trade for nearly 23 times profit, a ratio that has only been matched once since the dot-com bubble. The last time this kind of level was seen was in the aftermath of the financial crisis, where earnings were essentially nonexistant.
The Bull Case: Earnings are looking good - really good. The market is in the midst of one of the best rounds of corporate earnings upgrades for S&P 500 companies on record. In sum, estimates for 2018 profits have increased by more than $10 a share since mid-December, a pace four times faster than any stretch seen since at least 2012, according to data compiled by Bloomberg.
If you measure using those estimates, valuations don’t look as lofty - factor in 2018 estimates and stocks trade at a multiple of 17.7. If you extend to 2019 forecasts, the price-earnings ratio comes down to a healthy 16.
Sentiment
The Bear Case: Consumers are feeling good, possibly too good. A whiff of euphoria crept into stocks during one of the strongest starts to a year on record, with cash pouring in at unprecedented rates. The percentage of people who expect the stock market to climb is the highest on record, often an indicator that a market top is near. The last time optimism approached this level was in early 2000.
The Bull Case: Consumer confidence, which measures people's optimism about the economy's well-being, is hovering near the highest level in 17 years, stoking optimism that the motor of the economy is humming. That should translate to higher corporate earnings and give the market room to run.
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The Economy
The Bull Case: Virtually everywhere you look, the world's largest economy, already in its third-longest expansion on record, is showing signs of picking up steam. Unemployment is hovering around historically low levels, manufacturing is on the rise and consumer spending is higher. And it's not just at home. Global growth is synchronised to an extent not seen in more than a decade and should power markets higher.
The Bear Case: A stronger US economy could breed inflation and force the Fed to raise rates fast enough to inhibit growth rates. Consistent strength in key economic indicators supports the Fed's case for more hikes, which would raise borrowing costs for companies and consumers, making it more expensive to buy a house and harder to pay off credit cards. That ultimately can slow down the economy and result in a recession - which is what analysts cite as the most likely catalyst for the end of the bull market.
Bond Yields
The Bear Case: If yields keep climbing, fixed income is going to start looking more enticing than the equity market. Since the financial crisis, equities have been relatively more attractive, with higher "yields" than bonds. But as Treasury rates inch up, the gap in potential rewards to reap narrows. The spread between bond yields and equity profits has shrunk to the smallest in eight years, risking a tipping point where buyers could become more inclined to put money into the fixed income market.
The Bull Case: Rates are going up in response to strong economic growth, which doesn't have to be a bad thing.
“As the economy is normalising, rates should normalise, too,” said Brad McMillan, chief investment officer for Commonwealth Financial Network. “And what we’ve seen so far is rates starting to creep back into normal zones. If we can actually get rates back to where they should be, maybe we’ll be back to a normal economy in a few years. And that’s been the goal of public policy for the past 10 years.”
Longevity
The Bear Case: The rally has run long enough. This equity advance is now seven months from being the longest on record, signalling that a slowdown - or even a reversal of course - is on the horizon.
The Bull Case: Essentially, the bulls will keep running. Even with a pullback, like the one that's spread across the beginning of this month, people aren't likely to pull their money out of the equity market.
“Investors, for the most part, haven’t been stirred by the equity slump,” Chris Harvey, head of equity strategy at Wells Fargo, wrote in a note to clients. “Our take is that the fear amongst clients remains very low. Over the last 12-24 months, market participants have been conditioned not to sell the dip.”
