CHEERLEADERS IN FULL SWING

Signs of the times. Just as the Fed is about to starve investors of their financial heroin right when equity valuations are historically very high, broker strategists are creatively finding reasons to reassure us that everything will be fine. (My emphasis)

BAML warns that investors need to get used to liquidity starvation :The End of Maximum Liquidity

First, the Fed hike will mark the beginning of the end of massive monetary easing and a collapse of interest rates to effectively zero across the globe, and follows a
humungous bull market in both equities and credit in the past 6 years:

• Central banks now own over $22 trillion of financial assets, a figure that exceeds the annual GDP of US & Japan.
• Central banks have cut interest rates 577 times since Lehman, a rate cut once every three 3 trading days.
• Central bank financial repression created $6 trillion of negatively-yielding global government bonds earlier this year.
• 45% of all government bonds in the world currently yield <1% (that’s $17.4 trillion of bond issues outstanding).
• US corporate high grade bond issuance as a % of GDP has doubled to almost 30% since the introduction of ZIRP.
• US small cap 5-year rolling returns hit 30-year highs (28%) in recent quarters.
• The US equity bull market is now in the 3rd longest ever.
• 83% of global equity markets are currently supported by zero rate policies

Put simply, central bank’s provision of liquidity for financial markets has been unprecedented. The extent of Wall Street addiction to liquidity is about to be revealed and the potential for unintended consequences is clearly high.

BAML is tactically cautious (“mediocre returns, vicious trading rotation & flash crashes”) but strategically (“structurally” ) bullish; in other words, all bases are covered:

Our own convictions on tactics, strategy & asset allocation in light of the upcoming Fed hike are outlined below:

1. The Fed’s exit from zero in 2015 will prove far less dramatic than in 1937: investors today have been raised on a dovish not a hawkish Fed; inflation is
perceived to be under control, underscoring Fed credibility; and investor faith in economic recovery is bolstered by a virtuous cycle of rising housing activity, bank lending and small business activity.

2. Our tactical view is that until the US macro is unambiguously robust enough to allow the Fed to hike safely, investors will be cursed by mediocre returns, vicious trading rotation & flash crashes (the “Twilight Zone”). Investors should hold a little more cash and own volatility. Our tactical Q2 targets of 0.2% for the 5-year bund, 2% for Italy 10-year, 20 on VIX, 2000 for S&P500 remain intact.

3. We would also own some optionality to SPX upside in H2; (…) As Greece risks mount and investor concerns peaks, the contrarian play will soon be to add risk in Q3 via SPX calls.

4. We continue to believe that investors should watch bank stocks as the “policy mistake” barometer. Rising rates & rising bank stocks = good; rising rates &
falling bank stocks = bad. Thus far the banks stocks say it’s safe for the Fed to hike.

5. We remain structurally bullish the US dollar, bullish stocks, bearish rates & opportunistic in EM. We believe forthcoming regime change to Lower Liquidity-Higher Growth will ultimately prove positive for banks, large cap cyclicals, Europe, Japan, value>growth, and negative for high PE stocks, high DY stocks, high yield bonds & EM debt. The ultimate catalyst for the Great Rotation is a Fed hike & stronger global growth. (…)

Credit Suisse finds enough reasons to remain bullish on equities over its 58 page report: A bubble in equities: why this seems the probable endgame

I will spare you most of it, only offering here the best charts:

U.S. earnings revisions recently “almost” turned positive…

…Something we have not seen for quite a while globally:

China is not collapsing as “housing turnover has stabilised”. Note that for Credit Suisse, continued YoY declines in the 5-10% range qualify as “stabilising”…

Here’s the sophisticated bubble upside potential calculation (ERP: Equity Risk Premium):

Add that corporations are leading the way, buying equities like there’s no tomorrow:

Economic visibility is so high, the macro outlook is as certain as it was in …2000 and 2007-08:

Hmmm…Not very convincing, especially given these trends courtesy of RBC Capital Markets:

Fortunately, the financial heroin will keep flowing freely in Europe for a while, prompting Citigroup to lay a 128 pager on El Toro – The European Bull:

Europe has become a good news story in recent months and has provided investors with a strong “delta” opportunity: better GDP growth, better EPS growth and better liquidity (eg QE). Europe needs to move from “delta” to “delivery” to maintain performance leadership in global equities. We back delivery, ie Citi economists’ above consensus Euro Area 2015-16E GDP growth and our top down estimates for double digit EPS CAGR 2014-16E. We target 40% returns from European equities to end-16 (…)

Realizing that EU equities are not cheap on trailing P/E, Citi finds a twisted twist to be bullish:

Let’s be clear here. Valuation should be a key part of any investment process. But, the relationship between valuation and forward returns is only strong when forward returns are measured over multi-year horizons, eg 7-10 years. There is little relationship between spot valuation multiples and near-term returns, eg 1-3 years. So, if European equities deliver +40% or -40% returns over the next 12-18 months, it will not be because of the level of trailing P/E today, but will be because of events and net flows over this period in our view.

Instead of P/Es, we would put more weight on yield based valuation metrics such as DY [dividend yield] and FCFY [free cashflow yield], as well as more stable/longer-term metrics such as CAPE and price/book. On these measures, European equities show as close to long-run average levels or “fair value”.

(…) the DY for Europe ex-UK, which is currently around c3% and close to its 25-year average level of 2.8%. European equities have never, until recently, traded on a DY above both BBB-rated corporate bond yields and 10-year government bond yields in the last 50-60 years. Figure 9 shows that this yield gap between equities and bonds has extended significantly in recent quarters.

Equities look super cheap on this basis, providing there is confidence and security in the equity market’s coupon. This is why growth is so important to our view.

Bernanke’s gambit has become Draghi’s forecast. If you bring interest rates low enough for long enough, people will eventually buy risky assets solely on yield…

Analysts are harder to convince but Citi’s strategist claims that bottom-up analysts are just not getting it:

Figure 15 shows aggregate consensus recommendations for European stocks over the last 20 years. European equities are at all-time high levels. European analysts have never previously been so “bearish”, nor has the aggregate consensus recommendation previously disconnected from equity levels. This suggests that analysts are either taking an active stance against higher valuations, placing low confidence on growth/recovery or are even taking a prescient stance on the outlook for the global economic cycle. Alternatively, analysts are struggling to value stocks in a world of near-0% interest rates and are struggling to assess the correct cost of capital. Our view suggests that analysts, like investors, will come under increasing pressure in this cycle to “conform” and “chase”. Analysts are likely to consider lower discount rates and higher terminal growth rates as equity markets continue their ascent.

And, to reassure us all:

We take risks very seriously given our high-return base case. We categorise risks in five buckets: 1) economic growth, 2) market/EPS growth, 3) credit risk, 4)
inflation/interest rate risk, 5) event risk.

However

This is not the time to run through the detail of these risks; we’re running out of space (heck, we are only at page 19 of this 128-page tome!). But, most investors’ current “wall of worry” probably has Greece, soft US data and Chinese growth nailed to it.

Probably. They may also consider that this strategist, assessing risk as he is for other people’s money, has been more wrong than right in the past, otherwise he would likely be on the buy side.

Goldman takes the bull by the horns in Why valuations are not as stretched as they seem

Europe’s P/E has doubled since the lows in 2012; we believe any value case now rests increasingly on low bond yields and/or earnings catch-up. We expect bond yields to rise but only modestly given the ECB’s commitment to sovereign purchases. But low yields are unlikely to be a driver of further equity re-rating, in our view. Indeed we expect earnings to be the main driver of performance especially for the Euro area and periphery. These markets have operational gearing and lead indicators point to earnings improvement; moreover their Shiller P/Es are below average.

Value has disappeared…
With the P/E ratio now at 16.2x many investors argue that there is no value in European equities and it’s only with reference to low bond yields that equities continue to be attractive. We have some sympathy with this view – the ERP remains high (c.7.3%). And while the risk premium should come down in future years as growth improves and deflation risks recede, this may not help to reduce the cost of equity if bond yields also rise to reflect better nominal growth.

…but plenty of earnings potential
We continue to see value in Europe in terms of earnings catch-up and lots of recent lead indicators point to a turn in earnings (PMIs, Consumer Confidence, M1 growth). In addition margins and ROE – which are still far below peak in Europe – are linked to improvements in economic growth.

Accounting for earnings catch-up, valuation is not stretched
The Shiller P/E (price divided by 10-year average EPS) for Europe is still around its long-term average; whereas in the US it is far above trend. Moreover, in Europe the 10-year average EPS is itself very low. Far from being an overly generous measure of valuation for Europe which assumes some return to pre-crisis trend earnings (one many investors including ourselves doubt), we believe the EPS it’s based on is fairly depressed with potential to improve as economies recover. (…)

If you can look out far enough and assume that Europe is on its way to nirvana…But, in case you don’t trust the earnings scenario, GS has this for you:

Price to book has risen in Europe along with the P/E, but still remains around the long term average at 2.0x.

Note that GS’ “long-term average” only goes back to 1993 and includes 2 bubble periods in order to average 2.0. Also note that ROE, a key driver of P/BV has yet to perk up. (…)

There is an obvious relationship between GDP and ROE (i.e. profits) as GS shows above. But the assumption that ROE will return near previous peaks while GDP growth remains muted seems heroic (read wishful thinking) to me. Add that banks and other financials represent 23% of the MSCI Europe Index (16% in the S&P 500 Index) and consider that bank ROEs (American and European) are far from where they were in the good old days:

The math is pretty simple: if 23% of the Index achieves an ROE 10% lower, it shaves 2.3% off total historical ROE of some 12% near peak levels. This would only take the Euro ROE to about 10% from its current 9%. Tough to imagine P/BV rising much more with such ROE levels.

But if the ROE/PBV relationship also does not work, there must be another way to see value: 

If we assume that earnings are starting to recover it makes sense to look at a cyclically-adjusted market valuation metric such as the Shiller P/E. This is the ratio
of today’s price over the 10-year rolling average of earnings, all in real terms. On this basis, the market doesn’t look as stretched; Europe is around its average valuation after a substantial re-rating post 2012.

That assumes that one accepts to include bubble P/Es in the average. ‘Cause if one doesn’t, we are at historical peak levels.

Near the end, GS seems to think that it has to show it can also be realistic:

To be clear we are not advocating a view that earnings can return to the pre-crisis trend – we think there are good reasons why growth is likely to be slower in the future than it was on average in the two decades prior to 2007, including:

  – Lower trend GDP growth; Euro area GDP growth even in 2015 is expected to be 1.5% on our economists’ estimates and there is evidence that even in the US and UK where economies have recovered, earlier trend productivity growth may have weakened;

– Lower demand from EM; end of commodity capex cycle. The super cycle in commodity-related demand, and infrastructure spend in China have both been big
drivers of European company earnings in Oil & Gas, Basic resources and Industrials, but these trends are likely to have slowed.

– Less investment means less growth. Finally, European companies have not invested in recent years, and capex rates have been especially low; while there are
many reasons for why this might be one possible result is that future growth will be lower. We have discussed previously how companies have large cash balances and these generate no return, which is likely to continue to be a drag on growth potential for European corporates.

Why these constraints did not enter into the earlier analysis is unclear even though GS, like Citi, is trying hard to be clear.

So, will European equities meet expectations? They better!

In all, do you really want to sell your U.S. stocks and switch into this expensive dysfunctional and sclerotic market in the hope that Draghi’s currency manipulation and financial backstopping will result in even higher valuations? See also Don’t Be A Jerk!