August 31, 2020
Lowry’s Research has proven a reliable technical skipper since I have been subscribing a few years ago. In recent weeks, while some of its indicators were giving some initial warnings, Lowry’s remained positive and supportive of a rising equity market. That while I was beginning to feel unease about the apparent weakening of what I consider its primary indicators, Buying Power and Supply Pressure. In effect, Lowry’s numbers were showing that the market’s rise was increasingly due to declining Selling Pressure while Buying Power was dropping since mid-June.
Rising markets are much more solid if due to strong demand, indicating that buyers are genuinely attracted by the assets. Markets rising mainly because of a lack of sellers are very vulnerable to a quick and sudden mood reversal, often erupting from left field.
This summer, it was apparent that investors increasingly weary of valuations were hanging in because of FOMO, TINA and Big Mo.
After last Friday’s close, Lowry’s narrative changed as the sharp drop in Buying Power since August 11 was accompanied by a slight rise in Selling Pressure starting August 14, this while equity prices kept rising. “A continuation of these divergent trends in Buying Power and Selling Pressure, against the progress of prices, typically warns of an approaching market top.”
Several other indicators such as thinning market breadth and weakening short-term momentum add to what Lowry’s says are “under-the-surface deterioration”. It does not go as far as calling a top but recognises the need for “a broad-based resurgence of Demand” to offset the other negative “internals”.
What might trigger a broad-based resurgence of equity demand in the current environment?
- P/E valuation? Hardly at 24.2 times trailing and 12-month forward earnings. Even using full year 2021 EPS of $166.43, slightly above 2019 pre-pandemic’s $162.93, the S&P 500 P/E is at 21.1. Since 1957, the only times the 18-m forward P/E exceeded 20.0 was just before the two major bears of 2000-02 (-46%) and 2007-09 (-56%).
- Using the more stable-ranged Rule of 20 P/E, incorporating inflation to the valuation formula, the R20 P/E is now 25.7, well into the extreme risk area.
The Rule of 20 simply says that the Rule of 20 P/E invariably cycles between 16 and 24 with Fair Value at 20. Below 20, equity markets are increasingly attractively valued. Vice versa above 20. At the 20 Fair Value, the valuation upside from 20 to 24 (+20%) equals the valuation downside from 20 to 16 (-20%). Natural fear and greed phenomena occasionally result in some temporary slippage outside of the 16-24 valuation band.
Here’s what happened after similar extreme R20 P/E levels were reached since 1957:
- Dec. 1961: 24.7: -23.5% in 6 months to R20 P/E of 17.4 on rising Fair Value (FV rises with rising profits and declining inflation, and vice-versa). This was a valuation correction with rising Fed funds rates.
- Nov. 1968: 24.6: -32.9% in 20 months to a R20 P/E of 19.5 on declining FV. This was a valuation correction with declining fundamentals and rising Fed funds rates.
- Jan. 1971: 24.0: +13.5% for 2 years to a R20 P/E of 21.9 on sharply rising FV before -46.2% on a still rising FV before FV collapsed to a R20 P/E of 17.4. Equities remained expensive on strong fundamentals then corrected on valuation followed by collapsing fundamentals. The correction began when the Fed became clearly hawkish.
- Aug. 1987: 26.8: -30.0% to a R20 P/E of 18.7 on rising FV. This was a valuation correction with rising Fed funds rates.
- Apr. 1992: 25.2: +16.0% for 18 months to a R20 P/E of 21.2 on sharply rising FV before -7.8% to a R20 P/E of 18.6 on still rising FV. Gradual valuation correction while FV jumped 57%. The correction began when the Fed became clearly hawkish.
- Jan. 1998: 24.6: +8.0% for 4 months to a R20 P/E of 27.7 on rising FV before -15.5% for 2 months to a R20 P/E of 23.9 on declining FV before +58% for 2 years to a R20 P/E of 29.9 on rising FV before -46% to a R20 P/E of 18.2 on declining FV. Irrational exuberance fueled by rising FV before both valuation and FV collapsed. The correction began well after the Fed became clearly hawkish.
- Jan. 2018: 23.5: -12.6% to a R20 P/E of 16.9 on rising FV. This was a valuation correction. The correction began well after the Fed became clearly hawkish.
These 60 years cover all kinds of economies and financial markets, barring a medical pandemic, but one constant in the above observations is that major valuation excesses always corrected when a hawkish Fed took it on itself to end the party. It’s like if, at certain very elevated valuation levels, having climbed the wall of valuation worries, investors feel euphoric, fearless and push for an even higher summit. “Hey, we’ve made it up to here, let me reach for the top now!”
Today, our economy-fearful Fed tells us it won’t even consider removing the punch bowl for quite some time and is even actively participating in the party, making sure everybody stays on the dance floor.
The revamp is designed to address the “reality of a quite difficult macroeconomic context of low interest rates, low inflation, relatively low productivity, slow growth and those kinds of things,” said Fed Chairman Jerome Powell during a conference broadcast online. “We’ve really got to work to find every scrap of leverage in helping stabilize the economy.” (…) The change “reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” said Mr. Powell. (WSJ)
Gone are the Phillips curve and the pre-emptive hikes. Fed-watching is now passé. This fearful Fed is clearly feeding a fearless greed.
Between February 1998 and the August 2000 peak, investors justified irrational valuations based on eye balls and every company sporting a “.com” somewhere was seen set for infinite growth. Valuations went wild in part because losing money was fashionable, a perceived sign of modern, savvy, knowing management, willing to lose tons of money “short-term” in exchange for an eventual future domination.
Internet gurus popped up across the sell-side, most quickly reaching fame being seen “in-the-know”, seemingly understanding this totally new connected world and mapping it for clueless but trustful investors. These early influencers nurtured the nascent and self-feeding day-trading community, finding easy and quick riches, happy to contribute to ever rising, self-feeding stock momentum.
Sounds familiar?
The 1998-2002 roller-coaster round trip started at 1100 at 25x trailing EPS of $44.37, reached 30x EPS of $56.39 in mid-2000 and ended at 815 at 19.2x EPS of $44.04. In the meantime, NASDAQ quadrupled before doing its own complete round trip.
The other, inconvenient constant is that valuation per the Rule of 20 always returns to its “20” fair value level.
Given earnings expectations, the current 25.7 R20 P/E level is set to reach the 2000 peak during the next 6 months even if equities mark time from here. From the expected low in trailing EPS of $130, profits will need to rise more than 40% to over $185 before equities are fairly valued again (R20 P/E of 20) assuming inflation holds around 1.5%.
Can earnings rise quickly enough and sufficiently to bring valuations back to fair value before equity markets do the revaluation job themselves? Can this happen with a Fed sitting quietly on its hands by the dance floor?
Analysts are currently forecasting earnings reaching $189 in 2022. Given their historical tendency to overshoot by 10-15%, a safer goal would be 2023.
Are we living 1998-2002 again?
Our technical skipper warns of possible turbulent seas but keeps the engines running forward. But given current fearful valuation levels, what might trigger the much needed “broad-based resurgence of equity demand” in the current environment?
- A medical breakthrough which, as Fiera Capital’s Jean-Guy Desjardins described, could result in an “ideal environment of 3 to 5 years of highly visible and unchallenged global economic expansion” for equity investors.
- An economic surprise brought by fearless consumers spending their totally unrewarding fixed income investments.
- Unrestrained speculation fueled by FOMO, TINA and Big Mo encouraged by the fearful Fed openly feeding fearlessness.
Fiera Capital puts a 65% probability on a medical solution to the pandemic by the end of 2020 or Q1’21. A good question then is how will investors react to the end of the pandemic with regard to the many heavy weight stocks that have benefitted from it, which stocks now account for a pretty large chunk of the S&P 500 Index?
A possible fearful strategy for fearless investors willing to stay at the party would be to dance with the less popular “value” stocks. They may not be the most energetic dancers but they might not crash as much when the music stops as this Ed Yardeni chart illustrates.
The big difference between now and 1999 is that we are already in recession and a hawkish Fed is nowhere on the horizon. With a medical breakthrough and a likely long economic cycle, present-day “value stocks”, i.e. cyclical sectors like Financials, Industrials, Material and Energy, could well become popular again as central banks across the world aim at closing the huge output gap of 2020, even more so if the end of the pandemic means a relative slowdown in the pandemic-winners.
If no medical breakthrough, a not so trivial 35% probability according to Fiera Capital, rush for the exits, hoping that our technical skipper will show us the way before the lights go out.
Corporate insiders don’t seem completely fearless per Barron’s :
As legendary mountaineer Ed Viesturs said, “getting to the top is optional, getting down is mandatory.”
What some people call “summit fever,” he calls “groupthink,” which is when a majority of the group, desperate to reach the top, disregards dangerous weather, route conditions, or other important factors. The least experienced climber tags along thinking if everyone else is going, then it should be just fine. It’s almost a lemming-type effect. People get swept up in it, it’s that psychological feeling of safety. No one gives any thought to the acceptable level of risk.’
When I am climbing, I listen to the mountain. All the information is there, which helps me decide what to do. Arrogance and hubris need to be put aside, and humility and thoughtfulness are essential. I truly believe that is how I survived so many expeditions into a dangerous arena.”
Survival is a very personal thing. And this fearful Fed makes the music very enticing.
We have made many “firsts” during this bull market. Can a bear now sneak its way to the dance parlor while the Fed is busy dancing, trying to exorcise all “those kinds of things”?
Fed watching may be passé, but I am not fearless: I will be intently watching the skipper. In case he gets really fearful.