September 2015 Newsletter

September 2015 Newsletter

Summary of Recent Market Activity, Charts and Possible Implications

Credit Suisse analysts recently reduced their year-end 2015 target for the S&P 500, which now stands at 1,967 as of this writing, to 2,100, inferring 9.3% upside from the first day in September.

“We reduce our year-end 2015 and mid-2016 targets for the S&P 500 to 2,100 and 2,200 (and to 3,600 and 3,800 for Euro Stoxx 50), but remain constructive on equities for the following reasons”:

According to CS, summer sell-offs tend to reverse. Seventy percent of the time following a summer sell-off, markets have made new highs within a year. The inconsistency of some of the recent market moves suggests a degree of panic selling. Money is moving into bond yields even as the Federal Reserve is eyeing a rate-hike. Even the dollar is down, despite worries on growth and China.

September2015graph1  The consensus opinion of CS investment strategists is that too much of a slowdown in growth is being priced into this market. Conversely, as investor risk appetite abates, so does risk. The ratio of equity-to-bond returns are now discounting a fall in demand for US goods and services along with a fall in global PMI, or Purchasing Managers Index. This combination of lower estimates is now commensurate with levels consistent with only a 1.5% increase in global GDP. Yet, it now appears that global growth is modestly accelerating, further supported by European data releases over the past week. Furthermore, should the Chinese economy slow further, the Bank of China, the European Central Bank and the Federal Reserve would intervene with new market incentives. This could include a hold by the Fed to further its plans to hike rates this year.

For these reasons, the likelihood a bear market in equities has declined. Do not expect a bear market. The normal pre-conditions for an equity bear market are not in place: Historically, a sell-off in the S&P 500 of more than 10% after a period of longer than two years with no 10% correction has required a recession and a major credit crisis or extreme overvaluation. Analysts see none of these factors in place at this time. “Our ‘market peak’ scorecard scores only 1.6 out of 5 on the likelihood of a bear market,” according the CS global strategists. And to those analysts who continue to focus on the widening of high yield spreads by a similar magnitude as evidence of a pending bear market, historic similarities have preceded a bear market only 30% of the time.

Equity valuation is supportive: The equity risk premium, otherwise known as the calculation that shows the difference between safety investments and stocks is currently calculated at 5.8% in the US vs a warranted level of 5.2% and a long-run average of 4.2%. In Europe, the ERP is 8.6% vs a warranted 7.3%. The fair value P/E model for the US shows 16% upside, according to CS analysts.
Some analysts are concerned about sufficient liquidity to drive demand for U.S. equities. However, excess liquidity is now consistent with a re-rating of global equities upward. An estimate of corporate and private equity firms now projects that the sufficient corporate firepower exists to buy 14% of the entire global market by way of buybacks and cash-financed mergers.

The bad news is earnings. Despite earnings revisions, which tend to stabilize equity pricing, CS analysts have revised downward their expectations for total-earnings-per-share forecast for 2015 and 2016 to 7% below consensus in Europe for 2015 and 4% below consensus in the US for 2016. However, we stress that bear markets tend to happen when EPS actually falls by more than 5%, and currently that is not the estimate. In fact, net estimates call for 11% EPS growth in Europe in 2016 and 2017 and roughly 7% in the US. For US corporate profit margins to fall, it would be necessary to observe the cost of labor rising to a point that snuffs out pricing power in the U.S. The other trigger would be a global recession.

September2015graph2Here are the reasons analysts give for viewing the current sell off as being too pessimistic:
Global GDP growth in the first half of 2015 was already very weak

  • Global macro surprises are improving and the Purchasing Managers Index shows that orders are stabilizing
  • US growth is still solid given the fact that payroll income growth is 4% and can support consumption growth of 3%. Also real GDP growth was 3.7% in the second quarter, revised up from 2.3%.
  • The European Purchasing Managers Index is holding up and there appears to be sufficient pent-up demand to be optimistic. A slow-down in China is already reflected in the GDP numbers, with Chinese imports from Germany down 20% year-over-year.
  • The commodity-producing corporate sector reacts more quickly to falling commodity prices than consumer increases in spending. The lag effect of falling commodity prices will ultimately be a net boost to global GDP.
  • China remains the biggest macro risk, but there are some signs of temporary stability; the housing market is stabilizing, there is more room for a policy response, and the bar for a positive surprise is low, given that most unofficial manufacturing related data are already close to recession levels.

Factors that would turn the picture bearish include:

  • If China house prices were to resume their fall; that is, an added 15% fall in house prices would lead to a hard landing.
  • If “animal spirits” have been dented and the Purchasing Managers Index in Europe and Japan rolled over.
  • If there was financial contagion and the market for corporate bond issuance dried up.
  • If there were clearer signs of acceleration in US wage growth, which would be bad for margins and force monetary policy to tighten.
  • If a sharp flattening of the yield curve was to occur.

The bears would claim conventional QE has not worked. However, analysts point to US GDP which is up some 9% above its previous peak. For this reason economists believe that QE works by lowering the cost of debt, boosting asset prices and initially lowering the value of the currency (which then pushes other countries to pursue a similar strategy). If needed, another round of QE or postponement of Fed rate hikes would drive down the cost of corporate debt and that, in turn, would drive up corporate net buying further.

More importantly, if that policy response did not work, there would be more direct monetarization of government debt (for example, the central banks buying infrastructure bonds issued by an off balance sheet entity of the government). Ultimately, the end to the bull market occurs when there is an inflationary constraint on central banks, either because labor markets are tight and are operating beyond full capacity or because there is a supply-side led shortage of commodities. Accordingly, “We do not see either as being the case currently.” (CS, 2015).

The market is pricing in a full Fed rate hike by March 2016, with a 20% probability of a rate hike in September of 2015 and a 50% probability by December of 2015. Credit Suisse economists also think that the probability of a September hike is below 50% and expect the Fed to raise rates in December. Historically, in the run-up to the first rate hike, the fall in the market has been modest. With the exception of 1977, the S&P 500 has tended to have a short-term peak relatively closely to the point at which rates have risen. In both 1986 and 1994, the US equity market peaked in the same month as the first rate rise, while in 2004, the local peak in the market preceded the rate rise by around five months. The average fall in the US market in the run-up to the first hike has been some 3%, while for global markets it has been even lower.


This time around, markets have corrected by more than 10% in the run up to the first rate hike, contrary to the historic precedents. A point few people are thinking about now is that the purpose of the forthcoming Fed rate hike is not to slow the economy down, but to provide the central bank with room to cut rates in the event of another recession.

Best Regards,

Vaughn L. Woods, CFP®, M.B.A.

Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal.  Past performance is not a guarantee of future results.  Asset allocation cannot assure a profit nor protect against loss.  Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed.  Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.  VW1/VWA0209.

Credit Suisse, Global Equity Strategy, Garthwaite, et al, 8/28/2015