Wednesday, February 21, 2018
Speaker: Bill Stone, CFA, CMT, President, Stone Investment Partners LLC
1. Recent volatility in the market.
- In 2017 the market volatility was abnormally low with S&P500 intra-year drawdown of only 3%. Historical data (since 1945) suggests the average ("normal") drawdown of 14% and return of 8%.
- Historically, after such a low drawdown the next year has always been worse in terms of volatility, while the next year's market performance was mixed but positive on average.
- The very recent drawdown that we saw was 10.2%:
- The market had to deal with yields moving up.
- The bank index outperformed the market posting an 8.9% decline – banks were trading well because they benefit from higher yields.
- The market therefore is trying to discount higher yields, but doesn't seem to think that the economy will give in.
2. Global economic backdrop.
- Looking at the global economy it is hard to be negative – the projected 2018 GDP growth is 3.5%:
- Developed market 2018 GDP growth is projected at ~2.5%.
- Emerging markets expect to see over 5% GDP growth in 2018.
- US 2018 GDP growth is estimated at 2.5%-2.6% y-o-y.
- We see manufacturing PMIs across the globe are better than they were a year ago – all above 50 implying an expansionary economic activity. Historically, PMIs correlate with GDP growth (except for China).
- No signs of recession at least this year.
3. Earnings and valuations of stocks.
- Earnings growth has been strong around the world: in terms of 4Q17 earnings, the S&P 500 companies are running with 15% y-o-y growth, Europe and Japan – both posted 17% y-o-y growth.
- Since the beginning of the year, we see every sector of S&P500 increased its 2018 earnings estimates to currently estimated 18.5% y-o-y growth for the index (vs. 11% y-o-y growth estimated at the beginning of the year) – part of the increase is due to the fact that tax cut was not yet priced into the analysts' forecasts at the beginning of the year, however, that increase wouldn't be the case if the economic growth didn't continue to look solid.
- Interest rates do matter for valuations:
- Current S&P 500 is valued at 17.3x 2018 P/E (given $157 consensus earnings estimate) vs 10Y average P/E of 15.4x. and some could argue that it is overvalued.
- Let's look at their relative valuation to bonds. Historically, the earnings yield on S&P500 has been lower than Baa corporate bond yields on average by 150bp since 1960, and by 100bp since 1988. Based on 2018 earnings estimate, currently stocks yield about 5.8% which ~125 bp above the Baa corporates yield of 4.53%.
- Taking current Baa corporate yield as a starting point and subtracting from it the average historical difference of 100 bp we arrive at a hypothetical earnings yield of 3.5% that implies 2018 P/E estimate of 28.6x and S&P500 value of 4490 (given the consensus 2018 earnings estimate of $157) – 65% upside to current value, way too optimistic.
- Setting the earnings yield equal to current Baa yield gives P/E of 22x implying S&P500 value of 3454 - 27% above current market value.
- Setting the earnings yield 1pp above the current Baa yield to 5.5% (thus giving Baa yield a room for 200bp increase) produces P/E estimate of 18x implying S&P500 value of 2826 - 4% above current market which seems more realistic.
- Therefore, stocks do not look over valued to me. Buffet: "Stocks are not richly valued relative to interest rates".
- Tax reform is a big deal. However we should be careful about the amount of tax reform related increase in cash flows to put into valuation models – some of the increase may be offset by relaxed margins (due to tightening competition) and/or higher labor costs.
- S&P500 Valuation & Inflation - multiples are set to fall with growing inflation.
- Current inflation, yields and tax rates are favorable for stocks valuations compared to historical averages.
4. 2018 outlook.
- Global economic growth should continue into 2018.
- Fed is expected to rise rates 3-4 times which should move bond yields upward.
- Volatility likely to continue relative to 2017.
- 2018 earnings look solid + additional tax reform upside.
- We are anywhere close to recession – overheating (I don't see it yet) + external shock (e.g. oil price, but oil prices at this point are not in the risk area).
- Geopolitically – impossible to predict. No action is the best choice - most of the time the market starts recovering in about 20 days after the shock event.
- Be aware of the bond proxies in the equity markets.
- International markets still look attractive in terms of prices relative to the US market - in particular, very positive on Japan.
- As for me, bitcoin is a speculation not an investment. I define investment as something with positive expected return after inflation. Bitcoin is essentially a currency, and generally speaking, over the history currencies have not been a good investments. I don't know any currency (except may be Japanese yen at some point of time) with positive expected return after inflation.
- We believe in a blockchain - it has some other important implications for investments.
- Highly recommend Netflix documentary "Banking on Bitcoin" for those who are interested in cryptocurrencies.
1. You mentioned you didn't see a big recession risk in the near term - does that give you a reasonably high confidence that 2019 represents another positive year? In that sense, what kind of growth rate do you expect in 2019?
- Feel pretty positive about 2019 in terms of economic growth – it is too early to say that with confidence though, as it depends on how the economy will perform this year (e.g. overheating, shocks are hard to predict).
- We expect another year of corporate earnings growth next year.
- We watch if we see enough wage growth that starts to cut into margins as labor market has become so tight. If we see wages growth, then companies would most likely spend more on CAPEX, particularly on technology to increase productivity and decrease labor costs. In that view, we are optimistic on the technology sector, which at the moment does not seem too overvalued (compared to S&P), but tech companies should have a tailwind from the CAPEX spending growth.
2. You mentioned those 3-4 potential rate hikes in 2018. Can you talk about what makes it lean towards 4 times and what are the implications in terms of potential policy mistakes?
- The 2-year Treasuries have moved up which could be a signal that the market has already priced in those 3-4 hikes.
- I am worried about potential policy mistake when there is an inconsistency between what the Fed says and the market movements, which is not the case this time.
- The hikes have also been supported by the recent economic growth.
3. Do you see any bubbles or potential bubbles out there?
- The definition of bubble to me is when valuations get so high when they stop making any sense.
- Bitcoin certainly has some features of a bubble, however I don't know how to value bitcoin (as it has no cash flows), so it is hard to say whether the valuation we have seen is over its fair value.
- Usually the real bubbles have an underlying truth: e.g. tech bubble – the underlying truth was that the Internet changed everything, however tech companies' valuations were a bubble. Same thing is with bitcoin: I think blockchain is going to be a changer for a lot of things, but it is unclear whether it will show up in a price of bitcoin.
4. Let me expand that bubble question. We have European government bonds in negative yield territory – doesn't it feel like a bubble? Is it sustainable for them to have negative nominal yields?
- It doesn't seem to have a lot of sense to me either.
- The difficulty to call current bonds valuation a bubble lies in a fact that they do end up maturing at a par value and I cannot imagine how one can make a lot of money from the other side of it.