It is tough to look beyond the depressing daily death dispatches from around the world detailing the tally of the Covid-19 epidemic. Yet that is exactly what investors must to do, if they want to have a fighting chance to figure out what happens next. These data are undeniably terrible, but they are known quantities for markets, even in the U.S. and the U.K., where the numbers are rising too fast for their own good. They will continue to rise, for at least a few more weeks, at least. Meanwhile in the world as a whole, two immovable objects are now crashing into each other. We can’t return our economies to normal operation due to the risk of an uncontrollable public health crisis, but equally, we can’t maintain economic lockdowns indefinitely. The circuit-breaker in the form of a coordinated monetary and fiscal stimulus program to the tune of nearly 20% of global GDP is a stop-gap solution at best. This is because that is arguably the level of GDP that developed economies are set to lose through H1 alone. Contrary to popular belief, you can’t just freeze the economy, and then re-start at zero six months later after having printed trillions of dollars. Anyone who makes claims to this effect are, in my view, getting a little too excited about the second-order effects of our present misery, which is the economic shutdown itself, and the associated open invitation to unleash the MMT experiment. Don’t get me wrong, it is the right thing to do, but as I said, it is a second-order effect.
Read MoreEquities have wobbled a bit at the start of the month, but unless they lose the plot in coming weeks, it is fair to say that Q1 will be everything that Q4 wasn’t; decent and calm. Indeed, the finer details reveal an even more striking dichotomy with the calamity that culminated in the rout at the end of last year. Between June—when the PE multiple peaked at just under 21—and the low for the S&P 500 in the final weak of December, EPS rose by 13%, but the index fell by 10%. In other words, the multiple crashed, a story which was repeated across almost all key DM and EM indices. By contrast, the story so far in Q1 is the exact opposite. By my calculation, trailing EPS for the S&P 500 and MSCI World are down 0.5% and 2.1% year-to-date, respectively, but both indices have rallied smartly. This can only mean one thing; multiples have expanded, and they have indeed, by about 14% in both cases since the end of December. I am confident that the tug-of-war between multiple expansion and deteriorating earnings will determine the fate of many equity investors in 2019.
Read MoreI am short on time this weekend, so I am doubling down on the story I told last week, with two more charts and some additional comments. The first chart updates picture of the startling spread between price change in S&P 500 and its multiple. As of last week, the U.S. large cap equity index was down 0.2% on the year, but trailing earnings were rising just under 22%. The only way to square these two headlines is to note that the P/E multiple has crashed, from a high of nearly 23 in January to 18 today. The silver lining is easy to spot. The market is now about 20% cheaper than it was at the start of the year, a significant re-rating.
The flip side is that paying 18 times earnings for the S&P 500 is not egregiously cheap. If growth in earnings roll over, a further decline in multiples would, at best, lead to stagnation; at worst, it would drive prices much lower. That’s certainly a significant risk if you consider that this year’s impressive jump in earnings, at least in part, have been driven by tax cuts, which won’t be repeated next year. It gets even worse if we start to change the assumptions around share buybacks, another important support for earnings growth via its denominator-reducing effect on the share count in the EPS calculation.
Read MoreAs sell-side strategists parse the entrails of positioning data, and update their greed & fear models, to guess whether markets are due a rebound, investors should not forget the big picture. The conditions for further weakness remain in place. On the macro-level, the sharp slowdown global liquidity has been warning for a while that global—more specifically U.S.—equities had been rallying on borrowed time. Closer to the ground, the sell-off suggests that the multiple-crushing rise in bond yields and oil prices finally got the better of risk assets. The perma-bears will tell you that this is the drawdown to end all drawdowns, dragging global equities down to the netherworld of 2008 and 2009 price-levels. They have absolutely no justification for making such a call, but it won’t stop them peddling this narrative. Prudence suggests that we keep a close eye on liquidity in the credit market and, more specifically, signs of illiquidity in corporate bond funds and ETFs. The short-run is anybody’s guess, but if the recent past is a guide, it’ll go something like this: The market will rebound, eventually, retracing about half of the initial plunge. It will then roll over again, making a new low—the classic double-bottom—which can be bought aggressively.
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