Monday, October 29, 2018

Still just a panic attack?

A few weeks ago I opined that the sudden equity selloff was just another panic attack, and unlikely the start of a major rout or a harbinger of another recession. It's now turned into an official correction, with the S&P 500 down 10% from last month's peak. Has anything changed to make the prognosis worse? Lots of things have changed, mainly equity valuations (which have improved significantly), but the underlying fundamentals are still healthy and therefore at odds with the market's apparent level of distress.

Nine months ago (January 26th) the market was enthusiastic: the PE ratio of the S&P 500 (using Bloomberg's measure which counts only profits from ongoing operations) was just over 23. Today, despite the fact that profits have since risen almost 16%, that same PE ratio has fallen over 20% and now stands at 18.5. That's quite remarkable, considering the market currently expects profits to grow by another 25% over the next 12 months, which would imply a forward PE ratio of a mere 14.7, significantly below the market's long-term average of just under 17 (see charts below). In short, the market has gone from enthusiastic to very worried in a relatively short time frame. To judge from these metrics, while a recession seems very unlikely in the next year, beyond that the market appears to have lost all confidence.

The causes of this dramatic turn of events are many, and I'm now going to sum them up as "global angst:" a weakening Chinese economy, budding tariff wars, concerns about Fed tightening, a fragile Eurozone, weakening emerging market economies, rising oil prices, and all coupled with the fact that we are entering the 10th year of an economic expansion (which by itself makes investors quite nervous—how much longer can the good times last?). None of these factors have appeared out of the blue however; they've all been headwinds for awhile, but it seems they have rather suddenly combined into something like a perfect storm.

Equity valuations have plunged, but it's hard to find any evidence of a sudden or imminent economic downturn. In fact, financial market and economic fundamentals remain solid: swap spreads are low (which implies low systemic risk and abundant liquidity), credit spreads are up only slightly from relatively low levels, the yield curve is still positively sloped and real yields are still relatively low (which together imply that the Fed is far from being tight), the dollar is reasonably strong, and inflation expectations are reasonably anchored. The Powell Fed has given no hint of being willing to ignore the market's sudden distress in pursuit of an aggressive tightening agenda, and I seriously doubt they would do so anytime soon.

So it seems this is still in the nature of a panic attack, and as such it should pass. But of course there are events that can pop up that are unpredictable, and investors must always shoulder the burden of the unforeseen. If you can't take that heat, you shouldn't be in the market.

Here are some updated charts which flesh out the story:

Chart #1

Chart #1 illustrates how all of the market selloffs in recent years have been accompanied by a sharp rise in "worries." For "worries" I use the Vix index divided by the 10-yr Treasury yield. The Vix index rises as fear rises, while the 10-yr Treasury yield tends to rise as confidence in the economy rises. We've seen much more serious levels of worry in recent years than we see now.

Chart #2

Chart #2 shows that swap spreads, which are a key coincident and leading indicator of financial market and economic health, remain relatively low. At 20 bps, US swap spreads are fully consistent with healthy and liquid financial markets. At the same time they tell us that systemic risk is low. Liquid financial markets are a sine qua non for a healthy economy. No problem here.

Chart #3

Chart #3 shows the level of real and nominal 5-yr Treasury yields and the difference between the two, which is the market's expected annual inflation rate over the next 5 years. Inflation expectations today are very close to the Fed's 2% target. No problem here.

Chart #4

Chart #4 compares the level of 5-yr real TIPS yields with the real Fed funds rate. This tells us that the real yield curve is positively sloped, and the market is not concerned that the Fed has tightened too much. The time to worry is when the blue line exceeds the red line, as that would be an indication that monetary policy was too tight and the Fed would likely be force to cut rates in the future. That's not the case today. At worst, the bond market is telling us that perhaps the Fed will need to move rates up more cautiously in the future. That's not a problem.

Chart #5

Chart #5 shows 5-yr Credit Default Swap Spreads. These are highly liquid and generic indicators of the market's confidence in the outlook for corporate profits. These spreads have increased only modestly despite the sharp equity selloff, which further suggests the market is still confident in the outlook for corporate profits and the health of the economy. No obvious problem here.

Chart #6

Chart #6 shows Bloomberg's measure of the S&P 500's PE ratio, which uses profits from continuing operations. Since January of this year PE ratios have plunged rom 23.3 to now 18.5 (-20%). This reflects a rather sudden loss of confidence in the long-term outlook, especially considering that profits continue to rise. Curiously, the bond market appear to be much more confident about the future than the stock market, given the low level of swap and credit spreads. This further suggests the equity market may just be in the throes of a panic attack.

Chart #7

Chart #7 compares two measures of corporate profits: after-tax corporate profits as calculated in the National Income and Product Accounts (red line), and after-tax earnings per share based on a 12-month trailing average of reported quarterly earnings. Both are at all-time highs and rising. No problems here.

Chart #8

Chart #8 shows the Fed's preferred measures of inflation, based on a broad measure of personal consumption. Both total and core inflation are very close to the Fed's 2% target. No problem here.

Chart #9

Chart #9 compares the real Fed funds rate (a good measure of how loose or tight monetary policy is) with the slope of the Treasury yield curve. Recessions have always been preceded by a substantial tightening of monetary policy and a flattening or inversion of the yield curve. We're a long way from those two conditions today.

Chart #10

China has taken a beating in recent years, and especially this year, which has seen the steepest-ever drop in the value of the yuan. This has occurred in tandem with a decline in the Chinese central bank's holdings of foreign exchange reserves, and both are symptomatic of capital flight. Capital is leaving China because investors are worried about the future of the Chinese economy. In a relative sense that's good for us, but if China were to fall off a cliff, well, that would not be good. China is the biggest concern in the world right now, but their leadership could fix that problem by simply acquiescing to Trump's (and the WTO's) demands: respect intellectual property rights, and reduce or eliminate tariffs and subsidies. In short, China's outlook would improve dramatically if they simply adopted sensible policies. How hard is that?

Chart #11

Chart #11 compares the Chinese and US stock markets. Note that both y-axes have the same ratio between top and bottom values (15x), and both use a semi-log scale. China's stock market has truly plunged since January of this year, suffering a punishing loss of almost one-third of its value. Worse still, China's stock market today is trading at close to the same level as it was over 20 years ago, whereas the US market has risen 460% over the same period. Big problem for China. Free market-style reforms could do wonders for China's wealth. What's good for China would be very good for the rest of the world.

What stands out in all of this is that equity market fears are not supported by any deterioration in the economic and financial fundamentals, at least in the U.S. economy. That could always change for the worse, but for now it's still in the realm of speculation. 


Benjamin Cole said...

Another terrific wrap up by Scott Grannis.

Drink Pepto-Bismol and read Scott Grannis. (Or, just have a drink.)

But Grannis does touch on the key topic: China.

I think in the West, people forgot that China is run by the Communist Party of China.

President Xi and the CPC appear to be reasserting party control into every facet of the Sino society, including economics and business. I use the word "appear" as there is no free press in China, only propaganda. Evidently, even sophisticated Westerners regarded this as an investable situation. By the way, the Shanghai composite is down 45% from three years ago.

Oddly enough, I think the People's Bank of China is actually better run than the US Federal Reserve. But I lack confidence and the rest of Sino leadership and the economy.

George Madison said...
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Roy said...

Have you guys watched the recent Kiril Sokoloff interview with Stanley F. Druckenmiller on Real Vision TV? In the interview, Druckenmiller states that about 3 months ago he started to short the market and explains why. Druckenmiller is the best investor of the past 50 years, at least, based on his record. It should be noted, though, that he was able to achieve such return by being able to change his mind, sometimes by 180 degrees. So maybe today he went long, still, his insights are worth listening to.

Benjamin Cole said...

"According to Thomson Reuters, 78% of the S&P 500 companies that have reported have exceeded consensus earnings estimates, putting the index on track for a 25.2% year-over-year increase in earnings, 3.6% above estimates as of Sept. 30."

Oh, that's all. A 25.2% YOY boost in earnings, and topping estimates.

I have said it before: For Corporate America, right now is Fat City. That's good!

steve said...

The real surprise could be the GOP retaining control of the house. IF the market is angsting due to potential loss, then afterwards it should take off.

WealthMony said...

Excellent summary from Scott. I do agree with George that there is also worry over the election because of its uncertainty. Even if Democrats gain the House they can't change anything that has already been done without approval from the Senate and the ability for both houses to override a veto. Of course, there will be agitation multiplied against the White House. But who knows, Trump might work with the Dems and actually get some things done. That would be a surprise!

I personally think the biggest worry to investors (not the only worry) is the Fed raising interest rates too far and too fast and killing this newfound 3%+ growth.

marcusbalbus said...

do none harm.

david boyd said...

Excellent analysis and summation. However, I worry that higher dollar trend, the liquidation of the Fed's balance sheet, growing trade deficit, and impact of tariffs may be pushing the selloff.

Johnny Bee Dawg said...

"None of these factors have appeared out of the blue however; they've all been headwinds for awhile, but it seems they have rather suddenly combined into something like a perfect storm."

YEP! The catalyst was the Fed comments, a month before elections. Worst month for NASDAQ since their nadir internally in Oct 2008. Worst month for S&P 500 since their's in Feb 2009. Pretty harsh records. Those were major lows. The Fed matters, especially if they make the tariffs matter.

Market has repriced dramatically, and wants to think about improving now that election is about to transform from "rumor" to "news". Lots of short term indicators are oversold. Robustness of the bounce will depend on the election outcome, imo. We will just have to see.

Johnny Bee Dawg said...

...China has dug in it's heels, and refused to negotiate or acquiesce as they hope for political change in the US. If they have to face more MAGA Power after Tuesday for another whole election cycle, they'll have to capitulate sooner than later. Trump will have forced positive change for intellectual property rights that lasts for decades. And tariffs would evaporate.

Markets would like that. Alot.

Unknown said...

Scott - long time reader, first time commenter. Thanks for all of your posts over the years.

On your commentary to Chart #9 (1-10 spread versus the real fed funds rate, given the two are converging how can you say we are a long way off.

I’m aware the relationship may be skewed due to record low rates and a flat yield curve can sustain for years, but I would argue risk managers should be conzigant of this chart.

Scott Grannis said...

Re "On your commentary to Chart #9 (1-10 spread versus the real fed funds rate, given the two are converging how can you say we are a long way off."

Having the two lines converge is not key. That last happened in 2005, 2-3 years before the 2008 recession started.

Two things have to happen to be worried: 1) real rates must rise significantly; currently the real funds rate is only slightly above zero. 2) the yield curve needs to be flat or inverted; we're not there yet and likely won't until the Fed raises the real funds rate to at least 2-3%, or until the economy shows signs of being starved for liquidity (e.g., swap spreads rise significantly).

For now, the Fed is talking about very gradual increases in rates, maybe only 2 hikes between now and the end of next year. Futures markets are priced to a 2.75% funds rate in 12 months.

Scott Grannis said...

Re election risk. I probably should have included that in my list of things that have contributed to the recent panic. My best guess is that Republicans keep the Senate, while Dems gain a small majority in the House. A divided government can be a good thing sometimes, since not much gets done. If the House wants to spend money like crazy Trump can veto. The House can override Trump's impulses if they are unpopular enough. Could a divided government undo Trump's best policies (e.g., lower taxes, reduced regulatory burdens, stronger defense)? I doubt it, but it's tough to know for sure.

Meanwhile, the economy is in pretty good shape. Consumer confidence is soaring. Unemployment is very low, job openings are at record highs. The dollar is reasonably strong. We're no longer worrying here in California about Kim Jong Un lobbing nukes at us.

Can bad ideas like single-payer healthcare take root in a divided government? Not likely. Can tax cuts be reversed? Unlikely.

Christian S. Herzeca, Esq. said...

hey Scott

your 1-10 year treasury yield slope chart looks awfully flat. time not to fight the fed?...unless one might bet that the fed will slow down just a bit given continuing absence of inflation.

fwiw, I am 50/50 equities/short term debt and like mr bogle, half the time I wonder why I am so underinvested in equities, and the other half the time I wonder why I am so overinvested in equities.


Scott Grannis said...

Re "1-10 year treasury yield slope chart looks awfully flat. time not to fight the fed?."

Even though the yield curve is almost flat, it doesn't mean the Fed is too tight and should back off. The curve is still positively sloped, which essentially means the market doesn't expect the Fed to tighten much more for the foreseeable future: maybe 2 or 3 more rate hikes (50-75 bps). That the market doesn't expect much more than that means that the market doesn't expect the economy to get much stronger than it already is, which is only somewhat better than we've seen over the past 9 years.

A truly flat curve would imply no more rate hikes. An inverted curve would imply rate cuts. Both would imply that the Fed was "done". That the economy had no more upside (flat) and maybe a lot of downside (inverted).

"Almost flat" is not the same as flat.

terex said...

The only chart that really matters is missing 😉

George Madison said...
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Unknown said...

Maybe they are spooked about interest rates going up to keep bond traders happy who have to sell the bonds to finance the deficit that is going up so rapidly due to the Trump Tax Cuts and all of the urgently needed military spending. President Trump has made it clear that these rising interest rates are an outrage! And the tariffs too, the framers are getting killed. Now GM just announced a bunch of layoffs, I'm worried.

The only solution to this problem is to take on the wasteful spending. We definitely need to cut hard into Medicare, Social Security and Veterans Benefits. We just can't afford any of this sort of thing right now, this country is flat broke.

The minimum wage needs to go too, it's just killing everything.

Scott Grannis said...

Re rising rates and deficits: Don’t forget that the extra growth we are seeing (solid jobs and earnings gains) will almost surely generate higher tax revenues even in spite of lower tax rates. Growth cures all manner of fiscal ills.

Unknown said...


I'll drop you a line when the great howl over the soaring debt and deficit starts just as soon as the next Congress is called into session.

Social Security, Medicare, entitlements and all manner of wasteful Federal spending will surely be blamed for this latest debt and deficit crisis which will be threatening the Nation's survival. They must all be cut, we can't afford them, we are living beyond our means. That is how this script goes, right?

If the surging growth of the Trump Economy is going to cut the deficit, why is the deficit already rising? Odd. Circular logic being what it is, re-read papragraph 2 for the answer.

Benjamin Cole said...

The Cboe VIX dropped below 20 last Thursday, which is supposed to be a level that indicates the market does not expect volatility in the next 30 days.

In other words, the market does not expect much more volatility.

But I am reminded of a cartoon I saw in Mad Magazine probably around 1963: "If you can stay calm and collected, while everyone else is losing their heads...perhaps you do not understand the situation."

Teton said...

Scott, your blog has been like the holy grail for me the last several years as a professional investor. Thank you. Quick question, I show 9% earnings growth in 2019 over 2018 for the S&P. How do you get 20%+? And more importantly, with housing slowing and risks to home prices declining as rates force people to recalibrate (I know my home value has recently declined based on nearby comps), isn't there a real risk to consumer spending contracting? This is to say nothing of China auto declines, Europe auto declines, emerging market FX, etc signals. Why shouldn't I be more bearish given all of this?

Scott Grannis said...

Teton: Re "I show 9% earnings growth in 2019 over 2018 for the S&P. How do you get 20%+?"

I get my data from Bloomberg, and the EPS they report is a trailing 12-month sum of quarterly earnings from continuing operations, divided by the number of outstanding shares. As of October 2018 that number was $145.48 per share; as of October 2017 it was $119.11, for a year over year gain of 22.1%. Looking ahead one year, the market is expecting that number to grow about 23% to $179/share.

As for home prices, since prices and interest rates rising, affordability is declining. In some areas it looks like affordability has dropped so much that price gains are vanishing. I think the housing market is in a consolidation period in which prices will stabilize or perhaps decline somewhat as interest rates continue to rise and incomes continue to rise. As long as jobs and incomes are rising I don't see much chance of a contraction in consumer spending. In any event, as a supply-side economist I don't believe consumer spending is a driver of the economy. More important are things such as business investment, harder work, less regulation, and more after-tax income, all of which are the drivers of productivity, which in turn is what makes the economy stronger.

Teton said...

Scott. Thank you very much for your reply. I have to think that a consolidation period probably means a lot of market volatility which probably means business hesitation on investment / spend. In other words, it could all be circular.

Johnny Bee Dawg said...

Scott: how are swap spreads holding up?

M Needelman said...

Hi Scott. Do you have an opinion on the impact of a shrinking Fed balance sheet? Monthly Fed drawdowns had averaged $30B a month, but accelerated last month to almost $60B. While rates by themselves aren't too tight yet, is the combination of rising rates and Quantitative Tightening starting to drain liquidity? Is M2 growth an important consideration?

John Oppenheimer said...

I wonder what will happen if Trump decides to default on foreign debt, specifically countries that he thinks are cheating us. That would cause a financial crisis the likes of which we have not seen. Trump would say the Chinese are trying to sell their treasury bonds, and it's causing disruption in the treasury bond market; they stole all that money in the first place from us; we're not going to pay the Chinese back.

Johnny Bee Dawg said...

Why would you wonder such a thing?
Trump Derangement Syndrome

Bob Weir said...

Scott, are you all right? No postings since October 29. Rare that you say nothing. Bob Weir

Rob said...

I was just wondering the same. Hope all ok.