Traders work on the floor of the New York Stock Exchange.Spencer Platt/Getty Images
I will say this much, the stock market has managed to tiptoe through one land mine after another this cycle. And do so with a certain degree of panache.
A year ago, there is a mild freak-out over Grexit. We get over that and then step into the next land mine, which was the Chinese currency devaluation and that was actually the last time the U.S. market sank anywhere near close to a bear phase – and of course, right now it is all about Brexit and its fallout.
It is interesting how the market now manages to shrug off the fact that the yuan has slumped now for the fifth straight week as Beijing is now overtly allowing the currency to weaken as a tool to stimulate growth.
Six months ago, this would have caused Mr. Market to have a fit and today it is greeted with a yawn. Maybe six or 12 months from now, Brexit will be making back-page news as China's devaluation is today – this was hardly the case back in January.
All of the immediate post-Brexit loss has now been recouped and last week was notable for breakouts among the home builders (D.R. Horton hitting a new high on strong volume), GE, Facebook and of course, Apple, which reclaimed its 50-day trend-line.
Turning to the U.S. banks, one thing about the reregulated U.S. financials sector is its deep valuation characteristics – price-to-book value of 0.88 times (if you believe the book value numbers) versus 2.8 times for the S&P 500, which is very nearly the steepest discount at any point in the past 25 years.
Obviously, the reduced chance of recession from the Friday's headline payroll data helped out the equity market, as is the case with the ongoing "There is No Alternative" – that with about $13-trillion (U.S.) of government bond yields in negative terrain, there is no alternative.
After all, we have the bizarre situation where the dividend yield on the global MSCI matches the average 4.2-per-cent yield you can garner from a typical Baa-rated corporate bond.
There are some constraints, mind you:
- The history of the last dozen challenges of the high is that of a failed test;
- The VIX at 13 highlights a certain high degree of investor complacency;
- The latest Commitment of Traders report shows the hedge funds having already swung back to a net speculative long position on the S&P 500 (for four weeks running now);
- Market surveys show there to be twice as many bulls as there are bears – another sign of a fully priced overbought market;
- And a critical constraint is the complete lack of earnings visibility.
With the second-quarter reporting season under way, the bottom-up consensus is estimating a 5.4-per-cent year-over-year decline.
That said, hopes abound for a second-half recovery that sees the third quarter with a 0.8-per-cent gain and finishing off the year with a 7.2-per-cent runup in the fourth quarter. The problem is that these forecasts were premised with a view of a weaker U.S. dollar and yet since the Brexit vote, the trade-weighted greenback has firmed nearly 3 per cent.
And there is valuation – the S&P 500 trades at a 18 times forward price-to-earnings multiple, which is way ahead of the 10-year norm of 15 times, which is pretty darned expensive, though advocates of the "Fed model" that compares the earnings yield to bond yields will point to the gap as a source of valuation comfort.
The question is, What is the message for earnings from the ultra-low level of bond yields? Maybe the expected 16-per-cent profit rebound through 2017 is a bit pie-in-the-sky, especially if demand growth in Europe subsides. After all, over 40 per cent of U.S. corporate revenues are derived abroad and much of that from Europe.
Plus the Japanese experience with secular stagnation is a living lesson in not relying exclusively on near zero risk-free rates when it comes to stock market forecasting – especially when those same interest rates are actually flashing a signal of extremely anemic earnings growth down the pike.
Remember, these forward P/E multiples are discounting an impressive earnings recovery based on a weaker U.S. dollar and stronger oil. The problem is that the dollar has stopped going down and oil has shown toppy signs at the $50 mark.
In the meantime, China's growth remains lacklustre and the only question for the U.K. and the EU is the extent to which the heightened political risks slow down their economies or even tip them into recession.
David Rosenberg