Q: It must be a bad quarter – It has been all over the news – what happened?
A: Yesterday saw the end of a quarter that many investors (and asset managers) would prefer to forget. For example the Australian market finished down 8% for the three months to September 30th, the worst performance since 2011. Global markets weren’t any better, with the broad global index of shares, MSCI All Country World, being down over 9% in USD terms, however in Australian dollar terms, they were down less than 1%, showing why an unhedged exposure to offshore assets continues to be a good diversifying investment for Australian investors.
The Australian perspective is obviously tainted by the twin-hits to the resource and banking sectors. In this case the bad sentiment is partially justified. Many in the oil and gas sector have found themselves with too much debt and assets worth much less than they were expected to be, with Origin the latest to recognise the problem. The Glencore factor is also upsetting perceptions about the dividend stability of BHP and RIO. Meanwhile the banks are getting nervous about the property market as for the time being auction clearance rates are falling, and prices appear to be peaking along with increasingly a more involved banking regulator (APRA) which is resulting in a tightening of loan standards and capital requirements.
But despite the perceived negativity as seen from Australia and in the press, particularly with a focus on China, the evidence just isn’t as clear cut. One way of measuring whether things are getting better or worse, is to look at an index called the Citi Surprise Index. It is a truism in markets, that what matters is not whether the news is good or bad, after all that should be in the price, rather is the news better or worse than you thought it would be. So if we look at Europe, we can see that early in the year the data was improving relative to expectations. Analysts then adapted to this, but by this time whilst the data was good it wasn’t as good as they hoped. This has been reversing over the last 2 months – i.e. things are better than expected.
Citi Surprise Index - Europe
The US markets are not as pronounced, but the trend is similar:
Citi Surprise Index - USA
Q: OK, so there must be some bad news to cause this?
A: There is what is called the “Bloomberg Fallacy”: Where the headline on Bloomberg terminals (Bloomberg being the main data tool used by market participants) is written after the fact to explain what just occurred. This has been particularly prevalent of late, with arguable the most egregious example being Monday’s 2% fall in the US market being deigned to have occurred because of negative profitability growth in Chinese equities. Whilst China is more important than it used to be, it is beggaring belief to ascribe a 2% reduction in the total value of US stocks to this information! The same can be said about much of the press on China data of late: it is a result searching for a reason.
At Morphic we have another view, that there is a deeper reason – which equity markets have moved to reflect the news that was already in the prices of other asset classes, namely commodity and bonds. That is, with very low inflation levels globally and slower growth, EPS forecasts were too high for this level of growth, particularly for US stocks which have the headwind of a high US dollar to contend with. Equity markets previously took the “good part” of low yields, being the higher value placed on earnings, but ignored the “bad bit”, being lower nominal growth.
To support this assertion, we show the below - which are changes to earnings forecasts by the brokerage houses. Again, some more context, similar to the point made about the Citi Surprise index, what matters in markets is the change in earnings forecasts, more than the level of forecasts. So to interpret the below, if the number is 1, there is 1 upgrade to 1 downgrade. Anything less means there are more downward revisions to upwards revisions and vice versa.
This view that the markets globally were pricing too high of nominal growth (nominal being the price change including inflation), can be checked against nominal bond yields. At Morphic we internally calculate the implied growth calculations for the US market and compare to the bond market. We see a similar thing. Long term growth expectations have recovered from the nadir of 2012, but were trading near their peak post 2012, but bond yields are at the lower end.
Q: So, that’s all nice and theoretical, but where do you think markets are going?
A: We continue to hold our view, that this is a re-pricing of markets to reflect the deflationary forces of the world which will see lower nominal growth. Lower nominal growth should mean lower EPS growth (which is nominal. As such “fair value” on markets, choosing the S&P 500 as it accounts for nearly 50% of the world market cap, is in the 1750-2000 range. To move much below 1700 would require a large downward revision of earnings. Given the market closed at 1860 two days ago, we are at the lower end of the fair range.
The most likely outcome is that markets range trade until clarity emerges on deflationary outcomes and EPS revisions.
If we are wrong, it would be because the more bearish view, as held by some friends of ours, is that without Quantitative Easing, the expansion is “dying of old age” and will thus end naturally very soon, leading to large downdraft in earnings and heightened risk awareness, taking the market down to the 1500 level. The data does not support this view in our opinion currently, but we are aware of it.
In the meantime, we are looking for stocks that can be “paired out” to focus on individual stories that remove the market effect.