1/20/2021: Market Update by Jack Ablin, Chief Investment Officer at Cresset
We believe one of the best ways to assess current market conditions is through Cresset’s Five Macro Factors: valuation, economic backdrop, liquidity, psychology and momentum. These gauges offer a useful perspective on the current market environment and the outlook for the next 12-18 months.
Valuation suggests the market is expensive; in fact, most market valuation measures suggest US blue chip stocks are the most expensive they’ve been over the last 12 years, relative to earnings and sales. While valuation is not a great timing tool, it does suggest the markets will have a difficult time advancing without concomitant gains in revenues and profits.
The economic backdrop is mixed. Current conditions are abysmal, with a workforce that remains 6.5 per cent smaller than it was at the beginning of 2020. State and local governments, squeezed between an evaporating tax base and COVID-related expenditures, have shed nearly 1.4 million employees. Looking beyond the pandemic maelstrom, the promise of vaccines and robust fiscal spending have market participants penciling in robust growth in H2/21. The yield differential between the 10-year and 3-year Treasuries, a predictive growth indicator, increased to over 1 per cent from as little as 0.2 per cent a year ago.
Liquidity, the ability to borrow, spend and invest, was one of the critical factors behind the surge in risk assets during the last decade. Over the last 10 years, US large caps valuations expanded 164 percentage points more than what could be explained by earnings growth and dividend yield – which accounted for 100 percentage points – alone. This valuation expansion was directly attributed to central bank largesse. Liquidity remains a key ingredient today. Credit spreads, the yield differential between corporate bonds and US Treasuries, represent lenders’ willingness to extend credit to lower-quality borrowers and is a handy real-time liquidity indicator. Credit conditions are a good barometer of investors’ risk appetite. Tightening credit conditions was a valuable early warning indicator that began flashing red in Q4/07, a full year before the equity market fallout from the financial crisis. The good news is corporate bond spreads remain at the low end of their recent range, suggesting robust liquidity conditions. Another way of evaluating liquidity is looking at the trend in corporate borrowing rates. Over the last six months, the cost to borrow has declined, again suggesting favorable liquidity.
Psychology and expectations play an important role in the market’s near-term twists and turns. Stocks generally climb a wall of worry. Bullish and complacent investors have high expectations, and in a world in which the market reflects the intersection of reality and expectations, it’s better to traverse the investment landscape with nervousness and low expectations than with bombastic bullishness. Investor attitudes, which kicked off 2021 with an ebullient level of optimism, pulled back in reaction to the events in the Capitol earlier this month. The share of investors characterizing themselves as bulls has pulled back to the 59th percentile of its historical range. Another way to view investor sentiment is through closed-end fund premiums and discounts. Like rabid fans for a hot sports team, bullish investors buy closed-end funds at a premium to face value (NAV) while bearish investors are willing to sell well below face value to get out. Optimistic investors, emboldened by a strong stock market going into 2020, piled into the largest equity closed-end funds at a 2.1 per cent discount to NAV, substantially above their longer-term 9.3 per cent median discount. By March 20, however, news of the COVID-19 pandemic vaporized investor enthusiasm and prompted panicked investors to unload their closed-end fund holdings at an average 14 per cent discount. Today’s largest US large-cap closed-end funds are trading on top of their median 9.3 per cent discount, suggesting attitudes are on an even keel.
Momentum, the last macro factor, remains positive. To paraphrase Sir Isaac Newton, a market in motion tends to stay in motion unless otherwise acted upon. In market parlance, “don’t fight the tape.” The S&P 500 is currently trading about 16 per cent above its 10-month moving average, suggesting strong momentum. We point out, though, the momentum metric has lost its effectiveness in recent years thanks to the “Fed Put,” the notion that the Federal Reserve unleashes liquidity to limit market downturns.
Putting it all together suggests that it is changes in liquidity that will determine the market’s direction over the next several quarters. Easy liquidity has been an enormous tailwind over the last decade; any tightening could represent a future headwind. Anything that would cause interest rates to rise – like inflation, scaling back or ending the Fed’s bond-buying program, or bond market participants demanding a higher yield – represent the biggest risks to risk taking. For now, liquidity remains robust, suggesting the path of least resistance for equities is higher.
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