There have been few reasons to be optimistic about the equity markets so far this year. As of 30 June 2016, the S&P 500 earnings estimate was $118.79 per share (£90). That is an anaemic increase of 1% over 2015. And with the market already up by 7.5% for the year, it is difficult to see equities making significant headway from here.
Last year’s results reminded us there is a strong correlation between the S&P 500 annual return and earnings growth. In other words, anaemic earnings growth equals anaemic returns.
To top it off, during the past six years, August has been the worst-performing month of the year. Macro risk events loom large, including the uncertainty about the US presidential election and the lack of specifics from the candidates about economic policies. And what about the Fed and the possibility of a rate increase?
All of the above are reasons to be cautious on the equity markets at this juncture, but there is a problem with this viewpoint. It is an incredibly crowded position right now and put/call, margin debt and bear to bull ratios have all swung very negative.
According to Lipper, outflows from equities surpassed $90bn year to date, which is the biggest figure since 2011. And this is flowing into money market funds. As Sir John Templeton reminds us: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
Here are some other reasons not to be too cautious on the market:
Year to date, the Russell Large-Cap Value Index has outperformed the Russell Large-Cap Growth Index by nearly 500 basis points (see Chart 1). Is this sustainable? We think it is likely the markets are in the early stages of value outperforming growth.
By late January, the valuation spread between value stocks (cyclicals) and the market had moved above one standard deviation, indicating that value stocks were really cheap.
However, with a spread that wide typically comes a risk that the US economy is on the cusp of or in the midst of a recession. And a recessionary environment can cause the valuation spread to widen further.
However, since 11 February, as fears of a recession subsided, that valuation spread started to narrow. Momentum in industrials, materials, energy and financials – all value sectors – has improved.
If we review past value moves, they tend to last a minimum of two years. Therefore, we think five months into a regime where value outperforms growth is very early in the cycle.
Most importantly, in markets when value has outperformed, markets have gone up, sometimes by a lot. Value stocks do not begin to outperform on the cusp of a recession but on the peak of an economic acceleration.