Markets Insight
March 14, 2012 11:58 am
Stock market rally is running on empty
It’s difficult not to notice that, yet again, there is little substance or confirmation to this equity market rally, despite the fact that it still seems to have some legs.
Yes, there are economic indicators, in the US in particular, that are signalling improvement, most notably the latest employment numbers. On the surface at least, these suggest things may be starting to go in the right direction. The issue of non-existent wage growth still remains, which may explain why consumer spending has lagged well behind this apparent huge improvement in the headline employment data.
That Portugal and other eurozone countries apart from Greece have not formally had a “credit event”, and that China has not careened south, are also pieces of good news.
The reality, however, is that the world has not suddenly been “fixed” – not by the Federal Reserve’s “quantitative easing (QE)”, not by the European Central Bank’s longer-term refinancing operations, and certainly not by ultra-low interest rates across the developed world.
While I have maintained my caution regarding the market and macro outlook, there is never a time for dogma in this business. It is all about generating investment ideas and risk-adjusted returns. We are still in a meat grinder of a market. If not racked by volatility, as was the case in 2010 and again in 2011, then by eerily calm low-volume rallies in 2012.
Sure, two things have occurred recently to cause the “fair-value” estimate of, say, the S&P 500 to rise over time. One is the fact that corporate earnings have more than doubled off the 2009 depressed lows.
This is truly an incredible run-up over such a short time frame (helped in no small part by accounting changes, lower debt service charges, a weaker US dollar and tax benefits).
The other has been the compression in corporate bond spreads, which has fed right into an expansion in the price/earnings multiple. So while the fair-value range was 900 to 1,100 in 2010, and then 1,100 to 1,300 in 2011, it is now in a 1,200 to 1,400 band for 2012.
So yes, the fair-value line has been trending up, but the broader market is now close to bumping up against the ceiling.
And there are opportunities out there. We re-ran our S&P 500 sector screens based on dividend yield and growth characteristics, valuation and earnings-per-share growth estimates and found that the leaders of the pack at the start of the year are still in the lead now: technology, healthcare and financials.
We also found that tech and financials screen well when their price/earnings ratio is benchmarked against growth estimates for the next three years, a measure known as a PEG ratio. From Canada, the sectors we identified with the most compelling PEG ratios are materials, energy, telecoms and healthcare.
That said, it remains clear that this almost-uninterrupted equity market rally lacks substance and conviction.
The rally’s volume has been very weak and institutional players have been absent from the market. There has been very little participation from the retail investor, based on data from Lipper, a provider of information and ratings on mutual funds.
Indeed, US equity-based mutual funds have experienced 10 months of net outflows and $5.4bn so far in 2012. There has not been a year of net inflows since 2005 as private clients have used interim rallies as opportunities to lighten up at better levels.
Corporate insiders have been huge sellers of their own stock, exceeding $6bn last month (with the ratio of selling to buying hitting the astronomical 13-to-1 mark).
Moreover, the constructive price action in the bond pits suggests that asset allocators have been quiet too. The initial public offering market was in a slump during the October-February rally, yet another non-confirm. And merger and acquisition activity has sunk to 2008 levels. This is far from being consistent with a bull market that has any legs to it.
There remains a huge amount to be cautious about out there.
The recent market gains have been all about the more than €1tn injected into the European financial system. The optimism this has engendered is not unlike the brief spurts of liquidity-induced optimism that have followed various rounds of QE in the US.
And many of the economic numbers that have been hitting the tape in recent months have been a reflection of the warmest North American winter on record in the past 50 years, affecting home sales, retail sales, manufacturing and transportation and even consumer confidence.
So this stock market rally does not, in fact, reflect a dramatically strengthening US economy. There is actually a wide divergence between the intoxicating rise of the stock market in recent months and the sobering reality of a tapped-out consumer and fading growth expectations.
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David Rosenberg is chief economist and strategist of Gluskin Sheff
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Copyright The Financial Times Limited 2012.
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