MID QUARTER REVIEW - Halfway Through Q1 2020
One half of the first quarter of 2020 is in the past; it is time to review what happened so far. Against all the odds, U.S. stock market indexes have been expanding relentlessly; the S&P 500 market index is up +3.8% (SPY) (January 2nd to February 14th, 2020).
Digging deeper, the U.S. technology index Nasdaq 100 (QQQ) has increased +8.5% and the U.S broad fixed income market index +1.4% (AGG). The international equity markets, especially the Emerging Markets equities, have not been so fortunate, this index is down -3.5% (IEMG), and the Developed Markets equities markets are down -1.1% (VEA) year to date.
The U.S. government's 10-year interest rate is at 1.58%. Gold price per ounce is at 1,584 USD or +3.6% year to date, and U.S. WTI oil price is at 52.3 USD per barrel.
Since the start of 2020, 77% of U.S. companies of the S&P 500 reported Q4 2019. The corporate earnings results have validated the analyst consensus that earning growth is back, the blended earnings growth of the index stands at +0.9%, after three-quarters of negative earnings in 2019. (FactSet report - John Butters Feb 14th, 2020).
On average financial analysts are still forecasting single-digit growth of 2020 earnings in the coming quarters +2.1% for Q1 2020, +4.9% for Q2 2020.
The U.S. equity indexes are at the highest level ever, but this is not enough to avoid exposure to them, before we should look at several valuation metrics to assess where we stand historically.
As a thought exercise, we will use the ratio of Trailing Price over Equity (Trailing PE) and Forward Price over Equity (Forward PE). The first ratio measure the past 12 month earnings of the index divided by its current price. The second ratio measures the future 12 months of earnings divided the index current price. As you can see, the first ratio is based on facts and the other rate on analyst estimates.
Since 2010, these ratios have only been higher than today at the end of 2017, when the S&P 500 Trailing PE was at 24.1 and the Forward PE at 18.5. Nowadays, the Trailing PE for the U.S. S&P 500 market index is at 23 and the Forward PE ratio of 18.9. In a nutshell, we are in a high range of valuation, but if growth picks up, we may stay there for a while.
As you can see, the financial analysts are very optimistic, as they did at the end of 2017, but as it happens it the last two years, it was not without a couple of bumps in the road. These two metrics we explored are not still sufficient to have a complete assessment of the market value because there are so many analytically and sentiment variables involved.
There are a broad set of circumstances we must consider that might help support or derail the markets, so far in 2020,
Constant support from leading Central Banks
The global central banks continue their coordinated efforts to keep a low-interest-rate environment in the U.S., Europe, China, Japan. The low levels of interest rates have a dual purpose; first it holds a comfortable financial condition for companies and individuals to issue and pay debts, and second, it pushes investors towards riskier assets, away from safety to achieve better returns.
The temporal repo facility intervention by U.S. Federal Reserve to fixed issues with money markets since September 2019 has pumped more than 400 Billion dollars to the U.S. financial system. The temporary measure might become a permanent tool soon, meaning a kind of an “infinity quantitative easing” (or QE), although the Fed has already said, there is not such a thing. The central bank's support is the most robust tailwind so far for markets.
The 2020 U.S. Presidential election
First, the current administration seems that they will do whatever necessary to keep financial markets rising, as it looks like it sees the financial markets as a measure of their administration success.
Second, as the U.S. is in the lowest ever tax rate environment and the government budget deficit is one of the highest, without a financial crisis. Then the most significant political uncertainty to investors comes from any plan from any other presidential candidate that may increase individual and corporate taxes.
If there is a real chance of a meaningful tax increase, most of the financial markets may adjust themselves accordingly. So far, the markets seem to assign a very low probability of any change of rules. Therefore this is not a headwind currently, but it might become one if current political tendencies change.
U.S. - China Trade conflict truce
The temporary relief of trade tariffs, the lack of heated exchanges, and economic threats between the U.S. and China might create a boost to the corporate sector, although we need to keep in mind that the pugnacity is still intact underneath.
There are still technological restrictions to Chinese industries in place for advanced industries, such as communications (Huawei), and, most recently, airplane manufacturing. In the meantime, this is a relative tailwind as well.
U.S. corporate buyback programs
No one has had more benefits from the lower global interest rate schemes than the U.S. biggest corporations. These companies have used every opportunity to leverage their cash flows to do stock buybacks, mergers, acquisitions, and restructure their debt load.
If the U.S. economic growth keeps a slow but constant growth, these mighty companies might continue these financial strategies going forward until interest rates rise or their amount of debt becomes unsustainable to manage.
The stock buybacks and dividends have a combined return of 5.05% (four-quarters up to Q3 2019) for the S&P 500 market index, and they have been and still are a significant driver of U.S. stock performance nowadays.
Buybacks contributed more than corporate dividends, while dividends in the S&P 500 represent about 1.81% (four-quarters up to Q4 2019), buybacks are 3.12% (four-quarters up to Q3 2019). Other regions have not used these levers significantly, although European companies are catching up.
If you are wondering how big are these two drivers, buybacks and dividends represented 97.9% of S&P 500 operating earnings in Q3 2019, and it has been around those levels since 2015. (Yardeni Research February 18th, 2020).
The limits of buyback firepower are set by the capacity of corporations to increase corporate debt without alarming investors. So far, just a few U.S. companies on structurally decreasing industries have tested those limits. Eventually, we will reach those limits, but it does not seem to be anytime soon, a massive downgrade of debt quality will be required to cause trouble.
Global health crisis
The most recent threat to economic and corporate estimates this 2020 is the health crisis related to the new virus originated in China, the Coronavirus. The financial impact of health crises is usually short-lived for financial markets.
In the last six weeks, we have learned new facts worth of mention. Coronavirus is a fast-spreading disease, more than past viruses like i.e., SARS. In a short time, it has reached 75,000 cases. Coronavirus mortality rate (about 2%) is lower than, for example, SARS (10%) with current treatments.
This Coronavirus has already caused the death of more than 2,000 people; we hope a global coordinated science effort leads to a cure to end this illness.
If we look at the impact of Coronavirus to the global economy, we have already identified several effects which deserve attention:
Speed of Contagion: The velocity of spread is high, even with the extreme isolation measures implemented in China by their government, which have confined entire cities to contain the epidemic. Up to this moment, every scenario is valid, even a worldwide spread that may include Coronavirus within the list of common illnesses like flu, it is the most extreme possibility.
Duration of the crisis: Until there is a proven treatment to deal with the virus, and we know more about its effects, there will be extreme government measures globally to contain the spread. These drastic measures, although required, are the ones that might create the worst damage to world economies; every day, these constraints contribute to increasing the costs to societies and economies. In this case, the spread of Coronavirus has directly crippled the Chinese economy and its industrial power. Most of the global supply chains of technology, industrial, and manufacturing are dependent on China industrial apparatus. There is no question right now that Coronavirus will impact global economies, and its impact will be at least higher than SARS, based on the speed of contagion and duration.
Just recently, we have observed how several economic transmission channels have been affected, the commodities price downward adjustment (oil and iron), several technological companies impacts (i.e., Apple sales and supply chain), and even retail (i.e., Walmart sales in China and supply chain). This virus is seemed by far the most significant headwind of 2020.
Early signs of Irrational exuberance
There are increasing signs of over-optimistic behavior beyond collective rationality among U.S. equities, U.S. bonds, European bonds, and Private Equity. These cases are the exception, not the norm right now, but they are notorious.
Short term returns of three digits or more of individual stocks are creating a bitcoin-like fan effect of euphoria with a complete disregard of any financial measure. While many of these companies may have some merits product-wise, the evidence of cases of extreme sentiment is a clear sign of warning where a smart investor should take notice.
In the bond arena, the over-reliance or beliefs on the permanent existence of extreme negative or very low-interest rates have created a false sense of security over historically safe assets. An even small taste of higher interest rates for any cause might create a considerable asset adjustment typically reserve for riskier assets.
It is not only a feature of a few liquid financial securities these over-optimistic behaviors. There are also clear signs in private equity and real estate markets that money is piling on seeking to pay too much for meager returns. It has not escaped to the public eye the several Initial Public Offerings (IPO) of highly sought private investments that faced a rough reception at their first open market tradings days or that even failed to reach the demand for its launch.
As experience dictates, we should remain wisely invested but with reasonable caution.
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