S&P500 at 2,979 – limited potential upside (8 Sep 19)

With reference to my earlier write-up (click HERE) titled “Why am I cautious going into July…”, July was coincidentally the peak for S&P500. Hang Seng touched an intraday high of 29,008 on 4 Jul 2019 before slumping 4,108 points to an intraday low of 24,900 on 15 Aug 2019 (Hang Seng closed at 26,691 on 6 Sep 2019.) Personally, given the current market levels and information, I am not comfortable to raise my current percentage invested from 53% to significant levels (say >80%).

Why am I cautious in the market? Do read on…

 

Factors supporting my cautious basis

Above average valuations

Based on Bloomberg’s data on 5 Sep 2019, S&P500 trades at an average 19.5x current PE and 3.4x P/BV vs 10-year average 17.9x PE and 2.6x P/BV. In other words, it is trading at more than 1.5x standard deviation from its P/BV. Such valuations are not considered cheap, especially when we are in the midst of an earnings recession.

Accommodative central banks – impact to the markets is not straight forward

According to CME Group Fedwatch tool (click HERE) as of 7 Sep 2019, traders cited a 91% chance of a 25-basis point rate cut by U.S. Federal Reserve on 19 Sep 2019, and they have priced in a further 100 basis point cut by end 2020. This may be able to cushion the impact of rising fears of a looming recession. However, there are two noteworthy points. Firstly, based on current economic data, there seems to be a weak case (at best) to support a 100-basis point cut by next year. Should the Fed say, or act anything to the contrary of market expectations, there may be a sell off. Secondly, given current economic data, if the Fed communicates that it may have more cuts next year, this may have an adverse effect to the markets, as markets may think that even the Fed feels that a recession is coming, and this may become a self-fulfilling prophecy.

2QFY19 marks the 1st earnings recession since 1Q-2Q 2016

According to FactSet 30 Aug 2019, 99% of the companies in S&P500 have reported 2Q2019 earnings. Together with the estimated results for the remaining 1% which have not yet reported, the aggregate earnings for 2Q2019 came in at -0.4%. This represents the second consecutive quarter on year on year decline in earnings and marks the first earnings recession since 2Q2016. In addition, analysts estimate that 3Q2019 may report 3.5% year on year decline in earnings.

It is noteworthy that some strategists believe that a bull market ends when (amid other conditions), the three most important conditions are: Yield curve inversion (see the subsequent point below); negative earnings growth and economic recession. For now, we have fulfilled two out of the three conditions.

Many parts of the yield curve are inverted; some of which with high predictive track record

On 3 Dec 2018, the yield curve for U.S. 3Y note and U.S. 5Y note inverted. In March this year, the yield curve for 3-month T-bills and U.S. 10Y inverted for the first time in about 12 years. The inversion reverted back before inverted again in May this year and is still inverted as of now. Based on a 2018 paper by the Federal Reserve Bank of San Francisco, this part of the yield curve inversion is more accurate as a predictor of a recession 12 months into the future.

The widely watched yield curve for 2-year and the 10-year inverted last month. This is considered to be the most liquid bond market. In other words, an inversion of this part of the yield curve may indicate that more people are bearish compared to moves in other parts of the curve. Furthermore, this inverted yield curve 2Y / 10Y has an impressive historical track record of preceding each of the last seven recessions since 1969. According to Bank of America Merrill Lynch, they said it can take eight to 24 months for a recession to occur after the 2-year and the 10-year inverts. (At the time of this write-up, 2Y / 10Y yield curve has reverted back. i.e no inversion as of now)

Geopolitical risks

There are various geopolitical risks. As protests reach a 14th week in Hong Kong, even though Hong Kong Chief Executive Carrie Lam has formally withdrawn the extradition bill on 4 Sep 2019, there seems no end in sight and violence seems to be coming back after some respite. As we approach 1 Oct which marks the 70th anniversary of the People’s Republic of China, it is possible that China may want to get the unrest in Hong Kong under control before 1 Oct.

According to Financial Times dated 31 Aug 2019, Argentina hit a technical default and has just started the process of restructuring its US$101b loans. Tensions between Iran and U.S.; Japan vs South Korea and North Korea doing their seventh test of short-range ballistic missiles and other projectiles in a month with North Korea citing that hope for more U.S. talks with U.S. are disappearing (in a New York Times article dated 31 Aug 2019) are also some problems which investors may want to contend with.

There are also other familiar concerns such as Brexit and Italy which may weigh in the next few months. All in, market continues to be buffeted by such risks whose outcomes and equity markets’ reaction to the outcomes are difficult to predict.

Global economic data continues to weigh

Global economy continues to slow from the various economic data spanning from South Korea, China, Germany and Singapore. For example, South Korea reported on 1 Sep 2019 that its exports slumped in August for a ninth consecutive month. This is on the back of weak demand from China, and depressed prices of computer chips globally. China manufacturing PMI released on 31 Aug 2019 fell to 49.5 in August, below economists’ estimate of 49.7.

German business confidence (i.e. German Ifo Business Climate) reported on 26 Aug 2019 were below forecasts and fell to 94.3. This is the lowest since November 2012. According to the Bundesbank, they predict that the German export-centred economy may contract in 3Q2019 amid a significant decline in orders, coupled with a substantial drop in sentiment indicators for manufacturing firms. Singapore may also be on the verge of a technical recession in 3Q2019 (defined as two consecutive negative GDP growth quarter on quarter). For 2019, the Ministry of Trade and Industry has cut their GDP estimates twice, currently to 0 – 1% for the full year 2019.

It is noteworthy that U.S. economy has been quite resilient despite the global slowdown. However, the recent Aug U.S. ISM Manufacturing data released on 3 Sep 2019 (49.1) marks the first contraction since August 2016 and is the weakest figure since January 2016. If this continues, it may be an indication that the global slowdown is gradually affecting U.S. too.

Composite leading indicators compiled by OECD (click HERE), also point to slowing economic growth momentum in the Euro area, Germany and U.S.

Global funds cut weightage in stocks

Based on a Reuters Aug 9-29 asset allocation poll of nearly 40 wealth managers and chief investment officers in Britain, Europe, Japan and U.S., they increased their weightage in bonds and cash holdings to the highest since early 2013 and reduced the weightage in equities to the lowest since late 2016. Approximately 46% (median) of the respondents cited a probable significant market correction by end 2019.

Safe haven assets surging

Assets typically seen as safe haven such as Japanese yen, is trading at near seven month high against the US Dollar. In fact, on 26 Aug 2019, the yen has touched an intraday high since Nov 2016. Gold, another asset perceived as safe haven, has been hovering near six-year highs at around US$1,515 an ounce.

Sep – Worst month (on average) for U.S. equities since 1937

Based on Chart 1 below, Sep is typically the worst month on average for stock market performance. Since 1937, the average September performance of Dow, Nasdaq and S&P 500 are -1.0%, -0.5% and -1.0% (rounded up) respectively. Based on Dow Jones Market Data, after an August when the S&P 500 has fallen more than 1.5%, both Dow and Nasdaq perform worse at -1.1% and -0.8% respectively. S&P500 performs marginally better at -0.9%.

Chart 1: Sep stock market performance

Chart 1_Sep stock performance

Source: Dow Jones Market Data

Tariffs may be exerting an effect on U.S. consumers in the next few months

Based on Chart 2 below sourced from Bank of America Merrill Lynch, the tariffs which are expected to be effective on 15 Dec 2019 comprise mainly of goods imported from China. These goods are likely to be very popular with consumers in U.S. and U.S. consumers may be the ones paying for these tariffs. One of the reasons why the U.S. economy is still relatively stronger than other economies is partly due to its strong consumer spending. If the above tariffs take effect, my personal guess (disclaimer: I am not an economist) is that the U.S. consumers may also take a hit.

Chart 2: Total U.S. imports of goods subject to China tariffs

Chart 2_Total U.S. imports of goods subject to China tariffs

Trade tariffs against EU may be another negative factor

On 17 May 2019, President Trump announced a six-month delay in imposing tariffs on auto imports from European Union (“EU”). It is likely that we will be hearing more of this in the next couple of months as Trump’s administration will decide whether to impose auto tariffs on EU in November. According to market watchers, the trade tensions between U.S and EU are more important than that of China. This is because considering the exports and imports of goods and services, U.S.- EU bilateral trade outstrips that between the U.S. and China in 2018 by more than 70%.

 

Factors which may cause markets to surge

Bearish sentiment may be a contrarian indicator to buy

Based on Figure 1 below, Bank of America Merrill Lynch’s proprietary bull and bear contrarian indicator flashed a buy sign on 30 Aug 2019, the first since 3 Jan 2019. In addition, JP Morgan also joins Bank of America Merrill Lynch in the bullish camp this week, citing positive technical indicators and monetary easing should be able to negate the uncertainty from U.S China trade war.

Figure 1: BAML Bull & Bear Indicator

Figure 1_Merill Lynch Bull & Bear

Source: Bank of America Merrill Lynch

Chart seems to have staged a bullish breakout

Based on Chart 3 below, S&P500 seems to have staged a bullish breakout with a gap up. Indicators such as RSI, MACD seem to be strengthening. A sustained breakout above its recent trading range 2,840 – 2,940 with volume expansion may point to an eventual technical measured target 3,040.

Chart 3: S&P500 staged a solid breakout on 5 Sep with a gap up

Chart 3_S&P500 chart 6 Sep 19

Source: InvestingNote 6 Sep 19

China and U.S. trade talks may yield meaningful progress next month

According to pundits who have been following China and U.S. trade talks, they are hopeful that there may be meaningful progress next month. According to Hu Xijin, editor in chief of the Global Times, he believes that the U.S. may be more open to discussion with China this time. Furthermore, based on a widely followed blog called Taoran Notes, they noted that the usage of “meaningful progress” by China’s Ministry of Commerce, the first time since May 2019, may mean that there may be a higher chance of “new developments” in the trade talk next month. If they are correct on a positive outcome in the trade talks, this is likely to have a positive effect to the market.

However, Carlos Gutierrez, former commerce secretary under President George W. Bush, has a different view and believe the odds are not high for significant breakthrough because the U.S. and China are “too far apart.”

Dividend yields higher than bond yields may be a support for stocks

Based on Chart 4, there may be some buying interest for stocks, as equities are trading at higher dividend yields vis-à-vis 10Y and 30Y U.S. Treasuries. Since 1945, according to Sam Stovall, CFRA Research in New York, he noted that S&P500 has registered an average return of 12% in the following year, 80% of the time, for in the past 20 times when S&P500 dividend yield is higher than the bond yield of U.S. 30Y Treasury.

Notwithstanding the above, I hasten to point out that should companies’ results worsen due to whatever reason, they may cut their dividends to conserve cash. Thus, readers need to consider various scenarios as always.

Chart 4: Dividend yields vs Treasury Yields

Chart 4_U.S. dividend yields vs U.S. Treasuries

Leading indicators for OECD area indicate stable growth momentum

Earlier, I have mentioned that the composite leading indicators compiled by OECD (click HERE), point to slowing economic growth momentum in the Euro area, Germany and U.S. Just to provide a balance picture, the leading indicators for OECD area seem to indicate stable growth momentum which may arguably be not so gloomy after all.

More stimulus measures from China

According to an article on Bloomberg dated 4 Sep 2019, China’s State Council advocated the “timely” use of instruments comprising of broad and targeted reserve-ratio cuts to support the economy. In fact, The People’s Bank of China announced last Friday that it would slash the reserve requirement ratio by 0.5% for all banks with an additional 1% cut for qualified city commercial banks. This move is expected to spur bank lending as economy slows. This also comes on the heels of an announcement by the State Council on 16 Aug 2019 that they have listed 20 measures to improve domestic consumption, from remodelling struggling department stores and refurbishing commercial pedestrian streets etc. These stimulus measures if executed successfully, are likely to have some positive effect on China’s economy, or at the very least, to the sentiment in China.

Relatively resilient U.S. economy from consumer aspect

U.S. strong consumer spending and jobs market are some of the factors which market watchers point out to counter the possible recession angle.

Some sceptics point out that even though consumer spending data is stronger than expected in Jul 2019, this may not be sustainable as personal income rises less than expected at 0.1%, the smallest rise since last September.

Technical drivers may be part of the reasons why yield curve inverts

According to a Reuters’ article dated 20 Aug 2019 which cited J.P. Morgan’s quant guru, Kolanovic view that the recent yield curve inversion may be due in part to technical factors such as bank hedging in an environment of poor liquidity.

Other strategists believe that the yield curve inversion may also be due in part to the global search for yield (negative bond yields in Europe and Japan); increasing central banks action and skewed bond ownership. Thus, it may not be an outright clear indicator that US is about to enter a recession.

In addition, some economists pointed out that the yield curve has failed to predict recessions in 1954 and 1965. Nevertheless, I am still impressed by its strong predictive historical track record (correctly predicted seven out of nine recessions).

 

Conclusion

As readers are probably aware, I have reduced my percentage invested from 150% in early June to 12% in early July. From July to mid-August, I have raised my percentage invested to 194% (with the help of CFD – leverage) by buying Hong Kong (“HK”) stocks around mid-August (I have informed my clients on some interesting HK stocks in advance). I have already taken profit on these HK stocks in the later part of August. It is noteworthy that my timing is not 100% perfect. If I know that HK market may surge more in the 1st week of Sep, I would have waited until then to sell all my HK stocks to reap even more significant returns. What I am trying to convey is that I do not know whether markets will continue to soar or start to drop. However, I am acting according to my plans. In other words, my market outlook; portfolio management; actual actions are in-line with one other.

For the above write-up, I have put in a balance view on the positive and negative factors surrounding our global markets now. Given S&P500’s chart breakout, there is a good possibility that S&P500 may move a bit higher in the near term, and may even reach 3,040 in due course. However, such potential upside of around 2% is not enough to lure me to be significantly invested in the equity markets. My personal opinion is that given the current market levels and information, I am cautious and am not comfortable to raise my current percentage invested from 53% to significant levels (say >80%). I am likely to wait for weakness to accumulate some stocks. As usual, readers should do their due diligence and exercise their own independent judgement.

 

Important caveat

Naturally, my market outlook and trading plan are subject to change, as charts and new information come in. My plan will likely not be suitable to most people as everybody is different. Do note that as I am a full time remisier, I can change my trading plan fast to capitalize on the markets’ movements. Notwithstanding this, everybody is different hence readers / clients should exercise their independent judgement and carefully consider their percentage invested, returns expectation, risk profile, current market developments, personal market outlook etc. and make their own independent decisions.

 

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