Submitted by Nick Colas of DataTrek Research
I Am Everyday People
About the only thing that remains unchanged in capital markets since early January is the S&P 500, which crossed the “Unchanged on the year” line for the 8th time in 2018 just yesterday. In the meantime, rates and oil are up, the dollar is rallying and markets expect a more aggressive Fed. On the flip side, earnings expectations have ramped at an impressive pace. So what happens next?
“You buy back your book every day at the open.” That is the stock trader’s most productive mantra. Here’s what it means, in case the economy of language common to this vocation leaves you scratching your head:
- Everything that has happened in the past is irrelevant to your decision to hold on to a position in your portfolio (the “book”). If you made $100,000 on it yesterday, or lost $100,000, it doesn’t matter today.
- Holding on to a position overnight is therefore the same as buying it outright the next day.
- If you wouldn’t eagerly buy every stock you currently own at the open, something is wrong with your process. Because at 9:31am, that’s exactly what you’ve done.
Life lesson aside, there is another reason we bring this up: yesterday the S&P 500 crossed the “Unchanged on the year” line for the 8th time in 2018. In other words, markets seem eager enough to buy back their book at year-end 2017 levels, but are less certain about any other price. More than four months of news flow and US stocks are essentially unchanged on the year.
We cannot say the same thing about any other capital market that feeds investor confidence in US equities. For example:
#1. Crude oil prices are up 18% YTD, from $60.42 for WTI to $71.23 today. There’s some seasonality to how oil trades, as we mentioned yesterday. But the sentiment on oil prices has done a 180-degree shift in 2018 on geopolitical concerns and Russia/OPEC production discipline.
#2. US Treasury 10-Year yields have risen from 2.41% at the end of 2017 to 3.00% today. The highs for the year were back on April 25th, at 3.02%.
#3. US Treasury 2-Year yield has risen from 1.89% to 2.53%. That 64 basis point increase trumps the 59 bp change in the 10-year, which means the yield curve is modestly flatter than at year-end 2017. Hardly the sort of move you want to see, as the history of 2-10 spread tightening correlates strongly with upcoming recessions.
#4. The dollar (as measured by the DXY) may be relatively unchanged since the start of 2018, at 93.1 vs. 92.1 but look at the chart and the story changes. In January, the greenback was in a downtrend (good for stocks and risk assets). Now, it seems unstoppable to the upside.
#5. At the end of 2017, Fed Funds Futures markets believed the Federal Reserve would raise rates three times in 2018, ending the year at 1.90%; now the market’s best guess is giving even money on 4 rate increases (a point estimate of 2.2%).
#6: The same story holds for the market’s take on 2019 Fed policy. At the start of 2018, futures were discounting perhaps one bump of 25 basis points (to 2.07%). Now, they expect the better part of 3 rate increases (to 2.65%).
In short, every important market that informs US stock valuations has moved against us.
Stocks have one ace in the hole, however: corporate earnings. Here’s that data (courtesy of FactSet):
- Earnings expectations for the S&P 500 have risen by 8.8% for 2018 since the start of the year. The point estimate in early January was $147/share; now it is $160/share.
- Estimates for 2019 are up 8.6%, from $162/share to $176/share since the start of this year.
Look at those numbers again, because this is important. Wall Street earnings estimates have essentially come forward by an entire year in the last four months. Where analysts had $162/share for 2019 back in January, they now have $160/share for 2018.
In one respect, that’s an impressive shift and highlights the strength of the current US equity earnings picture.
But it is also troubling, because as we outlined at the start the S&P 500 is unchanged on the year. That’s how strong the other headwinds we listed have been. Were it not for dramatically higher expected earnings, US stocks would certainly be lower today.
So, do we “buy back our position” in the S&P 500 tomorrow morning? The short answer is “Yes”. The reason: those increases in expected earnings combined with a stagnant YTD market means US large cap stocks now trade for 16.8x this year’s earnings, rather than 18.4x where they started 2018. And with almost half the year in the bag, 2019 earnings expectations also matter. The S&P 500 trades for 15.3x Wall Street’s latest estimates there.
Yes, we know P/E ratio analysis alone is no investment edge, so here’s the rest of our thinking:
- US equities have absorbed a lot of bad news in 2018 (our list above).
- Earnings estimates have continued to increase anyway.
- The result has been an S&P 500 that has treaded water rather than drowned.
- At some point, and it could be soon, the capital market narrative that drives asset prices will shift to “the bad news is in the market, but the good news (earnings) is not”.
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