It has been one of the greater paradoxes of the record S&P rally from the February lows: how has the market continued to rise even with unprecedented outflows? In other words, “Who‘s buying equities?”
Overnight, Barclay’s chief equity strategist Keith Parker asks that very question, pointing out that global equities have continued to rally despite $128bn of outflows from equity funds since mid-March. His answer: futures buying (which has traditionally been associated with central bank intervention), whiuh since March ($60bn notional) has surpassed the amount of buying between October 2011 and May 2013,and which together with short-covering has more than offset the outflows.
He notes that with that dramatic shift in positioning basically done, retail and foreign investors are the incremental buyers/sellers of equities; S&P 500 returns have been 49% correlated with shifts in their combined ownership over the last 20 years. Active equity MFs are selling amid large retail redemptions while foreign investors are also selling US equities.
In other words, it may be all up to retail now:
“A turn in retail/foreign sentiment and a resumption of equity inflows would get markets back to more of a grind since the positioning-driven bounce has played out, but still elevated active manager positioning leaves the market vulnerable to risks.”
So, to better assess the path for equities and identify potential opportunities, Barclays seeks to better understand the buying dynamics across the investor and corporate landscape and provides the following observations:
- Since March, $60bn of net buying of US equity futures (notional) and $60bn of flow from short-covering in S&P 500 stocks more than offset the $50bn of outflows from US equity ETFs and MFs. Dynamics outside the US were likely similar. Short interest is back to 2015 lows and the equity HF beta is very high, leaving equities vulnerable.
- Equity MFs are net sellers given $164bn of redemptions since April, driven by retail. ETF inflows only offset some of the MF outflows. We are concerned that US equity funds are not prepared for a continuing redemption cycle with cash levels low.
- The rebalance into equities the end of June helped drive stocks higher, fuelled by the $2.5tr jump in the market value of bonds globally YTD ($1tr since May). The bond-equity correlation has risen over the last month, which is a risk to equity returns, and Fed comments at Jackson Hole (August 26) could be pivotal once again.
- Foreigners have been buying US bonds ($28bn per month) but selling US equities. Weekly data show that Japanese net buying picked up after May and spiked in mid- July, suggesting a return of the foreign buyer. Importantly, while net purchases of equities have fluctuated, gross purchases by Europe and Japan have surged, suggesting that QE may indeed be having a sizeable impact.
- With $1tr of annual dividends paid out globally and S&P 500 firms buying back over $500bn of stock on net, corporates remain the primary driver of equities. Strong Q1 buybacks likely primed the pump for the rally, but S&P 500 gross buybacks declined by $22bn in Q2 and 12m announcements are down $115bn YTD. Across sectors, actual net buybacks for healthcare and discretionary declined markedly from Q1 to Q2, while those for staples and financials rebounded sharply. Announcements for staples fell considerably, while those for technology rose and financials jumped.
- Across regions, Europe equity outflows YTD (-$85bn) reversed two-thirds of the post QE inflows and Europe MF positioning is underweight. EM equity MFs are also underweight as inflows have picked up. Across sectors, short-covering has been the primary driver of performance, but recent fund flows have gone to cyclical sector funds as defensives have had outflows. Across styles, small cap MF positioning is underweight as inflows picked up last week.
This brings us to the key disconnect: equity rally despite large equity fund outflows.
To better assess the path for equities, we seek to better understand who has actually been buying through the equity rally. In particular, there is a clear disconnect between the magnitude of the equity rally (MSCI AC World +8% since mid-March) and the magnitude of the outflows from equity ETFs and MFs ($128bn since March). Thus, it raises the questions of who has been the incremental buyer and whether the dynamics are sustainable.
What Barclays finds is simple: Futures buying and short-covering has fueled the rally, specifically “buying of US equity futures and short-covering in single stocks have been a primary source of fuel for the equity rally (~$120bn since March), more than offsetting the $50bn of outflows from US equity ETFs and MFs. Although the analysis below is based on US futures and short interest because of data availability, we would suspect that the same dynamic has played out outside the US as well; that futures buying and short-covering have offset the outflows from equity funds.”
Barclays also notes, that net buying of US equity futures since March ($60bn notional) has surpassed the amount of buying between October 2011 and May 2013 (Figure 2). In less than five months, positioning in futures has seemingly swung as much as it did over the 20-plus month period following the 2011 lows. We would argue that the dramatic shift was more warranted after 2011 given the introduction of extraordinary Fed policy (calendar guidance, Twist, QE3), a pickup in growth after a mid-cycle slowdown and a reduction in risk from Europe. Central bank policy globally has remained extremely accommodative, but the economy is grappling with some later cycle dynamics as the Fed is still trying to hike a second time.
Separately, for S&P 500 stocks, the flow to US equities from short-covering since March has been $60bn, and $26bn since June (Figure 3).
Indeed, short interest has fallen to the lows of last year as perceptions of risks have seemingly reset. Commensurately, our measures show equity HF net exposures are very high (Figure 4) amid the futures buying and shortcovering. The wall of worry, as measured by short interest and HF net exposure, has come down.
A quick look at the sellers reveals that active equity mutual funds continue to sell. As a result, Barclays says that one key risk to equities was the acceleration of redemptions from active equity MFs as positioning at funds was very elevated (i.e. low cash levels). Total outflows from equity MFs have been $196bn YTD with a monthly pace of about $40bn since April (Figure 5).
Accordingly, mutual funds have been large net sellers of equities. On the other side, ETF inflows have not been enough to offset the MF outflows. The DOL’s new fiduciary regulation is likely to keep MF redemptions at an elevated pace, and as such Barclays is again concerned that higher risk exposures and lower cash levels at equity MFs make the market more vulnerable (Figure 6). US equity MF beta is 1.4 std above average, levels that have historically coincided with market pullbacks.
And while the current trading pattern of increase equity futures buying coupled with a short squeeze, may well continue, Barclays notes that “the rise in the bond-equity correlation is a risk.” To wit:
The S&P 500 and the Barclays 20+yr US bond index have more than doubled since 2005 as yields have fallen with the long bond considerably outperforming since last year (Figure 7). The $2.5tr increase in the market value of bonds globally YTD ($1tr since May) dwarfed the excess cash on the sideline on our measures. The ensuing rebalance into equities around the end of June helped drive stocks higher as rates stayed relatively low. Equity-bond allocations are back to fall 2015 levels while cash ratios have fallen notably as both equities and bonds rallied.
However, as equities and bonds have both moved higher, the correlation between bonds and equities has risen considerably over the last month (Figure 8). The extreme negative correlation allows many multi-asset funds to have higher (and leveraged) exposures to both bonds and equities given the lower volatility of the diversified portfolio. A shift in that correlation could lead to weaker equity returns, as it did last spring and in 2013.
As a reminder, this is a concern voiced by BofA last week which pointed out that a sharp, concurrent move in equities and bonds, in either direction, could unleash another round of “risk parity” deleveraging, and lead to the next market drop.
So if index future buying is set to fizzle, and no more shorts are left to be squeezed, who will keep on buying? To Barclays the answer is two-fold: foreign and retail buyers.
From a demand perspective, the bank believes that foreign and retail investors are the incremental buyers (or sellers) of equities with US institutional equity allocations already at or near the highs and their cash levels fairly low. Against a secular downtrend, household ownership of equities plummeted during market collapses of 2000-2003 and 2007-2009 (Figure 15). On the other hand, flat to higher household ownership through 1996-2000, 2004-07 and since 2009 (or 2012) coincided with market rallies. All the while, foreign investors have been increasing exposure to US equities, particularly the late 1990s and 2008-2014.
Meanwhie, foreign investors have been selling US equities on net since 2014 and foreign ownership levels have edged lower. Household ownership has drifted higher, suggesting that retail investors in the US are buying equities. Figure 16 shows the change in the combined ownership of households plus foreign (x-axis) graphed against S&P 500 yoy returns; US equity returns have been 49% correlated to the combined shifts since 1996.
So far we have ignored the elephant in the room: not the marginal, but the base buyer – corporate buybacks. Here is a quick recap on where they stand currently.
The biggest buyers of equities are corporates themselves with S&P 500 net buybacks rising to $500bn over the last four quarters from $375bn in 2013. To put that into perspective, total inflows into equity MFs and ETFs were $159bn in 2013. With about $1tr of dividends being paid out globally, reinvested dividends are also a key source of flow, particularly outside the US where buybacks are less popular. Reinvested dividend payments rose in early August. The drop in IPOs YTD (~50%) and the continuation of M&A have also been supportive from a demand-supply perspective.
Based on those S&P 500 companies that have reported buyback data for Q2, gross buybacks fell by $22bn (-15%) from Q1 to Q2 and net repurchases declined by $11bn (-10%) (Figure 16). For the first time since 2012, more S&P 500 companies reduced the amount of buybacks in Q2 than increased the size (Figure 17). However, this followed a strong Q1 when companies seemingly upped repurchases during the selloff. Trailing four quarter buybacks remain stable. We would expect flat to mildly lower growth in Q3 as weak comps roll off. As a percentage of market cap, net buybacks in Q2 are 1.5% annualized, about the same level of 2012-2014 as buybacks have kept pace with market value.
What has been unsaid about all the above is that the one thing that is permitting all of the noted trends, are record low government and corporate yields, which in turn continue to lead to “financial repression” and a forced TINA purchase of equities around the globe. As some strategists have pointed out, as of this moment the only thing that could spoil the part is a pick up in inflation, which however is paradoxical since to a majority of the US population, those who are affected by record high rents and surging health insurance costs, not to mention college tuition costs, inflation is already a major issue. Which is why it is unlikely that the Fed will proactively intervene, even though as Deutsche Bank warned over the weekend, doing that will lead to even more pain for the economy until the disconnect between asset prices and fundamentals will grow so massive, that an entirely new paradigm shift will have to arrive to justify valuations. Then again, considering that GAAP PEs are in the mid-20 range, one can argue that the paradigm has already arrived.
via http://ift.tt/2buED8q Tyler Durden