Since the UK surprised the world on June 23, 2016 by voting to eventually leave the European Union, US equities and bonds have rallied remarkably. As the Federal Reserve does not make public the relevant data, it is difficult to measure international capital flows. However, given the timing of the US rally, it seems pretty apparent that a good deal of European capital has flowed into US based investments in the aftermath of that vote. Since the referendum, the S&P 500 has rallied 4% and the yield on the US Treasury 10 Year Note has fallen to 1.58%. Insofar as the US is really the only developed economy in the world currently with both positive real GDP growth and positive interest rates on sovereign debt, this huge capital transfer away from continually disappointing Eurozone markets is pretty understandable.
The rally in both US stocks and bonds has been a welcome relief from the long consolidation of prices going back to early 2015. However, there is a justified concern that this move may be pushing valuations to unsustainable levels. The PE currently for the universe of stocks we follow (approximately 300 US based all-cap companies) has stretched to 18.38 times forward earnings. There is room given historic valuations for that PE to expand further, however it is approaching the upper limit of its historic range (19.73 times forward earnings).
We would characterize the recent rally in stock prices as largely liquidity driven. That is, persistently low (and falling) interest rates around the world, as well as the changing dynamics in Europe from the Brexit fallout, have driven investors into US investments en masse. All else being equal, valuations can certainly remain stretched for a considerably long period as long as investors feel there are no other reasonable alternatives in the world. However, “stretched valuations” sometimes have a tendency to morph into “bubble valuations” given the right circumstances, which is something we obviously need to guard against. I do not believe US equities are at that point quite yet. Valuations are still within a normal historic range and there is simply too much liquidity around the world looking for returns.
Nonetheless, we do believe that valuations will ultimately have to moderate. Depending on how the earnings of US companies unfolds over the next few weeks or months, such a moderation could take several forms. The first scenario would be that earnings dramatically improve this year and the stretched valuations we speak of simply erode away as earnings and economic fundamentals justify the currently high prices. Obviously, that would be the most desirable solution, as the need for any market correction from excessive valuations would simply fade away. Plus, good earnings are usually accompanied by a stronger economy and stronger employment and all that goes with that. In fact, we have seen some signs that the Rising (E)arnings scenario might be taking shape. Several companies have reported surprisingly good and high quality earnings as of their 6/30/2016 reporting period; notably, Microsoft, JP Morgan Chase, and General Motors, as well as several defense companies and airlines. In the aggregate, as of the
time of this writing, 64% of the S&P 500 companies that have reported their 6/30/2016 earnings have beaten the average estimate for earnings from the analysts that follow those companies. That is an encouraging indication that US companies are beginning to generate decent earnings and cash flow once again, however, we would want to see a few more quarters of similar strength before being convinced of an earnings recovery for US stocks.
A second and probably more likely scenario than the Rising (E)arnings idea would be that the Fed, which has pretty clearly communicated its predisposition but inability to raise interest rates, would feel empowered by moderately improved earnings and a marginally stronger macro-economy to push through a higher short term interest rate. A higher fed funds rate and higher target rate on excess bank reserves would likely strengthen the US dollar, thus making US exporters less competitive. As well, commodity prices and particularly oil would weaken. Our feeling is that the Fed might actually feel compelled to use this very strategy to contain stock prices if prices do continue to rally into a perceived bubble valuation in spite of only a marginally improved economy otherwise. Higher interest rates do absorb liquidity, so consequently and at the margin, any stock price appreciation attributable to excess liquidity should be unwound quickly.
The third possibility that we see that could reverse the liquidity buildup in US equities would be that the European flight to US assets suddenly reverses itself. It seems to me that the European Union has a lot of issues to work out in the wake of the British referendum before investor confidence can be restored to pre-referendum levels. Currently, that seems like a tall order given the Syrian refugee crisis, the recent coup attempt in Turkey, and renewed populism and nationalism in several EU countries. It will likely take several years for the European Union to work through the integration problems that the Brexit referendum exposed. Consequently, it’s pretty unlikely that US equities would reverse their recent course from a sudden flight of capital back to Europe.
Therefore, our belief is that the recent rally to new high valuations may be sustainable. We would become increasingly more skeptical were valuations to continue to inflate, especially beyond the historic high valuation of 19.73 times forward earnings. Conversely, were the extremely loose supply of money and liquidity to reverse (higher interest rates), we would also look for valuations to moderate.
Finally, with aggregate growth in the US (Real GDP) seemingly stuck at 1.5% - 2.0%, we will likely need to continue our more active strategy of taking profits where individual issues appear over-bought and rolling into issues that appear over-sold. In such an anemic environment for growth, holding on to over-bought securities awaiting underlying valuations to catch up usually necessitates intolerably long periods of underperformance in those specific issues.
As always, please feel free to contact us if you have any questions or if you need to schedule an appointment to discuss your account or financial plan with us. This is particularly important if you have experienced a big change in your life recently (got married, retired, changed employment, bought/sold a business, etc.).
2015 Form ADV Notice and Offering – the firm’s 2015 amended Form ADV Part 1 & Part 2 filings with the State of Colorado Division of Securities and other regulatory bodies were filed timely 03/15/2016 and amended 06/09/2016. If you would like a copy of this important disclosure document, please contact us at (303) 442-3670 or email@example.com and we will be happy to deliver it to you at no charge.
Mark P. Culver
Culver Investment Company, LLC
360 Interlocken Blvd
Broomfield, CO 80021
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