Scary Monsters: Nightmare on Wall Street?
How are we to understand stock market action that has sent many markets spiralling into bear market territory? Global markets have reacted negatively to three important developments underpinning stock market action.
In the context of the current global economic environment, many renowned market strategists, such as Ed Yardeni, concluded that conditions are not in place for a major bear market, and that markets should recover. We tend to concur, with the caveat that too many analysts have arrived at similar conclusions. In the face of what are sometimes quite alarming market falls, are too many being too complacent?
Usually, for a sharp market recovery to take place after a downdraft, sentiment has to become much gloomier so that really adverse outcomes are priced into values. Remember all that ink that was spilled on doomsday commentaries with respect to the Eurozone in 2011, when yields on distressed country debt started to decline and stock markets embarked on an upturn?
Something that could be contributing to markets swooning beyond a reasonable point is the increasing prevalence of automated trading by super-computers. Many of these computers are programmed to detect momentum. They have seized on the current market direction and have a trading orientation that drives markets lower.
Any sensible market strategy must be grounded in valuations. Renowned finance author Burton Malkiel provided one in an essay for The Wall Street Journal in early 2015. He drew upon the cyclically adjusted price earnings multiples (CAPE) for the major regions of the world economy. The divergences are striking: Before the current swoon, the CAPE for the US was an extremely expensive 26, 20 for Japan, a more appealing 15 in a recovering Europe and less than 10 for emerging markets.
There are three important points here:
1. These metrics are not timing indicators, so they cannot be used to ascertain the right time to start buying equities again.
2. If markets are selling off because Wall Street is leading the way, in turn because its own securities have become too highly valued, you cannot protect yourself by acquiring assets in cheaper markets in other global regions. Usually, the major Wall Street markets are defensive in any global market downdraft, even if Wall Street itself is the source of it.
3. In the short to medium term, these valuation discrepancies create substantial opportunities. Participants at Davos in 2015 hoped to discuss the “Fourth Industrial Revolution”, in which robotics, artificial intelligence, machine learning, and other related technologies are in the vanguard of sustained economic advance. Lambda operates within this space. During earlier waves of industrial progression, countries that developed a technological or process edge retained it for many years. Today, because of the Internet and other new technologies, advances are rapidly dispersed around the world. Models of corporate performance in different markets also highlight a variable called “entrepreneurial talent”. While this may be more abundant in developed markets, their edge is fading, as children in developing countries increasingly learn from the same online programs as children in wealthy nations. Markets are priced as if developed markets like the US and Japan will retain an enduring technological edge, but even if they do, it will not be to the extent that markets suggest.
Growth, or the lack of it, is vitally important in aggregate earnings in major markets. Broadly speaking, earnings have been under pressure in markets such as the FTSE (which has a heavy commodity weighting) for some time. Essentially, all valuation models indicate that equities prosper when earnings growth occurs; equity investments always struggle when earnings contract.
Markets are good at looking through a current contraction to more prosperous times. A future post will explore the outlook for corporate earnings and their relation to valuations.
An interesting investment strategy would be to seek out undervalued assets, where the valuation differential understates the potential for technological catch-up. For example, consider how downbeat many investors are about Brazil. Does this make sense? Although the current political climate casts a shadow over economic and financial discussions about Brazil, think about the country’s relatively high real interest rates, and recovering non-commodity exports.
Modern technology is less of a basis for enduring differentials than before. Today, quality of governance and institutions can be just as important in establishing the degree of catch-up and productivity advances.