In focus - Market Views: Equities
Five charts to gauge the environment for equities
Judging the end of the market cycle is difficult. Here, Schroders fund managers - including Nick Kirrage, Nick Kissack and Alex Breese - discuss charts that have caught their eye.
Unstructured Learning Time
Stock markets wax and wane. The period of time in which they move from a state of expansion (bull market) to one of contraction (bear market), before expanding again is known as the “market cycle”.
Last year was an extremely difficult one for stock markets, prompting much commentary as to which ones had "corrected" (falls of between 10% and 20% from a recent peak) and which were technically in a bear market (falls of 20% or more).
Experienced market participants say that a gruelling 2018 might be a precursor to a better 2019 (see Schroders’ outlook for the coming year). However, a more challenging environment may be here to stay given the uncertainties facing the global economy. The speed at which quantitative easing (QE)1 is scaled back and global interest rates rise from this point onwards is unclear. US-China trade relations could improve or worsen, political tensions elsewhere might deteriorate or be resolved – these are just some of the unknowns ahead.
During the past decade, investors have enjoyed some very rewarding times when shares have spent protracted periods moving higher in lockstep with each other. More recently, share price correlations have fallen while volatility2 and performance “dispersion” have risen – dispersion is a measure of the difference between the best and worst-performing stocks.
In sum, markets have been behaving less uniformly, potentially creating opportunities and threats for investors.
Stock pickers are using volatile markets to back new ideas cheaply, but at the same time they don’t underestimate the challenges ahead – many expect top and bottom performers to become a much more important determinant of overall portfolio performance, and poor selection to be punished harshly.
Chris Taylor, Head of Alpha Equity, says: "As volatility and dispersion increases, you are raising the opportunity set for stock pickers. Rather than thinking about what product to use, investors need to think about their time horizons and avoid making knee-jerk reactions. Sell-offs can provide opportunities, so being patient and not too focused on the short term is critical."
Here is a selection of charts which some of Schroders’ fund managers have been studying to help them better gauge the market they operate in.
Is history at risk of repeating itself?
Prior to the fall in stock markets in late 2018 managers from the Schroder Global Value Equity Team flagged the below chart, alongside an article which investigated the sustainability of ever-higher “price/earnings multiples” for technology stocks. These include the so-called “FAANG” stocks of Facebook, Amazon, Apple, Netflix and Google. You can visit The Value Perspective website here for details of this analysis.
A share price can rise simply because investors view a company more favourably, without any tangible corresponding change in the company’s prospects. Collectively, investors ascribe a higher value to its stock, which, as a consequence, is said to enjoy a “re-rating” by the market. For the FAANGs, until very recently, this expressed itself as increasingly higher price/earnings multiples.
The price/earnings multiple is a valuation metric which is popularly used when analysing “growth stocks” (such as technology shares). It compares a company’s share price to its expected earnings for the year ahead. Growth in a valuation metric is one of three drivers of share price returns, the other two being dividends and earnings growth. A common trait of a growth stock is that the company prioritises reinvesting surplus cash back into itself in order to expand, so dividends are not an important driver of such shares.
For much of the last decade technology investors could argue that they were paying up for the prospect of decent medium-term earnings growth. However, as growth began to slow it became more difficult to argue this case. The FAANGs, and other so-called momentum stocks, became reliant on higher valuation multiples to drive their shares up. Technology, media and telecom (TMT) shares rose to unsustainable levels for much the same reasons in the late 1990s.
The chart illustrates how, in the three years prior to the US equity market hitting all-time highs last autumn, technology stocks – especially the Nasdaq index, which is home to all five FAANGs – were an increasingly important driver. The re-rating has subsequently reversed, weighing heavily on US equities, which have “de-rated” since October 2018.
Nick Kirrage, Fund Manager, Equity Value, says: "The FAANGs and other momentum stocks had become almost entirely reliant on multiple expansion for their share price growth. And, to put it bluntly, an environment where price/earnings multiples were rapidly outstripping even the most bullish of sell-side analyst forecasts had echoes for us of the long build-up to the dotcom bubble in 2000."
High expectations for the FAANGs, it appears, had left little room for disapointment. High expectations for profit margins are also under scrutiny as another potential risk for equity markets...
Investors appear optimistic about companies’ ability to expand profit margins
Since the global financial crisis many major economies have experienced long periods of uninterrupted economic growth. As a result some of the key inputs required to sustain growth, such a labour, are now less plentiful, as might be expected at an advanced stage of the “economic cycle”3 . This is already evident in the “macro-economic” data (rates of unemployment are at record lows and wage growth is picking up in many developed economies), and has also become apparent at the company, or “micro-economic” level.
The chart below from Morgan Stanley shows the proportion of European industry groups whose profit margins 4 grew year-on-year since the early 1980s, and the proportion of those forecast by sell-side analysts (the “consensus”) to grow profit margins in 2018, 2019 and 2020. It seems expectations are very high, with consensus forecasting 90% or more of industry groups to grow margins of EBITDA (a measure of profits) in both 2019 and 2020.
Alex Breese, Fund Manager, UK Equities, says: "When analysing companies, we look for an attractive risk-reward profile, focusing not only on the upside opportunity, but also the downside risk. At the end of last year we found that cost pressures had taken on more significance when assessing the risks. These pressures may have been tempered somewhat following the recent fall in commodity prices. However, expectations for future growth in profit margins over the next two years appear to set a high hurdle, at what is a relatively advanced stage of the economic cycle.
"Therefore we remain cautious around future earnings forecasts in many sectors but we also feel that investors with a contrarian strategy should be well equipped to avoid such elevated expectations, which are typically found in the more highly rated sectors/stocks."
Investors have been taking increasingly more risks
In another potential sign of complacency, equity investors have been increasingly prepared to back speculative initial public offerings (IPOs)5 as the market cycle has progressed. The chart below tracks the proportion of IPOs with negative earnings, and contains another important message, believes the Schroder Global Value Equity Team.
Kevin Murphy, Fund Manager, Equity Value, says: "With the percentages of IPOs with negative earnings nudging up towards those last seen in the run-up to the dotcom crash, the implication is that it is easier to IPO a loss-making business towards the end of a market cycle. It is definitely indicative of more risk-taking by investors.
"We take notice when traditional principles such as patience, prudence and a focus on valuation and balance sheet metrics start to appear outmoded and unexciting."
At the end of last year economists (modestly) downgraded their growth forecasts for the global economy and perceptions at the micro-economic level appear to be shifting too. According to Bank of America Merrill Lynch’s January survey of global asset allocators, credit quality has moved firmly centre stage. The survey found that investor demand for companies to improve balance sheets was the highest since September 2009.
Market-wide volatility picked up at the end of 2018…
Market-wide volatility picked up sharply at the end of 2018, with the Chicago Board Options Volatility Index (VIX), called the market’s “fear gauge”, spiking above 30 in December (see chart, below). The VIX reflects the amount of volatility traders expect for the US’s S&P 500 during the next 30 days. Rising market-wide volatility has, in the past, predicated periods of both negative (and positive, depending on the severity of the volatility) performance for markets, as explained by Schroders’ article here.
…was elevated individual stock volatility a red flag for this?
The increase in market-wide volatility experienced at the end of 2018 should not have come completely out of blue, say those who noticed a pick-up in individual stock volatility which preceded it.
The chart below tracks average share price moves (higher or lower) on results day for European companies, relative to average share price moves on a “non-earnings day”. Average non-earnings day share price moves are a good approximation of market-wide volatility, and, in general, the ratio has been above average since the financial crisis because markets have been so calm.
During Q3 2018, the ratio spiked to its highest level since Goldman Sachs began tracking the data in 2003. This occurred as an increasing number of shares experienced extreme price moves on results day, in sharp contrast to the otherwise calm market conditions, and, in many cases, despite earnings being in line with expectations.
Research from Ernst & Young (EY) looking specifically at profit warnings from UK-quoted companies recorded fewer alerts in Q3 2018 versus Q3 2017. However, the warnings generated average share price falls of 21%, comparable to the reactions seen 10 years ago at the height of the crisis. In the view of EY, the market’s focus has “shifted to future uncertainties” and investors “clearly want to be backing the fittest, most agile companies".
Nick Kissack, Fund Manager, Europe Desk, says: "This late in the business cycle, you tend to see individual stock volatility pick up ahead of an increase in market volatility. Added to their growing concerns around corporate margins, investors are very nervous about stock market valuations, trade wars, tightening global monetary conditions, political uncertainty and, at the same time, are questioning how long the market cycle can continue."
Bill Casey, Fund Manager, Europe Desk, says: "As a result of their nervousness, investors’ time horizons have become much shorter and, it seems, they are more prone to overreact to any incremental piece of bad news, potentially opening up good opportunities for long-term investors. At the same time the new environment is less forgiving of poor stock selection, and we’re likely to see the top five/bottom five performers become a much more important determinant of overall portfolio performance."
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1. QE is effectively central banks injecting money directly into the financial system by way of asset purchases (buying mainly bonds) to keep lenders lending and corporates spending and support economic growth. QE has been giving way to quantitative tightening (QT) as central banks have turned net sellers of bonds to remove money from the financial system.↩
2. Volatility is a statistical measure of the fluctuations of a share price and share price correlations measure how closely stocks move in relation to each other. Correlations and volatility can be used to describe conditions at the stock, sector or market level.↩
3. Economic activity waxes and wanes and the period of time in which an economy moves from a state of expansion to one of contraction, before expanding again is known as the business, or “economic cycle”.↩
4. The analysis is based on EBITDA (earnings before interest, taxes, depreciation and amortisation) margins, a popular measure of profitability used by analysts to compare different industries or businesses.↩
5. An initial public offering, or IPO, is the first sale of a company’s shares to the public, prior to them being admitted to trading on a stock market. ↩