‘Who or what are Macaroni Union?’ you may ask. They are a British band who, according to Forbes, ‘have incorporated scientific theory to unlock the world’s most relaxing song.’ Apparently their song 'Weightless' is so effective that it is considered dangerous to listen to while driving. Don't try it at the office!
But back to markets… this feeling of weightlessness was far from an obvious outcome when I wrote my Equity Outlook late last year. Back then, in the aftermath of Donald Trump winning the US election, my main point was that 2017 would be anything but boring:
So far things have played out even better than in my optimistic scenario.
How did we get here? In short, markets have re-priced global growth prospects. Some of the improvement in leading indicators was likely already underway, but Donald Trump has certainly boosted some US business confidence measures and helped markets along as well.
While there has been plenty in his first few weeks in office one could disagree with, when it comes to the economy and markets it’s been all ‘Good Trump’ and no ‘Bad Trump’. There has been some delivery on deregulation promises, commitment to tax reform has not wavered, and the risk of geo-political mistakes has been assuaged by appointing a competent foreign policy team. What’s not to like? All in all it has been a very risk asset-friendly mix of macro news flow. Higher growth expectations have let equities cope well with rising Fed hike expectations; a textbook reaction.
Can it continue? Of course the answer to that question has to be ‘yes’. In theory, there’s no upper limit to how high equities can go, or to quote the Notorious B.I.G.: ‘Sky’s the limit’. Applying the TMT bubble’s PE to today’s earnings would put the S&P 500 at around 3,500. This puts the year-to-date rally into perspective: if we kept up the pace of the first two months, the S&P 500 would trade around 3,200 by year end.
A more sensible question is ‘how aggressive are the assumptions needed to justify these levels?’ I think about this in terms of earnings and valuations: what are realistic earnings estimates and what multiple would I pay for those earnings. Starting with earnings, $134 in 2018 seems achievable for the S&P 500, implying 7% earnings growth this year and 5% next year. Applying a PE multiple of 18x, the average of the past 2 years, to this EPS number would give an S&P 500 target of around 2,400 for end of this year. Unfortunately, this target is uncomfortably close to where we are today - in March. To get to significantly higher targets would require a significant upgrade to our global growth assumptions, or pushing other macro assumptions into uncomfortable territory.
It is, of course, not at all unusual for equities to trade north of fair value estimates. A return of retail investors could be one way to get equities to bubbly valuation levels. This source of equity demand has largely been absent from the bull market so far, but there have been tentative signs that retail interest is picking up. In the past this has sometimes been a signal that the equity bull market was entering its later and often excessive stages.
But when things feel comfortably calm and positive it’s even more important to not forget that even the most pleasant slumber can sometimes be rudely interrupted.
A sugar-induced bout of growth euphoria could end up with a nasty hangover. As Tim has argued, a fiscal stimulus is the last thing a US economy operating at close to full capacity needs. With an overstimulation, a pickup in inflation and faster than expected Fed hikes becomes a realistic possibility; markets could be on their way to anticipating the next recession by year end. It is equally likely that markets' current focus on ‘Good Trump’ underprices the risk that he follows through on his anti-trade and anti-immigration campaign slogans. We would also not completely rule out the risk of ill-advised comments raising geo-political risk levels. And we haven’t even mentioned China yet, where concerns about growth sustainability could easily resurface post the October handover of power.
So, what’s next? US equities have moved to the edge of what we would consider fair value. But fair value estimates are more art than science. They are also not useful tactical timing tools; equities can trade far away from perceived fair value for long periods of time. Instead, when equities rally beyond fair value it makes us more inclined to listen to tactical signals from our sentiment indicators. On that front we find no evidence of excessive investor bullishness, so for now we’re happy to keep a tactically neutral view of equities and enjoy the calm waters while we can.