Rudi's View | Jul 17 2024
By Rudi Filapek-Vandyck, Editor
Today’s markets are confusing many, not in the least because many traditional indicators don’t seem to apply anymore.
Us, humans, we like to at least have some sense of control or predictability about things, and when that “security” drops away, we feel uncomfortable.
This, to a large extent, explains why today’s bull market has not been widely embraced as a positive phenomenon. There are way too many contradictions involved.
When the Federal Reserve (and other central banks) embarked on a steep tightening path in early 2022 it didn’t take long for bond markets to invert; whereby short-term yields exceed those further out on the yield curve, which is a classic signal that economic recession is on the horizon.
The US yield curve started inverting in mid-2022. Two years later, the expert community is still debating whether there will be negative economic growth or not. Locally, the official statistics have remained in positive territory because of seldom-witnessed immigration influx.
The RBA might yet deliver one more rate hike, but other central banks outside of outlier Japan are all preparing for policy loosening, i.e. rate cuts. The global policy reversal has already started, now also including the RBNZ.
Bond markets in Europe and the USA have already started to price-in rate cuts before year-end. Clearly, this is a positive for equity markets… as long as that anticipated economic recession does not follow next.
Can investors simply rely on financial markets getting it right? Of course not! Markets reason in the here and now and if/when signals change down the track, they simply re-adjust accordingly without blinking first.
2024: The Big Dichotomy
A lot is being written about the dichotomy in share markets where a small selection of strong performers keeps pushing indices to fresh all-time record highs, leaving behind a large majority that simply cannot catch a bid, outside of the occasional attempts for momentum reversal.
There’s an even greater contradiction happening between numerous traditional indicators pointing at economic recession and economies simply refusing to play to that script.
With the bulls firmly in charge of share markets, the bears have their indicators to rely on, but little else. Sour grapes, heartache and migraines, maybe?
Calls and predictions of a severe share market correction, let alone a crash, have been well off the mark and completely out-of-sync with markets that rally further into blue sky territory.
In defence of the many Cassandras, today’s dichotomy surrounding some of the most used indicators is quite remarkable, and possibly unprecedented. It might even elicit the occasional observation that this time, indeed, things do look different.
Apart from the two year versus 10 year yield curve (we know bond markets don’t always get it right), the equally closely followed ISM index, believed to be in lock-step with economic momentum albeit more skewed towards manufacturing, has generated a negative reading for 19 out of the past 20 months. March this year is that one positive exception.
To date, there has been no previous precedent of this magnitude. If history were a carbon copy for today’s world, economies would be in deep doo-dah by now. But they are not.
Another indicator that turned strongly negative at the end of 2022 was M2 money growth in the US economy. This is why so many remained sceptical about equity markets throughout 2023. But M2 money growth has again turned positive.
The latest indicator to raise eyebrows is the so-called ‘Sahm rule’ that stipulates when US unemployment rises by 0.5 percentage points (or more) from its trough, economic recession will follow next. That increase is measured from the three-months moving average in the official unemployment rate. Economists will tell us the Sahm rule has accurately predicted all American recessions in the modern era.
But in light of all the other failed indicators, is 2024 the exception that breaks this indicator’s perfect track record?
Corporate Earnings & Valuations
The general picture doesn’t change when we zoom in on what has transpired in share markets since october last year.
After that strong rally from (in hindsight) beaten down levels, markets have been flashing overbought warnings since early 2024 and in-house sentiment indicators at the likes of Citi and Macquarie are suggesting sentiment is too ‘hot’ overall, but July yet again is paying no attention.
Share markets are trading on multiples that look elevated by historical standards, nobody denies it, but this is at the same time where general agreement stops. Are Nvidia shares really in a bubble when its EPS has grown by 452% in FY24, with a further 100%-plus to follow for the current financial year?
Yes, it is true, only 24% of stocks in the S&P500 have outperformed the index over the first six months of the year, possibly an all-time low, with the equalweighted index only up 5%, not that different from indices locally.
But there’s equally a valid argument in that those outperformers are carried by strong growth, supported by megatrends such as GenAi, data centres and GLP-1s, also offering a lower-risk profile in light of higher-for-longer bond yields, a tepid deceleration in inflation, and still valid questions about the outlook for economies.
To further add to that argument: earnings for the so-called Magnificent Seven grew by 51.8% year-on-year in Q1. For the rest of the pack, the comparable number is only 1.3%.
As pointed out by more supportive market observers: earnings forecasts, in particular for Gen.Ai-related beneficiaries, have continued rising, which has subsequently translated into further share price gains.
The not-so-supportive sceptics have a point though: earnings growth cannot possibly keep going at current breakneck pace.
At some point, one has to assume, at least a pause in the uptrend will announce itself. Whether that pause shows up in the upcoming Q2 results season in the US looks highly questionable, but investors shall soon find out.
Two reasons for investors to not throw caution in the wind, either today or later:
-when stocks trade on high multiples small downward changes can have a rather large impact on modelled valuations and the share price
-there’s a lot of crowding going on in today’s share market winners. If/when parts of these funds start flowing elsewhere this too can have an outsized impact in the moment
Market consensus is currently positioned for 8.8% earnings growth in Q2 on average for the S&P500. If this number survives the actual results, Wilsons points out it will mark the strongest year-on-year growth since Q1 of 2022 when 9.4% was achieved. Eight of eleven sectors are expected to report growth in Q2.
Currently the average multiple for the S&P500, forward-looking, is 21x but Wilsons points to the fact that multiple drops below 18x when one strips out the winners from the technology sector.
That median multiple ex-Mag7 doesn’t look extremely bloated at all and would allow for a broadening of the (out)performers in the share market, on the proviso other sections of the market also start reporting positive earnings growth.
In The Land Of Down Under
In Australia, the polarisation underneath share prices has not been dissimilar. Banks and resources are having a relatively tough time (operationally) and one of key differences is average EPS growth for the ASX200 is negative for FY24 (the financial year just concluded). Forecasts are more positive for FY25, but nowhere near the numbers seen in the US.
As things stand right now, only weeks out from that all-important August results season locally, consensus sees average EPS for the ASX200 contracting by -3.5%, having already contracted by -3% a year ago in FY23. The forecast for FY25 is a positive 5.8% which, if proven correct, also implies a broader, better growth environment.
The local PE multiple sits around 16.5x, which is equally above the long term average, but I’ve explained earlier we’re no longer comparing apples with apples when comparing to the past as the local index has gone through impactful changes in composition. That, plus an equally bifurcated share market means the local market too could grow into its multiple if/when earnings growth shows up for today’s laggards.
Readers who pay attention to these numbers will have noticed analysts’ expectations locally have also improved over the weeks past. This despite the fact there remain plenty of companies for whom forecasts are deteriorating, albeit, it has to be pointed out, largely because of mid-year sector updates on miners and energy companies.
A lot has been written about how cheap shares in today’s lagging sections of the local share market seem, including for small and micro-cap companies, for cyclicals, and for REITs generally, and with the ECB and Fed ready to start cutting interest rates in a few months’ time, it is possible local laggards will enjoy a come-back simply because of the global copy-effect.
Locally, one would hope the RBA does not hike in August, but apparently that is the typical view from someone who has a mortgage in Australia. I do believe the ‘value’ proposition on the ASX is muddied because parts of the economy are arguably in a recessionary condition with underlying trends still deteriorating, which means the risk for profit warnings remains high, either this month or in August.
At the same time, the winners from the past 18 months are not by default awaiting a pause or a break in their growth trend. The risk of selling out too early remains, even if local Growth stocks could be sucked in by any correction in share market winners in the US.
One factor that might rise to investors’ attention in the months ahead is possibly a stronger Aussie dollar, thanks to the RBA being handcuffed by still too high local inflation trends.
But let’s first find out what local corporate profits and cash flows look like. In about two weeks’ time, the first small batch of corporate results will open the August season.
In the long term, beyond all these short-term impacts and considerations, investing in the share market remains closely related to corporate earnings. Fingers crossed we can all avoid the cluster bombs and booby traps (though some share prices weakening will present opportunity).
FNArena traditionally monitors corporate results closely, and will continue to do so throughout August: https://fnarena.com/index.php/reporting_season/
FNARENA VIDEO
Dani and I have put together a video to explain our focus (and enthusiasm as investors) for GenAi, the fourth industrial revolution:
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(This story was written on Monday, 15th July, 2024. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena’s see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: contact us via the direct messaging system on the website).
