During our monthly Day Hagan Market Update Webinar on Wednesday, October 17, we discussed how the dynamics driving the financial markets have changed since the market low on March 9, 2009. As you can see in the list below, the monetary stimulus, low interest rates, fear, and cheap valuations that provided a generational price low in 2009 have likely largely run their course. Common sense dictates that for U.S. equity markets to continue to move higher, each of those factors losing prominence (i.e., becoming less supportive for the market) will have to be offset by something equally positive.

9 Years Ago Current
Central banks supportive Central banks reducing/removing/normalizing support
Central banks had many policy options Central banks have fewer policy options to stem a recession
Many potential positive policy catalysts
Fewer potential policy catalysts (monetary and fiscal already)
Interest rates moving lower Interest rates moving higher
Consumer sentiment pessimistic Consumer sentiment optimistic (contrary indicator at extremes)
Business sentiment pessimistic Business sentiment optimistic (contrary indicator at extremes)
Active over Passive Passive over Active (setup for coordinated panic?)
U.S. stock market at decade lows U.S. stock market at/near all-times highs
Valuations low Valuations higher
U.S. Corporate earnings have upside U.S. earnings growth rates may be peaking
Weak inflationary pressures Inflationary pressures building
Tariff/trade war risk low Tariff/trade war risk high
No Brexit (UK leaving the EU) Yes Brexit
No Italgo (Italy leaving the EU) Maybe Italgo
Buybacks Buybacks strong but expected to peak
Pension liabilities Pension liabilities higher (but higher rates may help)
Federal debt increasing Federal debt - exploding higher again

What can positively offset some of the aforementioned hurdles?

From where I’m sitting right now, only one thing will keep this market moving higher: stable economic growth—and it needs to be global in scope. To be clear, we need to see economic improvement from China and the EU. (Even though Venezuela, Argentina, Brazil and Italy are getting lots of press.)

And I think this is where investors see problems, especially when looking at the prospects for international growth relative to the U.S.

Below is Ned Davis Research’s (NDR) Global Recession Probability Model. It is based on leading indicators for 35 countries and includes measures of money supply, yield curve, building permits, consumer and business sentiment, stock prices, manufacturing and production. It shows a high likelihood that a global recession is in play. For regions including China, Japan and the EU, economic models are right on the cusp of moving into zones that signal potential economic slowdowns. (Note: We’re watching PMI numbers closely for signs of confirmation. Although most PMIs remain above 50 and indicate expansion, over the last month, there has been widespread deterioration in the readings.)

 Global Recession Probability Model Chart.

Conversely, when looking at NDR’s Economic Timing Model for the U.S. (chart on next page), activity seems to be holding up. The model is based on 27 economic measures, and at its current reading of +22, strong U.S. economic growth is indicated. In fact, looking back to 1948, when the model has been at levels of +16.5 or better, the U.S. economy (based on the Coincident Index) has gained at a 3.86% average annualized rate.

Our view is that as long as the U.S. economy holds firm, downside risks will be limited to what we view as “normal” market declines. Typically, since 1900, there is an average of just over 3 “dips” (declines of 5% or more) each year. Typically, once the market declines 5%, the average maximum drawdown from high to low is about 11% (daily closing basis—source NDR). After yesterday, most U.S. indexes have hit those average drawdown levels.

 NDR Economics Timing Model vs. S&P 500 Chart

Additionally, as you can see in the statistics box in the chart above, the S&P 500 has typically gained at a +7.46% annualized rate when the NDR Economic Timing Model is in the current zone. Economic growth must continue. We also note that other factors are more positive than 9 years ago:

9 Years Ago Current
U.S. economic growth weak U.S. economic growth good
Unemployment high Unemployment low
U.S. household debt ratios high U.S. household debt ratios better—consumer still strong    
No tax reform Tax reform/corporate and individual taxes lower (mostly)
Number of regulations increasing Regulatory burdens declining—business optimism improving
Bank liquidity (capital) low Bank liquidity (capital) high (financial system is in better shape)

At this point, we have to consider what is priced into the markets.

The S&P 500 closed at 2,656 last night (Wednesday). Analyst expectations for 2019 year-end S&P 500 earnings are around $177. This puts the current S&P 500 Price/Earnings ratio, based on 2019 expectations, at 15x, which is right between its 5-year and 10-year averages (shown below). Not too bad, you might think. However, NDR has done some work that indicates P/E ratios at previous earnings peaks have been substantially lower. In fact, the average P/E at earnings peaks since 1927 is just 13.1x, which would point to an S&P 500 target of 2,318 or about -12.7% below last night’s close.

 About S&P 500 Earnings Expectations Table

About S&P 500 Earnings Expectations Table

Alternatively, one could choose to be an optimist and believe that P/E multiples will remain elevated into 2019, which would indicate substantial upside.

So, what is an appropriate multiple? Several factors impact multiples, but let’s walk through a few.

  • Interest rates ➤ Higher interest rates usually reduce market multiples

  • Inflation ➤ Higher inflationary pressures usually reduce market multiples

  • Volatility ➤ Higher volatility usually reduces market multiples

  • Earnings expectations ➤ When earnings growth expectations peak, it usually reduces market multiples

  • Economic growth expectations ➤ When economic growth expectations peak, it usually reduces market multiples

  • Psychology ➤ Fear will cause investors to pay less for earnings, so P/E multiples tend to contract as fear builds

When we net it out, the outlook for multiple contraction is a more likely scenario than multiple expansion. Therefore, we would lean more toward the 14x to 16x multiple range for 2019 rather than an optimistic scenario of 18x to 20x. And as long as the world economy shows absolute growth, then a 13.1x multiple is probably too low.

With that in mind, for the overall markets to gain traction, it then becomes a function of earnings growth (rather than multiple expansion). And earnings can only grow if revenues increase and/or margins improve.

Revenues will grow with the economy. But margins, as you know, are subject to myriad influences, some industry- and company-specific, and some out of a CEO’s control; can you say “tariffs?” How about “tax cuts?”

As I’ve said before, can you imagine what this decline would have looked like without the corporate tax cuts? Or, would it have even happened without the tariff overhang and impact on global trade?

I suspect that, from a back-of-the-napkin perspective, the tax cuts and tariffs are somewhat offsetting and the market repricing is a function of the rest of the points made earlier.

At this point, our discussion about what the world was like 9 years ago versus today and multiple valuations argue that the broad market was due for a pause. However, we’d note that if earnings season is halfway decent, economic growth stabilizes, and central banks are steady and thoughtful about their normalization paths, we’re now at significantly oversold technical levels with valuations that are seemingly more palatable.

The chart below features the CNN Fear Greed Proxy. It’s now at levels consistent with short-term bottoms.

 CNN Fear Greed Proxy Chart

And it looks like investors are better hedged now than at any other time since the January 2016 bottom (next chart). This may embolden some risk-taking and reduce the levels of potential panic if the markets continue to lower. Note: This composite includes measures of cash, put options, inverse ETFs, inverse mutual funds, shorting futures contracts and credit default swaps.

 Equity Hedging Index

Furthermore, when we review all of the indicators in the universe, we can see in the next chart that the number of indicators that are excessively pessimistic far outweighs the number of indicators that are excessively optimistic. From the time-honored contrary opinion perspective of buying when others are most fearful, this, too, would argue that a wide swath of technical indicators is supporting at least some near-term support.

 Percentage Showing Excess Optimism-Pessimism Spread Chart

Summary: The pieces are in place for a near-term bottom. We’ll be watching Thursday’s action for signs that systematic traders are nearing a selling climax, and subsequently watching the quality of the next rally. For us to become more constructive, we’ll need to see broader participation on the upside.

Lastly, a few words of wisdom that I picked up from my time at Ned Davis Research: “Go with the flow until it reaches an extreme and reverses.” This means don’t fight the trend (tape) until there are tangible signs that the selling is drying up and buyers are gaining traction. As of Wednesday’s close, that wasn’t the case. So, while there are plenty of indicators saying “get ready,” we’ll wait for model confirmation before adding positions. Just as importantly, if our overall broad market equity models turn bearish, we’ll be quick to get more defensive.


Donald L. Hagan, CFA
Day Hagan Asset Management

—Written after the market close on 10.24.2018.  

PDF Copy of Article: Day Hagan Research Update October 25, 2018 (pdf)

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