Sometimes it pays to ignore the fundamentals. Just like it pays to pick up pennies in front of a steamroller.
Maybe the market isn't at risk of another Lehman moment (a definite steamroller event), but the global economy is slowing. The global economy would be slowing faster if not for the unprecedented monetary easing actions from central banks around the world.
Despite the negative fundamental backdrop, large allocations to cash have been an expensive insurance for protection against downward movements in the equity market. The reality is that worrying about a potential global recession could have kept you out of enjoying a great year based on the S&P 500 (SPY), which is showing an 11.7% total return year-to-date.
However, whi defensive allocations are a source for portfolio underperformance this year, the underlying challenges/risks continue to build. While investors can treat the incoming macro data as an unfounded wall of worry, it is hard to dismiss the loss of momentum in corporate earnings.
Second quarter earnings were mediocre at best, despite lowered expectations. Factset indicated that companies in Q2'12 had the lowest beat on revenues since Q1'09. Factset also indicated companies guidance for Q3'12 has been trending below mean EPS estimates (as of an 8/31/2012 report). (Add FedEx to the lower guidance list with its updated guidance on Monday.)
The following table is the year-over-year growth in S&P 500 quarterly operating earnings. Margin expansion has stopped contributing to earnings growth and revenue growth as decelerated over the past 4 quarters. Current estimates (operating EPS, bottoms up) for Q3'12 are for a 1.1% year-over-year decline. Q4'12 operating EPS estimates call for 13.8% year-over-year growth (and likely to come down.)
Figure 1: Quarter S&P 500 Earnings Growth Y-O-Y
Source: JP Morgan, S&P, Author
* 99.2% reported
Previously, I considered the S&P 500 at fair value (within a valuation range of 1,250 to 1,500) based on the Cyclically Adjusted Price-to-Earnings (CAPE) metric and reversion to the mean scenarios for 2013 earnings. While this isn't a prediction in a 10%-20% decline in 2013 S&P 500 operating earnings but rather caution based on:
· The global economy is slowing which will impact aggregate corporate revenue growth.
· Corporate profit margins will no longer be a tailwind for earnings growth.
Despite these concerns, the markets over the past 3 months have largely trended upwards. Volatility measures such as the CBOE Market Volatility Index(VIX) have declined since the May/ June market swoon. What I failed to consider was the favorable market actions when trading volumes are light and an overall reduction in short (bearish) positions. Lastly, the vacuum of information from European policy makers through the summer has helped (out of sight, out of mind), with the only major market moving news being positive comments on July 26th from Mario Draghi, president of the European Central Bank.
Therefore based on my outlook, I continue to believe that insurance in the form of higher allocations to cash, while expensive, has been frustrating but not unwarranted. The markets recent gains are not based on a positive catalysts but rather movements from the margin. (As volume and European policy makers return in September, we will have a better idea of market direction.)
The contrarian in us would note that the S&P 500 at fair valuation and lack of earnings momentum is less attractive than international equities. While I don't allocate capital to countries specifically, countries like Italy, (iShares MSCI Italy (EWI)) is likely an undervalued asset. [Check here for a detailed look at country CAPEs.]
Figure 2: EWI
Rolling into September
Despite decelerating earnings and weak economic data, most risk asset classes are trading over their 10-Month Moving Average (10MMA). The notable exception is the broad based MSCI Emerging Market Index (EEM). Asset classes that are recently above their 10MMA are precious metals (GLD), commodities (DBC), and international stocks (EFA). (On a more technical basis, several of these asset classes have broken their intermediate downtrend established from the peak in the spring of 2011. This improves the possibility of sustainability of the move above the 10MMA (i.e. less chance for getting whipsawed).
Figure 3: Asset Classes
While the intermediate trend is used as our primary risk management tool, the "risk-on" environment is in divergence with incoming economic data. Therefore we remain cautious and are paying close attention to breadth (advance/decline summation indexes) and sentiment (put/call option ratios) indicators for signs of changes in market internals.
Current internal market health based on sentiment/breadth indicates a pause in the recent rally, with a slight deterioration in breadth.
Ignoring the macro data has been the best investment strategy today as cash allocations have not provided much benefit as the S&P 500 in on track for a solid 10%+ year. However, the economic cycle is attempting to slow despite efforts by central banks around the world. Furthermore, corporate earnings are decelerating and likely will continue to slow based on lower economic growth and reversion to more normalized operating margin levels.
Despite most asset classes in "risk on" mode, I believe risks are biased to the downside. Therefore, I recommend being on alert with long positions for signs of internal market weakness that might indicate equity markets beginning to discount a lower growth outlook.
Disclosure: I am long SPY.