"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way." That Charles Dickens opening to The Tale of Two Cities is an apt description of financial markets today. While disagreement among market participants has always been a feature of markets, seldom has there been such a divide between those who believe that we are on the verge of a massive correction and those who equally vehemently feel that this is the cusp of a new bull market, and between those who see unprecedented economic and policy uncertainty and market indicators that suggest the exact opposite. Is one side right and the other wrong? Is it possible that both sides are right? Or that both sides are wrong?
The investor divide is visible, and sometimes dramatically so, in almost every aspect of markets, from risk indicators to fund flows to consumer behavior.
1. Risk on? Risk off?
Do we live in risky or safe times? It depends on who you ask and what indicator to look at. Over the last two decades, the VIX (Volatility Index) has become a proxy for how much risk investors see in equity markets and the graph below captures the movement of the index (and a similarly constructed index for European stocks) over much of that period:
VIX: S&P 500, Euro VIX: Euro Stoxx 50
Last year, the volatility measures in both the US and Europe not only took Brexit and the Trump election in stride but they have, in the months since the US presidential elections, continued their downward move, ending May 2017 at close to historic lows.
Lest you believe that this drop in volatility is restricted to stocks, you see similar patterns in other measures of risk, including treasury yield volatility (shown in the graph) and in corporate bond volatility. This volatility swoon is also not restricted to the US, since measures of global volatility have also leveled off or decreased over the last few months. In fact, the volatility in currency movements has also dropped close to all-time lows.
In sum, the market seems to be signaling a period of unusual stability. That is at odds with what we are reading about economic policies, where there is talk of major changes to the US tax code and trade policies, signaling a period of high volatility for global economies. The economic policy uncertainty index, an index constructed by looking at news stories, CBO lists of temporary tax code provisions and disagreement among economic forecasters, has been sending a very different signal to the market than the market volatility indices:
In the months since the election, the indices have spiked multiple times, breaking through records set during the 2008 crisis. In short, we are either on the cusp of unprecedented stability (at least as measured with the market volatility indices) or explosive change (according to the economic policy indices).
2. Funds in? Funds out?
The ultimate measure of how comfortable investors feel about risk is whether they are putting money into stocks or taking them out and fund flows have historically been a good measure of that comfort. Put simply, if investors are wary and risk averse about an asset class or market, you should expect to see money flow out of that market, and if they are sanguine, you should see money flow in. In the graph below, we look at fund flows into equity, bond and commodity funds, by month, from the start of 2016 to April 2017:
Source: Investment Company Institute
More money has flowed into both equity and bond funds, on a monthly basis, since November 2016 than in the first ten months of 2016. While the fund flow picture is consistent with the drop in volatility that you see across the market-based risk measures, there are discordant notes here as well. First, and perhaps least surprisingly, the perennial market bears have become even more bearish, with concerns about macroeconomic risk augmenting their long-standing concerns about stocks trading at high PE ratios. Second, there are big name investors who are cautioning that a market correction is around the corner, with Jeff Gundlach being the latest to argue that it is time to sell the S&P 500 and buy emerging market stocks. Finally, there is some evidence that money is leaving US stocks, with the Wall Street Journal reporting that money going into US stocks is at a 9-year low, while inflows into European stocks hit a five-year high.
3. Corporate and Business Behavior
Ultimately, risk does not come from market perceptions or newsletters but is reflected in consumer spending and business investment. On these dimensions as well, there is enough ammunition for both sides to see what they want to see. With consumer confidence, the trend lines are clear cut, with consumers becoming increasingly confident about both their current and future prospects:
That confidence, though, is not carrying through into consumer spending, where the numbers indicate more uncertainty about the future:
While consumer spending has increased since November, the rate of change has not accelerated from growth in prior years. You can see similar divergences between confidence and spending numbers at the business level, with business confidence up strongly since November 2016 but business investment not showing any significant acceleration. In short, both consumers and businesses seem to be feeling better about future prospects, but they don't seem willing to back up that confidence with spending.
So, how do we go about explaining these stark differences between different indicators? Has risk gone up or has it gone down in the last few months? Is money coming into stocks or is it leaving stocks? Why, if consumers and businesses are feeling better about the future, are they not spending and investing more? There are four possible explanations and they are not mutually exclusive. In fact, I believe that all three contribute to the dichotomy.
Markets have become inured to crises: The last decade has been one filled with crises, in different regions and with different origins, with each one described as the one that is going to tip markets into collapse. Each time, after the debris has cleared, markets have emerged resilient and sometimes stronger than they went in. It is possible that investors have learned to take these market shocks in stride. Like the boy who cried wolf, it is possible that market pundits are viewed by investors as prone to hysteria and are being ignored.
Disagreement about economic policy changes/effects: It is also possible that economic pundits and investors are parting ways on both the likelihood of economic policy shocks and/or the consequences. On economic policy changes, the skepticism on the part of investors can be explained by the fact that governments across the globe seem to be more interested in talking about making big changes than they are in making those changes. On the effects of changes, the logic that policy uncertainty leads to economic uncertainty which, in turn, causes market uncertainty is being put to the test as governments and central banks are discovering that policy changes on everything from interest rates to tax rates are having a much smaller impact on both economic growth and investor behavior than they used to, perhaps because of globalization.
Macro to Micro Risk: One of the residual effects of the 2008 crisis was an increase in correlation across stocks, with the proportion of risk attributable to market risk in individual stocks rising, relative to firm-specific risk, with that effect persisting into 2016. Since November 2016, the correlation across stocks has dropped, as investors try to assess how new policies on taxes and infrastructure will help or hurt individual stocks. And this may explain the drop in the VIX, even as individual stocks are perhaps getting riskier.
Politics first, analysis later: It is no secret that we live in partisan times, where almost every news story is viewed through political lens. Why should financial markets be immune from political partisanship? I have seen no research to back this up, but my very limited sampling of investor views (on politics and markets) indicates a convergence of the two in recent months. Put simply, Trump supporters are more likely to be bullish on stocks and confident about the future of the economy, and Trump opponents are more likely to be bearish about both stocks and the economy. Both sides see what they want to see in news stories and data releases and ignore that which does not advance their theses.
So, who is right here? I think that both sides have reasonable cases to make and both have their blind spots. On crisis weariness, it is true that market watchers have been guilty of hyping every crisis over the last decade, but it is also true that not all crises are benign and that one of them may very well be the next "big one". On economic policy changes and effects, I am inclined to side with those who feel that the powers of governments and central banks to guide economies is overstated, but I also know that both entities can cause serious damage, if they pursue ill-thought through policies. On the political front, I won't tip my hand on my political affiliations, but I believe that viewing economics and markets through political lens can be deadly for my portfolio.
My Sanity Check: Equity Risk Premiums
As you can see, it is easy to talk yourself on to the cliff or off the cliff, but after all the talking is done, it remains just that, talk. So, I will fall back on a calculation that lets the numbers do the talking (rather than my biases) and that is my computation of the implied equity risk premium for US stocks. On June 1, 2017, as I have at the start of every month since September 2008 and every year going back to 1990, I backed out the rate of return that investors can expect to make on the S&P 500, given where it was trading at on that day (2,411.8) and expected cash flows from dividends and buybacks on the index in the future (estimated from the cash flows in the most recent twelve months and consensus estimates of earnings growth over the next five years in earnings). Given the index level and cash flows on June 1, 2017, the expected annual return on stocks (the IRR of the cash flows) is 7.50%. Netting out the 10-year treasury bond rate (2.21%) on June 1 yields an implied equity risk premium of 5.29%.
To put this in perspective, I have graphed out the implied equity risk premiums for the S&P 500, by year, going back to 1960.
To the extent that the equity risk premium is higher than median values over the 1960-2017 time period, you should feel comforted, but the market's weakest links are visible in this graphs as well. Much of the expansion in equity risk premiums in the last decade has been sustained by two forces.
Low interest rates: If the US treasury bond rate was at its 2007 level of 4.5%, the implied equity risk premium on June 1, 2017, would have been 3%, dangerously close to all-time lows.
High cash return: US companies have been returning immense amounts of cash in the form of buybacks over the last decade and it is the surge in the collective cash flow that pushes premiums up. As earnings at S&P 500 companies flattened and dropped in 2015 and 2016, you can argue that the current rate of cash return is not just unsustainable but also incompatible with the infrastructure-investment driven growth stories told by some market bulls.
The first half of 2017 delivered some good news and some bad news on this front. The good news is that notwithstanding rumors of Fed tightening, treasury bond rates dropped from 2.45% on January 1, 2017 to 2.21% on June 1, 2017, and S&P 500 companies reported much stronger earnings for the first quarter, up almost 17% from the first quarter of 2016. The bad news is that it seems a near certainty that Fed will hike the fed funds rate soon (though its impact on longer term rates is debatable) and that there is preliminary evidence that companies have slowed the pace of stock buybacks. The bottom line, and this may disappoint those of you who were expecting a decisive market timing forecast, is that stocks are richly priced, relative to history, but not relative to alternative investments today. Paraphrasing Dickens, we could be on the verge of a sharp surge in stock prices or a sharp correction, entering an extended bull market or on the brink of a bear market, at the cusp of an economic boom or on the precipice of a bust. I will leave it to others who are much better than me at market timing to make these calls and continue to muddle along with my stock picking.