We are back in Singapore after three weeks on the road meeting clients. As we noted last week, there had been a growing perception or prevailing bias that equities are now in a “crash up” phase. Over the past year, the S&P500 is up 34% and the MSCI World index is up 28%. Approximately 80% of that return has been valuation expansion. By contrast, the contribution from earnings growth has been modest. Stated differently, returns have mostly been driven by easier financial conditions and perceptions of risk, not fundamentals. Of course, these factors are reflexive or self-reinforcing. Perversely investors will pay a higher valuation multiple when they are confident, or consensus beliefs are optimistic. They probably ought to do the opposite except in a strong momentum driven market.
While earnings estimates have improved more recently, the major contribution to returns has been valuation expansion. The S&P500 price to earnings ratio reached a trough at around 16 times in the correction phase in 2022. It has now expanded to 21 times and as high has just under 25 times earnings (chart 1). Note that 16.7 times is the 80-year average for the S&P500, equivalent to an earnings yield of 6% (1/16.7 = 6%). That is our sense of long-term neutrality or equilibrium.
Chart 1
On this basis the US equity market valuation is optimistic relative to longer run neutrality and especially against the competing risk-free assets (US 10 and 6mth Treasury Bills) which yield equivalent or higher on a sot basis. To be fair, the natural state is for companies to grow earnings over time. Equities might still outperform defensive assets if the US economy has entered another cyclical expansion phase.
On the negative side, the resilience in macro conditions in the labour market, potential structurally higher core services inflation, re-acceleration in pipeline inflation pressure is a legitimate challenge to the “disinflationary” consensus beliefs. The optimists in markets have priced both a lower path for rates and resilient growth. Our quarrel with markets remains the probable inconsistency in that prevailing bias. Although broad financial conditions have eased since October last year, short term interest rate expectations (the implied yield on December 2024 SOFR) has increased again to around 4.5% again (chart 2).
Chart 2
In conclusion, consensus beliefs in a range of positions correlated to lower rates are extremely one-sided (crowded short convexity). Risk compensation in equities and credit are extremely narrow. Realised and implied volatility are compressed, index call skew is also biased to upside calls. From our perch, the only way out of this for the Fed is to crush the labour market. Our sense is that the Fed Chairman made a policy error with the December “dovish pivot” and amplified that error at the March meeting last week. The current FOMC might have repeated the Arthur Burns error of the 1970s.
Meaningful rate cuts are unlikely while the equity market melts up and financial conditions remain ultra loose. While the Bank of Japan has commenced the transition away from ultra-low rates, the implied carry in USD rates while “America is Pumped-Up” probably continues to favour the dollar. A correction lower in USDJPY is likely an opportunity to scale-up USD and Japanese equity exposure over the next few weeks. From a tactical vantage point, if you are going to keep dancing (with risk assets) dance close to the exit.
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