Interview With Financial Sense on Identifying the Next Bear Market

We were interviewed by Cris Sheridan of Financial Sense on August 24th. During the interview we discuss current market technicals, the macro-economic environment, the investor sentiment backdrop and the prospect for future equity returns. One theme of our discussion is what to look for ahead of a bear market in US equities. Another theme is how the current period of low volatility will likely resolve.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

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Profit Margins Expand to New Highs to Boost 2Q17 Results

Summary: The headline numbers for 2Q17 financial reports are good: S&P profits are up 19% yoy; sales are 6% higher; profit margins are at new highs. This is in stark contrast to early 2016, when profits had declined by 15% and most investors expected a recession and a new bear market to be underway.

These strong results are not due to better oil prices. Sales for the sectors with the highest weighting in the S&P have grown an average of 9% in the past year. Moreover, margins outside of energy have expanded to 10.8%, a new high.

Bearish pundits continue to repeat claims that are more than 20 years old: that "operating earnings" are deviating more than usual from GAAP measurements, and that share reductions (buybacks) are behind most EPS growth. These are both wrong. Continued growth in employment, wages and consumption tell us that corporate financial results should be improving, as they have in fact done.

Where critics have a valid point is valuation: even excluding energy, the S&P is now more highly valued than anytime outside of the 1998-2000 dot com bubble. With economic growth of 4-5% (nominal) and margins already at new highs, it will likely take excessive bullishness among investors to propel S&P price appreciation at a significantly faster rate.

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84% of the companies in the S&P 500 have released their 2Q17 financial reports. The headline numbers are good. Overall sales are 6% higher than a year ago, the second best growth rate in more than 5 years. Earnings (GAAP-basis) are 19% higher than a year ago. Profit margins are at new highs of 10.3%, exceeding the prior highs from 2014.

Before looking at the details of the current reports, it's worth addressing some common misconceptions regularly cited by bearish pundits.

First, are earnings reports meaningfully manipulated? This concern has been echoed by none other than the chief accountant of the SEC, who has complained about non-GAAP earnings numbers being "EBS", or "everything but bad stuff." Enlarge any image by clicking on it.

August Macro Update: Slowing Growth in Employment and Consumption

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

The bond market agrees with the macro data. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (arrows). The lag between inversion and the start of the next recession has been long: at least a year and in several instances as long as 2-3 years. On this basis, the current expansion will last well into 2018 at a minimum. Enlarge any image by clicking on it.

Fund Managers' Current Asset Allocation - July

Summary: Global equities have risen 7% in the past 3 months and 16% in the past year, yet fund managers continue to hold significant amounts of cash, suggesting lingering doubts and fears. They have become more bullish towards equities, but not excessively so: less than half expect better profits and a better economy in the next 12 months.

Allocations to US equities dropped to nearly their lowest level since November 2008 in July: this is when US equities usually outperform. In contrast, weightings towards Europe in particular have jumped to levels that suggest this region is likely to underperform. These weightings also suggest that Europe is likely to be the source for any global "risk off' event. Notably, the S&P has outperformed the Europe's STOXX600 by 7% the past two months.

Fund managers remain stubbornly underweight global bonds. Current allocations have often marked a point where yields turn lower and bonds outperform equities.

For the first time in eight months, fund managers are neutral towards the dollar after having considered it overvalued since November.  During this time, the dollar has fallen 7%. A headwind to dollar appreciation has dissipated.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Overall: Relative to history, fund managers are very overweight cash and very underweight bonds. Their equity allocation is modestly overweight. Enlarge any image by clicking on it.

Within equities, the US is significantly underweight while Europe is significantly overweight. 

A pure contrarian would overweight US equities relative to Europe and emerging markets, and overweight global bonds relative to a 60-30-10 basket. 

Weekly Market Summary

Summary:  US equities reached a new one-month low late last week before rebounding on Friday. In particular, NDX found support right on its mid-May low. This is now an important line in the sand, with implications for SPY as well; so long as the Thursday low holds, look for higher prices.

Despite general weakness in equites over the past several weeks, there have been no notable extremes in breadth, the volatility term structure or put/call ratios that often mark durable lows. On balance, this suggests any short-term gains are unlikely to be sustained longer-term. Moreover, in the past 2 weeks, equities have posted strong gains overnight that have been entirely given up during cash hours, a pattern that has the whiff of distribution.

Earnings reports for 2Q begin this week.

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US equities remain in a long term uptrend. The 20-weekly ma (blue line) is often an approximate level of support during uptrends. Enlarge any image by clicking on it.