Friday, March 22, 2013

The Great Hand-Off, Dark Pools and Things That Go Bump in the Night

Despite Thursday’s 13 point dip on the S&P 500, the broad index still sits within striking distance of its record high, set in October 2007.  Given year-to-date gains of 8.4%....on top of a strong finish to 2012… analysts are asking whether the time has arrived for investors to transition from the fixed income instruments that they have favored since exiting the financial crisis (and lovingly supported by the Fed’s largesse) and now bump up their exposure to equities, a trade that is often referred to as The Great Hand-Off. If you consider it odd to ask this question when the S&P 500 is only a hair’s breadth from its peak, you are not alone. The fact that this question has been so hotly debated in financial circles infers that there are many who do not believe in the validity of the current equities rally. Alas, critics have plenty of ammunition to back up their arguments. Chief among these are questions about the growth prospects of the broader economy, the strength…or absence....of underlying drivers of EPS growth and everyone’s favorite parlor game: what’s going to happen when the Fed even hints about dialing back its support of risky assets in financial markets.

Where Is My Hair Gel and Ouija Board? I’m Going Technical (For Once)
As is seared into the souls of traders everywhere, markets bottomed almost exactly four years ago. Since then shares have rallied 128%. As with many bull markets, the gains have been front-loaded with the S&P 500 rising nearly 60% in the first year of the rally and almost 75% by March 2011. For sidelined investors looking to hop back into the market, that bus likely left long ago. Similarly the 2002-2007 rally saw 50% of its gains come in the first two years. Shares edged up over the next two years followed by a year-long surge beginning in mid-2006, but we know how that movie ended.

Of course if the S&P 500 breaks out above current resistance levels, pursuing as yet-to-be-established highs, the aforementioned stats on the distribution of gains in bull markets becomes about as useless as the old Powerball tickets strewn across my desk. But as long as we are venturing into the realm of technical analysis, those of that ilk will point out the formation of a peak that has not been broken through in any of the past three bull markets.

One method favored by traders to validate rallies is to look at participation, namely in the form of trading volume. As seen below, volume of S&P 500 shares has trended south for most of the post-financial crisis era, including during the recent assault on the all-time peak. This means that not only is new money not jumping on the bandwagon, but those already invested are happy with letting others do the bidding for them. Activity carried out by market participants with an actual pulse is likely a lot less, given the large hunk of trading volume generated by algorithmic programs playing off each other (and being buoyed by the Bernanke Put, which is tacitly keeping a floor under prices).

In one of the more unsettling interviews I’ve recently heard, a famed strategist stated that he no longer relies upon volume as a reliable metric, given that so much activity has moved into so-called dark pools: large trades that occur away from the major exchanges. Isn’t one of the key strengths of U.S. financial markets the transparency of price discovery? I’ll put this phenomenon in the category of dark matter, black holes and other mysterious concepts that keep me awake at night.

At least we still have volatility in the tool kit to gauge the rally’s strength. And by observing the VIX index…the so-called fear gauge….investors apparently see little reason on the horizon to hedge their bets in the form of purchasing options on S&P 500 listed companies. As seen below, despite a few periods of angst driven by flair-ups in the Eurozone Debt Train wreck, the VIX has trended down since 2009, currently residing at post-crisis lows. A sign of confidence….perhaps. Or maybe, like lower volume, evidence that investors simply are not actively engaged in current market movements. Thursday’s slide, which induced a 12% pop in the VIX, likely got some folks’ attention.

Dipping A Toe Back into The Pool
Much of the Great Hand-Off talk has been fueled by recent data showing a reversal of equity fund investment flows at the beginning of this year. January marked the first month of net inflows into domestic equity funds after 20 straight months of outflows.  But after an impressive January, according to the Investment Company Institute, the ensuing five weeks have seen a paltry $740 million of inflows. So rather than signifying a change in sentiment, January’s bump was possibly a consequence of early-year rebalancing as portfolios had swung too far in the direction of fixed income.

Speaking of fixed-income funds, the chart above illustrates just how much in vogue such instruments have been since 2009. And why not? Equity investors took a bath during the crisis and the Fed’s aggressive purchases of Treasuries have crowded portfolio managers out of those securities, forcing them into investment grade and junk corporates as well as international bonds. With so many yield-starved investors focusing their firepower on those slices of the market, of course prices will rise. The chart above puts some perspective on how out of favor equities have become and how crowded the bond trade is. Since 2009, total bond fund inflows have topped $1 trillion. During the same period, global equity funds have seen nearly $270 billion in net outflows. The damage would have been worse except for the slightly positive net inflow towards non-U.S. equity funds during this period. Also the continued steady inflows into bonds infers that rather shifting away from fixed income, investors are instead allocating a portion of their mountain of idle cash towards equities, albeit it at a very slow pace.

Back to Fundamentals…..And to Reality
Investors won’t shift back towards equities simply because bonds have become frothy. With the S&P near its peak, they will need to identify fundamental strengths that could drive future gains. One such source is the record amount of cash on corporate balance sheets, but this could be a double-edged sword. It is up for board members to decide. Liquid assets of nonfinancial S&P 500 firms are nearing $1.8 trillion. Having nearly 6% of total assets tied up in low-yielding instruments is not why one invests in equities. Rather than taking on the volatility of the stock market, one would be better off sticking his money in bank account….just not a Cypriot one. With investors finally getting agitated at such an asset mix, boards must make a decision to either deploy these funds by investing in markets and product lines with potentially lucrative returns, or returning them to shareholders in the form of dividends or buy-backs. For equities to push higher, the status quo cannot continue.

During this four-year rally, there have been a series of solid fundamental drivers pushing markets higher. Manufacturing firms had their time in the sun. Export growth was robust for a while. And during the entire time, EPS growth was being driven by streamlining operations, resulting in juicy profit margins. After rebounding from a crisis low of 6%, operating margins of S&P firms have climbed above 9%. But this play has likely seen its final act. As the saying goes, any more cuts start hitting bone. As illustrated below, EPS gains….driven by such expense-cutting measures…were robust through much of 2011 but have since fallen off a cliff.  

Based on 2013 EPS estimates, the S&P currently trades at 13.9, still below its long-term average. The earnings multiple has expanded on the combination of rising market levels and revised (lower) earnings estimates for the next four quarters, which investors are evidently choosing to ignore. Once again, thank you Chairman Bernanke.

And here we get to the crux of the matter, which can be best described as paradox: with firms running lean, robust revenue gains must finally become a contributor to future earnings growth. In a consumer-driven economy like the U.S., this means workers must be more willing to open their wallets. With access to credit…justifiably…curtailed, such confidence can only come from gains in employment and rising wages. And therein lies the rub. That much-delayed stage of the recovery will add to corporate costs. The eventual contraction in presently high operating margins will knock an existing leg out from under equities just as top-line growth adds another. With wages being the key expense in a service-based economy like America’s, this Catch-22 becomes even more apparent.

The Macro-Scene: So Much for Pent-Up Demand
Going big picture, economic prospects will also play a role in determining equities market sentiment. As seen below, quarterly changes in the S&P 500 and U.S. GDP tend to track each other, with equities shifts slightly leading those in the broader economy.

That is not necessarily good news for shareholders as domestic GDP growth over the past decade has fallen short of its pace between 1980 and 2000. Even with credit-fueled consumption, U.S. GDP prior to the crisis averaged only 2.4%. During the past three years of recovery, gains have only averaged 2%.  At least investors can hang their hats on the fact that U.S.-listed does not mean U.S.-centric, as nearly half of S&P 500 revenues come from abroad, markets which often have rosier growth prospects than does the home front. Still, the release of pent-up domestic demand, which has yet to occur in full, would be welcome support for shares.

While estimates show a return to higher growth levels, clouds remain. The important European market for U.S. producers won’t be going on a shopping spree anytime soon. Domestically, an uptick in regulations, most notably from the 2014 implementation of key components of the ACA (Obamacare), may create headwinds for small businesses that would otherwise be seeking to expand operations and hire staff.  Yet perhaps the strongest macro hurdle remains joblessness and its impact on wage growth. As seen in the chart below, annual wage growth has been on downward trajectory for some time. More worrisome, when adjusted for inflation……and yes I used the headline number since people do tend to eat and put gas in their cars….wage growth has been flat or negative for much of the past decade. No wonder authorities were so quiescent during the credit run-up. “Let them eat cake.”

Referencing the paradox above, without growth in real wages, the consumption-engine of the U.S. economy will likely not get reignited anytime soon.  And wages will not grow until the excess capacity of idled workers is finally absorbed back into the marketplace. It is no coincidence that wages remain subdued at a time when cash on corporate balance sheets is so high. Not that I am off to get Karl Marx’s image tattooed on my forearm, but the German philosopher did speak of a transfer of revenues away from labor and towards profits, which is exactly what the $1.7 trillion dollar mountain is.

Back to Bonds
Neglected in this discussion on the hand-off to equities is the other half of the equation: the plight of bonds. Yes, plight. Implied in terms like transition, reallocation and hand-off, is a seamless shift in asset classes. There is no guarantee that there will be anything seamless about an end to the bond trade. Likely many a fixed income fund manager loses sleep every night fearing what will transpire once the Fed removes its supportive $3 trillion dollar hand from the bond market. No one wants to be the last out the door so once any whiff of the Fed taking its foot off the accelerator gets stronger, the rush to sell could lead to a buyer’s strike and plummeting prices. Not only would lousy liquidity trash the orderly functioning of the bond market, it would also send interest rates higher….and quickly. The prospect of a relative spike in borrowing costs is one of the key risks that could send the economy back towards recession.

The Road Paved with Good Intentions Leads to……..France?
The original premise of Fed intervention in the market was to provide temporary liquidity until the private sector was able to strengthen their balance sheets and step back into the game. The same rationale held true for Keynesian stimulus and the extraordinary stabilizers (e.g. extended jobless benefits, food stamps) on the fiscal side of the equation. But after four years, the U.S. is at risk of these supports becoming permanent parts of the economy. And with that, the country becomes France, just without the Foie Gras, great museums and Mediterranean coast.

No comments: