RMG Wealth’s Stewart Richarson asksif equities are a buy, sell or hold
Stewart Richardson, chief investment officer at RMG Wealth Management, has outlined the arguments for buying, selling or holding equities.
Equity markets have been on a tear recently, somewhat to our surprise. We thought we would share some of our thoughts and explain how we are positioning our portfolios.
The last four years have taught investors that when the US Federal Reserve is printing money, the US and a good many other equity markets are going to rise. Therefore, with the Fed currently printing at a rate of US$85bn per month, we have to be long overall of equities. We are long of equity markets although we probably should have been a bit more aggressive. We currently have long exposure to the US, UK, Japan and China. From a relative perspective, we think that the rally in European equities in the last 8 months has closed the valuation gap that had previously existed (a gap that had existed for good reason we may add), and no longer represents long term value. We have a short exposure to European equities relative to some of our long exposure elsewhere.
We hear from a number of commentators that equities are attractive because earnings are better than expected (or even that earnings will improve with the economy later this year) and valuations are attractive. Frankly, we think these commentators simply believe that the market is going up because of Fed liquidity and current bullish sentiment. Of course, these bullish commentators have been right about the recent market direction, but are they right to be bullish now? The work that we do and the research that we believe is credible indicates that markets are not cheap and that corporate earnings in the future may actually be lower than they are today. If future corporate earnings are lower than current levels, that would be a real shock to investors.
David Rosenberg at Gluskin Sheff makes an excellent observation that lower interest costs and lower taxation have boosted S&P 500 earnings by about $30 a share since 2007. He notes that prior to the crisis, S&P 500 earnings (four quarter trailing) were at about $90 per share compared to about $100 today. Without the interest and tax boost, the S&P 500 would be trading at 22x earnings. Of course, given the cycle and the FED’s efforts in lowering interest rates, we should expect these two line items to help boost corporate coffers, but investors should not expect any further significant boost in the quarters ahead.
We would also make the point that corporate share buy-backs have significantly boosted S&P 500 earnings, and although we don’t have the exact “contribution” to S&P 500 EPS, we have seen research that estimates corporate share buy-backs in the US$1.5trn range since 2007. We would also just add that individuals, hedge funds and institutions (e.g. pension funds and insurance companies) have been net sellers of equities since 2007 whereas corporations have consistently been net buyers. The FT Lex column wrote on this during the week indicating that the vast majority of free cash flow is used to fund dividends and share buy-backs thereby leaving little for capex and investment.
Investors need to be aware that it is capex and long term investment that drives future growth, not share buy-backs, and the lack of recent investment since the crisis will be another inhibitor of future corporate earnings growth.
Research from John Hussman (also picked up by Albert Edwards at SG) shows that corporate earnings are likely to FALL over the next four years. The work shown by John Hussman shows that by looking at the US national accounts, it is easy to illustrate the relationship between corporate earnings growth and the combined savings rates of the household and government sectors.
The key point to make is that corporate profit margins are closely linked to the combined savings of the public and household sectors – when these two sectors are dis-saving (as is currently the case) then profit margins will be high and vice versa. Therefore, to expect profit margins to remain high, we would have to expect government deficits to remain very high (possible, but perhaps not for much longer) and the household savings rate to remain at historically low levels (currently around 3%). Frankly, we expect combined public and household dis-saving to revert to a net savings picture over the next several years, and therefore we expect profit margins to contract dramatically. Assuming this happens, then corporate profits will decline over the next few years, and any belief that equity markets are good value at current levels should be seriously challenged.
In terms of the sentiment condition of the US equity market, investor bullishness is comparable to that seen at or near important highs of the last four years which were followed by decent corrections. In fact, one or two indicators are at levels seen in early or late 2007 prior to the 50% bear market.
The message here is that we are at or close to some sort of peak in the equity market that could lead to a correction of 5% – 10% at least or maybe more.
With the fundamental picture certainly not bullish according to our work and sentiment consistent with a market peak of some sorts, all we need to see to be even more cautious on our equity exposure is a bearish technical signal. Our technical work indicates that the market uptrend since last November is beginning to look a bit tired, and with markets either stalling or topping at this time for the last three years, we are attentive to signs that markets are turning lower. To be clear, the S&P (as a broad gauge for the US), the UK and Japan are still in uptrends and so we are bullish of these markets. The Nasdaq 100 index is by far the weakest of the US indices and we have a tiny short on that index. Europe remains mixed technically and we believe it is the best candidate for leading any upcoming decline in equity markets and we are therefore bearish.
To conclude; our valuation work (which is best used as a long term guide to whether markets are attractive – it does not help with short-term market timing) indicates that the market is more expensive than the vast majority of commentators will tell you. Furthermore, future corporate earnings could well fall well short of where the market is expecting when we consider the long held relationship between earnings/GDP versus profit margins. The investor sentiment today is as bearish for the market as we have seen at all the previous market peaks since this bull market began in March 2009 and in some cases is comparable to the investor sentiment seen immediately prior to the start of the crisis in 2007. None of this matters so much in the very short term until we get a technical signal that the bullish trend is turning lower, and outside of some European markets and the Nasdaq 100, evidence of this is still a bit scarce. Perhaps the message from us is that now is probably not the time to buy the market. For the moment, most equity positions can be held but we need to be very attentive for sell signals and be ready to move to a bearish position when the technical signal is given.