Marcuard’s Market update by GaveKal Dragonomics
By Charles Gave
Over the last few months I have argued that the US stock market rally was running on fumes. In the intervening period, US equities have, of course, powered to new highs. While my earlier comments were nuanced, I can now say that for the first time since 2007 my valuation model definitively points to US equities being overvalued. For a rules-based investor such as myself, this is worrying.
Hence, it may be useful for readers to conduct a brief run-through of my main US equity market rules.
This exercise begins with a simple assessment of whether the return on invested capital in the US is above or below the cost of capital. The answer can be seen in the “Wicksellian spread” shown in the chart. When the spread is below -1.75pp, history suggests it is time to get defensive. At such a point, the ROIC is below the cost of capital by a margin that is usually associated with trouble (in my Wicksellian jargon, the natural rate of interest is well below the market rate). At such points, investors should sell equities and move into either government bonds or cash.
The last time this situation occurred was in November 2015 and the next five months saw US equities sell off. Equities also hugely under-performed US long bonds through to June 2016. What followed early last summer was a narrowing of the Wicksellian spread due to falling corporate yields rather than rising economic activity (ie. a stable natural rate and declining market rate). The net result is that since last July, my Wicksellian spread has been roughly 50bp above the critical -1.75pp threshold that seems to mark trouble. Hence, there would seem to be little immediate threat of the ROIC crashing below the interest rate, the main condition for a bear market.
However, it should also be recognised that markets often fall without fundamental developments in the underlying economy. The relationship between the return on capital and its cost may not have changed, but the market may simply become overvalued and overbought. Such adjustments are usually deemed “corrections”, and with the benefit of hindsight they are often seen as opportunities to add to a position.
In this regard, consider US equity valuations. The S&P 500 is now one sigma overvalued versus a simple valuation model whose two components are corporate profits derived from the national accounts and a proxy for long rates. In fact, this model is very similar to the Federal Reserve’s, although I replace long rates with US economy’s structural growth rate (in the long run these two variables should converge to the same level)
This model has thrown up some interesting readings since the financial crisis. In 2008-14, the S&P 500 was constantly undervalued, allowing me to advise a largely constant long US equity position. Given that my Wicksellian spread was nowhere near the danger zone, the mantra in this period was “to reduce risk, increase your equity exposure.”
Then, from 2014 to Donald Trump’s win last November, the market was generally fairly valued. Hence, I moved to a 50/50 balanced portfolio, embracing long duration bonds whenever genuine value materialised.
Today, long rates in the US are more or less where they should be. Hence, I need to deal with the following:
- An overvalued stock market, which implies that a correction looms;
- A fairly valued bond market, which won’t offer great protection in the event of an equity correction;
- An overvalued US dollar exchange rate.
Simply put, a number of my rules suggest that US equities should be under weighted.
As such, investors should consider the US as a funding source and deploy capital in the UK, Japan, France and parts of emerging Asia.
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