Covenant Weekly Market Synopsis as of December 9, 2016

December 11, 2016

Another week, another record. Equity markets continued to push higher around the world on hope and faith in the future Trump administration’s economic policies. Those positive vibes were buttressed by firmer domestic economic data and an accommodative message from European Central Bank President Mario Draghi last week. The Dow Jones Industrial Average, although representing only a thin slice of corporate America, is a hallmark of stock market performance given its long history and now sits less than 250 points away from 20,000. The number itself is arbitrary, but investors seem to like round numbers so there is a lot of buzz about “Dow 20K”. However, it is the Russell 2000 Index that has been the real star amongst equity indices. Investors expect that a lower corporate tax rate and reduced regulations will be of particular benefit to these smaller companies that tend to derive more of their revenue from domestic sources. Last week the Russell 2000 tacked on another 5.6% bringing its six-week total to 16.5% (vs. 8.9%) for the Dow.

Over the last several years, strong equity market performance has been accompanied by strong bond market performance as the prices of both asset classes rose together. That correlation has broken down of late, resulting in painful losses for investors holding long duration (i.e. interest-rate sensitive) investments. Yields on longer-dated US Treasury bonds ticked up again last week (meaning the prices of the securities fell), while the yield on the 2-year UST remained unchanged as the yield curve continues to steepen. Price changes in the commodity complex were mixed, while the US Dollar rose another 0.8% and the VIX Index (a measure of expected market volatility aka “the fear index”) plunged by nearly 17% to 11.75.

For a detailed view of weekly, month-to-date and year-to-date asset class performance click here.

 

Debby Downer or Realistic Rick: In light of all the well-deserved euphoria around recent stock market performance (more than 50% of the S&P 500 year-to-date gains have come in the last six weeks), it is worth taking a step back to evaluate the move in the context of economic fundamentals. Investors can (and do) move markets well abroad of fundamentals, and markets can remain detached from fundamentals for extended periods of time. Eventually however fundamentals reassert themselves which is why you see valuation metrics such as the price-to-earnings ratio expand and contract over time, but generally mean revert around their average level. On this point, the chart below of the Shiller PE Ratio* illustrates the current valuation of the S&P 500 based on average earnings over the last 10 years.

 

Shiller PE Ratio

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Source: multpl.com

Keep in mind that the Shiller PE Ratio is not intended to be a market-timing signal, although market events have been associated with it. Rather the metric has demonstrated strong predictive capabilities for future, long-term stock market returns. A high ratio implies lower than average long-term average returns and vice-versa. Currently the ratio stands at a level that has only been exceeded on two previous occasions, one of which was the highly unusual Dot-com Bubble. There are many critics of this metric and it is not a perfect forecasting tool. That being said, while markets may continue to rise in the short term to even higher valuations, history suggests that (absent an acceleration in corporate earnings growth) equity market returns over the next 5-10 years are destined to be muted relative to historical averages…and certainly lower than those experienced recently.

 

Caught in the Act: China is a currency manipulator, just as president-elect Trump and the media have long claimed. Importantly though, China’s manipulation is not intended to reduce the value of the Renminbi to make their exports more competitive in the global marketplace (the typical reason for central banks to reduce the value of their currency), but rather to prevent the value of the currency from plunging. If China’s currency were allowed to float, unhindered by China’s central bank, the currency would quickly devalue and wreak havoc on the Chinese economy. This, in turn, would be extremely negative for the global economy. As the chart below illustrates, since 2014 China has spent nearly a trillion dollars (25% of their available foreign reserves) supporting the Renminbi. The decline in foreign reserves reflects asset sales (including US Treasuries, of which China is the largest foreign owner) which China uses to fund purchases of the Renminbi, therein supporting the price. So, while China is certainly manipulating their currency, their intent is not as nefarious as posited by the media. Now China’s restrictive trade policies are a different matter for a different time.

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Sources: Bloomberg and Covenant Investment Research

As an aside, every central banks acts to manipulate the value of their country’s currency in an effort to increase or slow economic growth. Since the Financial Crisis the major central banks have adopted a “race to the bottom” approach to help their countries grab a larger portion of the shrinking global economic pie. Witness the negative interest rate policies in Japan and the Eurozone, or the long-held zero-interest rate policy in the United States. It is what it is… currency wars are a post-Financial Crisis version of “The Cold War” in which no shots are fired, and central banks do not publicly acknowledge their intent, but their actions are very real.

 

Economic Wrap-Up: It was a relatively slow week for economic data releases, but there were a couple of nuggets. The October Job Openings and Labor Turnover (JOLT) survey provided further evidence of a stable/mature labor market. Job openings, at 5.5 million remain high, but little changed from the level seen one year ago. It is worth noting that the number of people quitting their jobs (2.2%) relative to the number people being laid off (1.1%) is the highest since 2007. These metrics indicate that job-hopping is becoming more prevalent as employees have sufficient confidence to quit their jobs to seek better opportunities elsewhere. The ISM Non-Manufacturing Index for November rose to 57.2 (well above expectations) and is at its highest levels since October 2015.

Be well and Godspeed,

Jp.

 

* The cyclically adjusted price-to-earnings ratio (“CAPE”) is defined as price divided by the average of ten years of earnings, adjusted for inflation. It is also known as the “Shiller Ratio”, named for Robert Shiller, who won a Nobel Prize for his research into the metric.