Somebody must be excited, with markets hitting or beating peak valuations set in 2000. For instance, Enterprise Value/Market Capitalization is near the peak set in March of 2000, and Warren Buffet’s favorite valuation measure, Market Capitalization/GDP, is above its March 2000 peak (h/t SentimenTrader). Shorter term measures are also stretched, with heavy call buying (risk on), little put buying (risk off), and a consistent bid to the market (more buyers than sellers). As an example, the S&P 500’s weekly RSI (Relative Strength Index (momentum)) has hit a high not seen since 1929. If nothing else, that doesn’t sound like things that happen at stock market valuation lows. What does it really mean, though? Honestly, not much in the short term. As the saying goes, the trend is your friend until it ends, and there’s no strong sign of it ending.
I do think it pays to look for when the trend could end, though. There are a variety of ways to look at that, but for my purposes I’m more interested in when the highest odds of a longer-term decline could happen. For that, I look to both macro-economic fundamentals, such as GDP, and corporate fundamentals.
The fundamentals for the fourth quarter of 2017, which are going to be reported this month, look pretty good. About the only negative thing you can say about them is that both economic and corporate fundamentals data expectations are pretty high, which could create a decline as reality could fail to keep up with expectations. While that could happen, that seems like a fairly thin reed to rely on to expect downside. The longer-term future looks tougher, though.
The first quarter of 2018, from a macro perspective, looks reasonably good, based on comps and early data, but it doesn’t look as good as the fourth quarter of 2017. Should we care? Not normally. What we’re really looking for is a trend change, and one point doesn’t make a trend. What makes things more interesting is that macro GDP comps get tougher as the year goes on. The improving data from 2017 will get lapped in 2018, and the year over year comparisons will get increasingly tougher as 2018 goes on. That means we can target the peak from a macro standpoint unusually quickly. Q4 2017 looks very likely to be the best looking quarter from a growth perspective. While the first quarter of 2018 is quite likely to look good, it’s also likely to be good at a slower rate, and that rate of change is highly likely to continue for a while. What can we do with that knowledge? We can use that to invest in a slower growth world before it’s a popular trade.
That may sound crazy to some people, but that’s generally what we do – we enter into an unpopular trade because, looking forward, we see a trend changing or a current risk/reward that looks out of whack. The last time we did this was retail in late 2017. It was a deeply unpopular trade, because the trend was down and Amazon was going to eviscerate retail. What we saw were easy comps and high odds of improvement, and we’ve gone from 4-year lows to 2-year highs on the retail index (XRT) in pretty short order. Now what’s currently deeply unpopular that provides a good risk/reward?
Broadly speaking, it’s the idea of growth slowing. Looking at consensus market calls, the expectation seems to be continued GDP growth. That’s fine, but the consensus tends to be priced in. Consensus sees smooth sailing, but that’s priced in. What we see is that such complacency is unwarranted. The economy may grow for a bit, but at a slowing rate, which is lower than consensus expectations. Thus, at some point sooner rather than later we’ll want to invest in things like utilities and staples.
But wait! Aren’t pundits calling for the 10-year Treasury yield to soar higher from here? Sure – that’s consensus. The Commitment of Traders report shows there are a lot of people short Treasuries- people are positioned for them to fall in price as interest rates go up. It’s a crowded trade, and we generally take the other side of crowded trades that we disagree with. It’s also worth mentioning that consensus has been calling for the imminent decline of Treasuries for several years now. I don’t see how anything has changed here, it’s just the usual short-term bouncing around between euphoria to despair.
To most people, I think the idea of investing in utilities sounds wrong right now, and that’s fine. That tells us there’s a lot of fear there, and a lot of people have been shaken out. It’s an uncrowded investment opportunity, which is often a low risk/high reward opportunity. The idea isn’t to invest in the best looking asset right now, but to find what will be a good asset in the future. If we’re right about our macro outlook, sectors like utilities will make a lot of sense for the bulk of 2018.
What if you don’t care about macro-economic data, preferring to focus on corporate earnings? Earnings comps also face a wall of higher comps and expectations, and it keeps getting tougher as the year progresses.
One question is timing. Market tops tend to be processes that occur over a period of time, not single points in time, as Hedgeye’s Keith McCullough is fond of saying. Trying to time the peak perfectly is unlikely – the market as a whole doesn’t tend to just drop all at once. What I like about this current market setup is that the odds of winning with this strategy looks like it should go up over time as comps get tougher. We may not be right for today, but we’re probably right as 2018 continues. Thus, while getting the timing right may be tough, time should be on our side.
All that said, I’m not saying that anything all that dramatic has to happen. I’m just saying that the markets, as can happen so often, expect the recent past to continue indefinitely, and to me the odds say that complacency isn’t warranted. We have a differentiated opportunity here, but I don’t expect the next great downturn to start in the next few months, just a slowing.
Put differently, instead of a decline, you can have a rotation from some sectors into others. For instance, in 2000 tech got creamed while staples actually went up. The overall market fell a bit, but some areas did pretty well while others did fairly poorly. Similar to 2000, the overall environment is still fairly benign, it’s just that some expectations have become awfully high. Today, with an environment similar to 2000, isn’t it fair to think a similar outcome could transpire?