What a difference one day and a few trillion dollars will make! Reminiscent of the European Central Bank’s bold 2012 OMT (outright monetary transaction) roadmap, ECB President Mario Draghi defies all odds and silences all crepe hangers by announcing a 60 billion Euro per month asset purchase by the central bank.
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Liken to a newly minted department store buyer flush with cash, Draghi waltzed through New York City’s garment district announcing he would snap up everything available along the avenue and would keep his wallet open until such time that his beloved Europe reached escape velocity.
Markets have learned to trust him as ten year yields (borrowing costs) on the continent shriveled including: France fell 0.09 percentage point, Spain dropped 0.13 percentage point, and Italy declined 0.15 percentage point. Even Greece, with all the current political drama, took comfort as its 10-year treasury yield dropped a stunning 0.5 percentage point!
On our shores, the S&P500 digested the news and quietly reset up 31.03 points adding 70 points since last Friday when the anticipatory period began. U.S. 10-year Treasury yields were basically flat while the U.S. dollar rallied 2% against the Euro.
In a strange turn of events, Europe’s main equity indices are now up an average 6% year-to-date while the S&P 500 meanders along the flat-line. It’s becoming increasingly evident that it’s now Europe’s turn to demonstrate the unmitigated gall to rally – and do so well before the data says so (i.e. recall U.S equities circa 2013) while our stock market will frustratingly languish behind despite persistent signs and wonders suggesting the U.S. economy is both good and great. Up until now, this has been one of the most hated rallies in history – it has most recently converted masses of new congregants – new believers who are marked with doubt. Doubters and haters typically grease the skids for market rallies however, this time they may have it right – albeit for the wrong reasons.
Market moves are centered on either fundamentals or psychology and similar to a long road trip, fundamentals may grow tired and allow psychology to take the wheel while other times they are both happy to drive the station wagon together. Over the past year, psychology drove more often than not as fundamentals surely wouldn’t have permitted the four or five white-knuckled drops and bounce-backs that our equity market encountered since last January.
Lately it looks as though fundamentals have had enough and have taken the wheel – reassuring us to look at what’s directly ahead as opposed to extrapolating every known, convoluted combination of what if or what could possibly be.
First, and foremost, like an enormous late summer, stationary weather front, the Fed looms on the calendar. While many are beginning to dismiss the June meeting as home opener (i.e. raising rates), the chances of July and/or September is immeasurably higher than most people think. It’s absolutely not true that a rate hike (or hikes) automatically begets a selloff however, it will – at the minimum introduce volatility and, at the maximum, remove a barrier – sending a succinct message that the Fed will no longer grade papers on a generous curve – you must do your homework and ultimately heal on your own!
Secondly, stock valuations (i.e. present value of a stock based on perceived future earnings) are high in that they simply cannot absorb a negative shock (e.g. civic disruption, stagnant earnings, and inconsistent growth metrics) like they once could. Recall the markets in 2010 and 2011 where the negative shocks were like stubborn weeds slipping through every possible open sliver along the sidewalk yet, the market reacted as if it wasn’t paying attention. During those years, real risks including -Greece, Spain, Euro implosion, U.S. unemployment and the like were simply not enough to waylay the market in part to the very low valuation of S&P 500 stocks. We are now estimating $120-$126 forward earnings for the index (a very wide range due to uncertainty with earnings over weak oil and strong U.S. dollar) which would place us in a valuation in the mid-to-upper teens.
If you take the average valuation over the last quarter century, we are in the “slightly above average” valuation area. If you take out the “dot-com boom” years (valuations where exponentially high), our present valuation would be considered near the upper atmosphere. Other words, we are driving a car on well-worn shock absorbers – our market may not be able to absorb anything except a smooth turnpike and furthermore, markets will need to see clear-cut evidence (real earnings growth, solid economics) before venturing out on its own.
Currently, the ECB will provide a massive tailwind for the next few weeks and perhaps months as participants grow cozy with its mandate. Some will say European equities are already overpriced – they may be absolutely right however, I heard something eerily similar about U.S. equities four years ago. This could very well be another opportunity where the fat get fatter!
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