03 November 2017
Equity markets are outperforming, but they are increasingly concentrated and overvalued.
Since Trump’s presidency, markets have become more momentum-driven, and the House Tax Bill magnifies this bias. The reality is the US tax reform is still rife with many moving parts and complexities.
But, momentum is a double-edged sword and prone to rapid reversals of fortune.
As always, long-term investors should focus on building a balanced and diversified portfolio that can navigate different economic cycles.
At first glance, it was just another up month for stocks in October, making it easy to forget how challenging August was for market participants. If you have already forgotten, let me remind you that after a very positive quarter that ended in June, markets in August were confronted with a slew of events (e.g. North Korean tension, impacts of Hurricane Harvey, among others) that shook markets a few times. These turned out to be short-lived, and the stock markets played catch-up all the way into the second half of third quarter.
October followed the third quarter with even more positive results, largely led by strong quarterly earnings in the US technology sector. Today, the technology sector has grown to roughly 24.5% of the S&P 500. This is very different than December 2008, when technology represented only 14.8% of the market value in the S&P 500. Needless to say, US technology was the leader with impressive monthly gains of 6.6% in October. The bigger laggard in the market, however, is consumer staples, which had a lackluster Q3 (-0.8%), and went on to shed another 1.4% in October (Figure 1).
We can’t ignore current events when we’re looking at the markets. The world and the markets have been closely watching the Republicans’ attempt at reforming the US tax system. Markets are viewing the US tax reform as a net-positive, but recognise and acknowledge that no matter what changes, not everyone can win, potentially leading to ultimately widening the gap between winners and losers. For example, the tax bill could hurt homebuilders, and that’s why US Real Estate Investment Trusts lost 0.7% in October.
The fixed income market has also reacted negatively to early rumours on the proposed US tax bill reform. Between 7th September and 26th October, 1y-3y, 3y-10y, 10y-20y and 20y+ US government bonds lost 0.5%, 1.8%, 3.4% and 5.1%, respectively. Some of these bond losses were partially recouped towards the very end of October as they benefited from the uncertainty regarding the tax bill. More on the impact of the tax bill proposals ahead.
Elsewhere, in international equities, the Asia ex-Japan region, which has close to 30% invested in China, gained 4.3% in October. This gain, however, masked the volatility experienced by the Chinese bond and equity markets. The calm that persisted through the recent Communist Party Congress was broken when policymakers renewed their pledge to reduce leverage in China’s financial system. In response, government bond yields rose, and sparked a 2.7% decline in the MSCI China Equity index (between 16th and 26th of October). The Chinese equity market recovered after the People’s Bank of China stepped in with cash injections into the financial system.
In contrast, Japan was the steadier performer after Shinzo Abe’s solid election win. The victory was welcomed by markets, as it is viewed as a green light to continue with the Bank of Japan’s massive monetary stimulus program. Japanese equities responded with a 5.4% gain in October.
Source: StashAway, Bloomberg
As it stands today, we are in a situation where the stock market is more reliant on the technology sector for growth. The problem, though, is that valuations are expensive. To evaluate valuations, we use earnings yield, which is basically earnings (per unit of share owned) expressed as a percentage of the stock price. Intuitively, it measures how much earnings are generated by every dollar invested in the stock market. Earnings yield makes it easier to compare returns with the stock markets and with other asset classes, such as investment grade corporate bonds.
Let’s, for a second, focus on what companies are actually producing for their stakeholders. According to Bloomberg’s estimates, the US technology industry was producing $19.40 of earnings per share in September 2011. At the time, investors were paying an average price of $258.67 for that $19.40 earnings per share; this was equivalent to 7.5% in return on capital (otherwise known as “earning yield”). Today, earnings are significantly higher, at around $34.1 per share, but investors are also paying a much higher price for it. At an entry price of $793.02, earnings yield (or returns on capital) is significantly lower at 4.3% per annum, compared to the 2011 7.5% earnings yield. Looking at the earnings yields here clearly illustrates the current overvaluation in the markets.
With such concentrated returns, it’s difficult to pick the winners. Thus, portfolios should be intelligently diversified in carefully selected sectors and differentiated asset classes. This will give you better exposure to the overall market.
Specifically, in response to these over-valuations, While StashAway’s portfolios have exposure to US Technology, our StashAway’s asset allocation framework (ERAA®) has been allocating larger capital in differentiated asset classes, such as US convertible bonds, Asia ex-Japan, and European equities, than in US technology.
Aside from reliance on the technology sector for earnings growth, the stock market is also increasingly biased by momentum, with larger corporations showing stronger increases in value than smaller ones. This trend is apparent when one compares the equal-weighted version of the S&P 500 (removing market value bias) against the regular version (market value driven). Since late-April, the equal-weighted index has underperformed the regular version by around 2.9%. This signifies that the gap between the winners and losers in the stock market has widened. Figure 2 illustrates the rise in both momentum bias and the widening gap between technology and other sectors.
Momentum is a double-edged sword. It can be prone to rapid and sudden reversals. Given today’s market momentum in tandem with the US tax bill reform, momentum can reverse if the tax bill fails to pass or gets watered down. So, it’s not wise to chase momentum. Instead, long-term investors should focus on sourcing multiple pockets of returns across asset classes, not just in equities.
Source: StashAway, Bloomberg
Note: Both market-cap and equal weighted S&P indices are normalised to $100 on 27th April 2017. This means that the spread between them is zero on 27th April.
Trump’s presidential victory in November 2016 has clearly brought about major changes in market behaviour. These days, positive news tends to generate quicker and larger market responses than negative news does (“momentum bias”). This market behavior can result in an underestimation of risk and uncertainty of events.
A new reason for the growing momentum bias can be attributed to the House tax bill proposal. The bill further widens the gap as it creates its own list of winners and losers. For one, homebuilders and companies with higher borrowings generally underperformed, as the House tax bill aims to limit mortgage and interest expense deductions.
Yes, the one-time reduction in corporate tax rate from 35% to 20% is a welcomed move. But there are several complexities that are not friendly to large US multinational firms. For instance, as of time of writing, there are scale-backs of the tax cut in the form of the 12% tax on foreign liquid assets and the 5% tax rate on all other unremitted foreign earnings back to 1986. Lastly, due to the controversy around personal income tax (some income brackets win and some lose), there is a fair chance that the bill would not pass or could be watered down.
The reality is the US tax reform is still rife with many moving parts and complexities. Quoting just several lines from the slew of news coverage at Bloomberg:
“…the bill ran into opposition almost immediately Thursday. It would cap the mortgage-interest deduction on new home sales at $500,000 -- a departure from the current cap of $1 million for couples filing jointly. The National Association of Realtors, which has been wary of the tax plan, said that measure “appears to confirm many of our biggest concerns”.
“Nobody knew that was in there,” said Representative Tom MacArthur, a New Jersey Republican. “They kept that from us,” he said of House leaders, “and I don’t appreciate that.” He said he was “undecided” on the bill.
The past year, filled with events including multiple national elections, hurricanes, nuclear bomb testing, and US tax bill reform talks to name a few, is a great reminder that large and small events can (and do!) occur at any time. These events repeatedly lace markets with different types of uncertainty. An asset allocation strategy that favours growth assets, strongly pays attention to valuation, and diversifies sectors, geographies, and instruments is what it will take to endure the uncertainty and be prepared for market-shaking or economy-shifting events.