Equities Rebound: Is It Safe?

This post asks the question: "With global equities rallying back, "Is It Safe?" to take an aggressive position in risk assets. To set the mood, you might (or might not) want to watch this clip of Dustin Hoffman and Laurence Olivier in the movie Marathon Man.

In the last few posts, I have been writing about the sell-off in asset markets that began after Fed Governor Janet Yellen spoke at the Jackson Hole conference at the end of August. Yellen's speech was balanced and this spooked markets into thinking that the Fed might tighten sooner than expected. I referred to this concern as "Exit Ennui" and compared it with the selloff in asset markets that occurred in the May 2013, the so-called "Taper Tantrum". Bonds, commodities, high yield credit, EM equities and US small cap stocks all sold off over the first three weeks of September, while US and other DM stock markets held up well. However, in mid-September, signs of slower global growth, including falling crude oil prices, caused the sell-off that started with Fed tightening concerns to shift to global equity markets and a sharp correction followed. Commodities continued to sell off but bonds rallied back, with the 10-year US Treasury yield falling to 2.15%, its lowest since prior to the Taper Tantrum. 

The low point for equities was reached on October 16. On that day, equity markets turned higher when St. Louis Fed President James Bullard suggested that the Fed should consider extending QE, "to make sure inflation and inflation expectations remain near our target". The Bank of England's Chief Economist followed the next day with a suggestion that weak global growth should perhaps keep the Bank of England from raising its policy rate for an indefinite period. Since then, equities have roared back and bonds have given back some of their gains. 

The chart below, using weekly closes, shows the maximum drawdowns since August 29 (in Canadian dollar terms) for the ETFs regularly tracked in this blog and their subsequent rebounds.

The largest declines were in Canadian equities (XIU), commodities (GSG), Eurozone equities (FEZ) and Emerging Market Equities (EEM). Gold (GLD), US small cap equities (IWM) and Japanese equities (EWJ) also saw large drawdowns. In fixed income ETFs, the largest drawdowns, which occurred in the first three weeks of September, were in Canadian inflation linked bonds (XRB), Canadian Long Bonds (XLB) and non-US Developed Market government bonds (BWX). Corporate bonds had the smallest drawdowns.

What about the rebound? Which assets have performed best? The strongest rebound has been in US small cap equities (IWM), followed by US long Treasury bonds (TLH). Both of these ETFs have more than recovered from their drawdowns. 

Which assets have lagged in the rebound? Commodities have continued to flounder, not yet having found a bottom, although there were tentative signs of a rebound this week. With commodities not rebounding, Candian equities (XIU) and Emerging Market equities (EEM) have lagged other equity ETF rebounds. In fixed income, US long Treasury bonds (TLH) and US investment grade corporate bonds (LQD) have led the rebound, while emerging market local currency bonds (EMLC) have lagged.

While the Exit Ennui drawdown has been the biggest correction of 2014, the "buy the dip" mentality is clearly alive and well. The portfolios we track hit their weekly lows on October 10. With Bullard's help they have rallied back, but all remain lower than their August 29 levels. 

The question now is: with equities having rallied back, "Is it Safe?" to take a more aggressive position on risk assets. The answer is probably yes, but still with great caution.

Equities are still overvalued by reliable metrics, although a bit less so than at the end of August. Q3 earnings reports are coming somewhat mixed, but do not yet show signs of any surprising weakness. 

Bonds, which were already overvalued in late August, are now more overvalued and are at risk of giving back their recent sharp price gains if US economic data remain on the strong side. 

What investors need to be wary of is a series of bond sell-offs which trigger equity sell-offs. This would be the reverse of the pattern witnessed throughout the period of increasingly accommodative monetary policy as measured by the growth of the balance sheets of the US Fed and other major central banks.

While Mr. Bullard may have turned around the equity correction for now, Dallas Fed President Richard Fisher voiced the opposing view that. Despite the equity sell-off, the Fed should not delay its exit from QE. Fisher said:

"We've been floating this market with the Ritalin of easy monetary policy… indiscriminate investing took place ... all boats rose regardless of underlying value... People will actually have to do work ... have to understand analysis in order to make good investments."

So, "Is it Safe?" If the Marathon Man doesn't know, who does? 

 

Oscillate Wildly: The Drawdown So Far

Oscillate Wildly is a catchy instrumental by The Smiths that you might want to listen to in an effort to calm yourself as market volatility ratchets up. In a post back on May 16 that I dubbed Comfortably Numb (after the Pink Floyd song), I noted that volatility across all asset classes had been low and falling for months and that investors risked being lulled into complacency by huge central bank liquidity injections. 

I said in May that the period of suppressed volatility could end either:

• when stronger than expected US and global growth caused a spike in bond volatility and bond yields, or 
• when weaker than expected growth caused a spike in equity volatility and a sharp correction in overvalued equity markets.

I suggested that since it was difficult to determine which of these scenarios would play out, that the prudent course of action was to trim risk exposures across all asset classes and temporarily move into cash. This seemed a good choice because, as I noted, "When the inevitable rise in volatility occurs, it will be possible for the investor to analyze which scenario is playing out and, once it has run its course, where to put the cash back to work". 

The recent spike in equity volatility and sell-off in global equity markets is not a straightforward case. It began after Fed Chair Janet Yellen gave a balanced speech at Jackson Hole that noted the strengthening of US growth and progress toward reducing labor market slack. The speech spooked markets into thinking that the Fed might hike rates sooner than expected. Bond volatility rose as bonds sold off, while equities hung in relatively well through mid-September. But as September gave way to October, market concerns shifted to the weakness of global growth, especially in the Eurozone and to the continuing drop in commodity prices. As growth concerns gained the upper hand equity volatility spiked and global equity markets sold off sharply. 

In a September post entitled Exit Ennui, I compared the current selloff across asset markets with the selloff witnessed in the spring of 2013 associated with the Taper Tantrum. It's interesting to update that comparison today, after a particularly bad day for global equity markets.

The two episodes had several things in common. Both were triggered initially by concerns about a shift to less accommodative US monetary policy. Both saw declines across all asset classes, as illustrated in this chart which shows local currency returns on the ETFs tracked regularly in this blog.

The drawdown in equities in the Exit Ennui selloff through October 8 is similar or worse than in the Taper Tantrum. The S&P500 ETF (SPY) has suffered a similar loss. Other DM equity markets, including Canada (XIU), Eurozone (FEZ), Japan (EWJ) and US Small Cap (IWM) have suffered worse losses than in the Taper Tantrum. The commodity ETF (GSG) has also experienced a much sharper loss, reflecting the downside surprises on global growth.

Fixed income ETFs, which fared poorly through mid-September have rallied back as global equities sold off. US and Canadian long bond ETFs (TLH and XLB) are back to close to flat since the beginning of the selloff. Inflation linked bond ETFs have sold off much less than in the Taper Tantrum, as have Emerging Market bond ETFs (EMB and EMLC) and corporate bond ETFs (XCB, LQD and HYG).

The movements in these ETFs tells me that what started out as an early Fed tightening scare has morphed into a global growth scare. Markets are pushing back expectations of when the Fed will begin to raise rates once again.

For Canadian investors in global ETFs, the pain of the selloff has been mitigated somewhat by the coincident weakening of the Canadian dollar. In the Exit Ennui selloff, the C$ has weakened 2.8% vs. the US$, more than double the 1.3% it weakened during the Taper Tantrum. This has meant that the drawdown triggered by Exit Ennui is taking a different shape from that of the Taper Tantrum as shown in this chart of ETF returns in Canadian dollars.

The chart clearly shows that in the Exit Ennui drawdown, which began with a selloff in bond markets, the best place for Canadian investors to hide has been US dollar denominated bonds.

As a result, risk balanced portfolios have performed better than a conventional 60/40 portfolio in the Exit Ennui drawdown. 

It is still too early to draw a conclusion about the current drawdown and to redeploy cash. The main question that needs to be answered is whether the slowdown that is engulfing Europe, Japan and many of the emerging markets will spread to the US, UK and Canada. If so, US and global equities have considerably more downside. If not, and growth in these countries proves resilient, equities may stabilize, but bonds could come under renewed pressure. Those who took the prudent advice can sit tight and listen to Oscillate Wildly.   

Global ETF Portfolios for Canadian Investors: Review and Outlook

Global markets pulled back in September. The month divided into two parts. The first three weeks saw US bonds selling off and the S&P500 holding its ground as markets priced in the possibility that Fed tightening might begin earlier in 2015 than previously anticipated. The last seven trading days of the month, saw a different dynamic, characterized by global growth concerns. Bonds recovered some ground, but equities sold off at the end of the month. For Canadian investors with currency-unhedged portfolios of global ETFs, losses were mitigated by another sharp weakening of the Canadian dollar.  Significant market and global macro developments in September included:

• Every ETF we track in this blog lost ground in September in local currency terms.
• The US dollar strengthened against most major currencies, including a 3% monthly gain against the Canadian dollar. 
• Global equity ETFs were weaker across all major markets. The bigger losses were in Emerging Markets, US small cap, and Canadian equities. 
• Global government bond ETFs posted mixed returns, with long duration US and Canadian bond ETFs posting the best returns and Emerging Market Local Currency bonds posting the worst returns.
• Gold and commodity ETFs posted further sharp losses. 
• Energy prices weakened further as the WTI crude oil futures price fell to $91/bbl at the end of September.
• US GDP growth for 2Q was revised up to 4.6%, but growth stalled in Europe and showed further signs of weakening in China.    
• Global inflation moderated in August as energy and corn prices fell. Eurozone inflation remained stuck at 0.3%. 
• Central banks continue to be on divergent paths, with the US Fed and BoE preparing markets for policy rate hikes within six to nine months while the ECB and BoJ remain under pressure to increase stimulus. The Bank of Canada remains neutral as to whether its next policy move will be a tightening or an easing and seems to be clearly signalling that it has no intention of tightening ahead of the Fed. 

Global Market ETFs: Monthly Performance for September

The S&P500 closed September at 1972, down from a record-high of 2003 at the end of August, but was still up modestly from 1960 at the end of June. Global equity ETFs were uniformly lower in September. For Canadian investors with unhedged foreign equity exposures, however, the weakening of CAD turned some of these losses into gains. US Large Cap stocks (SPY) lost 1.8% in USD terms, but gained 1.1% in CAD terms. Japanese equities (EWJ) lost 0.3% in USD, but gained 2.6% in CAD terms. Eurozone equities wee down 2.8% in USD but flat in CAD terms. Other equity ETF losses were too large to be offset by currency movements. Canadian equites (XIU) lost 4.0%, while US small cap stocks and Emerging Market equities (EEM) lost 1.4% and 5.0% respectively in CAD terms. 

Commodity ETFs posted further sizeable losses.  The Gold ETF (GLD) returned -3.5% in CAD terms, while the GSCI commodity ETF (GSG) returned -3.3%.

Global bond ETFs posted mixed returns in CAD terms. ETFs with positive returns in September included the US long government bond (TLH), which was down 1.3% in USD but returned 1.6% in CAD, and USD-denominated Emerging Market bonds (EMB) which returned 0.7% in CAD terms. ETFs with negative returns included Canadian Long Government bonds (XLB), which posted a -1.7% return, EM Local Currency Bonds (EMLC), which returned -1.7% and Non-US government bonds (BWX) which lost 1.5% in CAD terms.

Inflation-linked bonds (ILBs) also posted losses in September. US TIPs (TIP) lost 2.6% in USD terms, but gained 0.3% in CAD terms. Canadian RRBs (XRB) returned -2.3%, while Non-US ILBs (WIP) returned -2.7% in CAD terms.

Corporate bonds were also mixed in September. US investment grade (LQD) and high yield (HYG) bonds lost ground in USD but returned 1.2% and 0.9% respectively, in CAD terms. Canadian corporate bonds (XCB) returned -1.0%.

Year-to-date Performance through September

In the first nine months of 2014, with the Canadian dollar depreciating 4.6% against the US dollar, the best global ETF returns for Canadian investors in CAD terms were in US long-term bonds (TLH), US large cap stocks (SPY) and USD-denominated Emerging Market bonds (EMB). The worst returns were in commodities (GSG) and Eurozone equities (FEZ). Canadian equities, which were the top performers through August, finally succumbed to weak commodity prices in September.

In global equities, the S&P500 ETF (SPY), returned 13.3% year-to-date (ytd) in CAD terms. The Canadian equity ETF (XIU) returned 11.9% ytd. US small caps (IWM), returned 6.0% ytd in CAD terms. Emerging Market equities (EEM), after a rough September, returned 5.5% ytd in CAD terms. The Japanese equity ETF (EWJ), after rebounding in September, returned 2.8% ytd in CAD terms. The Eurozone equity ETF (FEZ), which had been the top performer through May, continued to suffer from geopolitical tensions and EUR weakness and returned 1.3% ytd in CAD terms. 

Commodity ETFs had lackluster performances this summer after strong starts to the year, dragging down year-to-date returns. The Gold ETF (GLD) has returned 5.4% ytd in CAD terms, while the GSCI commodity ETF (GSG) returned -3.2%.  

Global Bond ETFs lost some of their lustre in September. Foreign bond ETFs have benefited from a combination of weaker than expected global growth, weakening commodity prices, safe haven demand and accommodative central bank policies. The US long bond ETF (TLH) returned 15.1% ytd in CAD terms. USD-denominated Emerging Market bonds (EMB) returned 12.9% ytd in CAD terms. The Canada Long Bond ETF (XLB) posted a gain of 9.7% ytd. Non-US global government bonds (BWX) posted a return of 5.4% ytd. Emerging Market local currency bonds (EMLC) suffered from EM currency weakness to return 5.2% in CAD terms. 

Inflation-linked bonds (ILBs) weakened in September but continued to turn in strong year-to-date gains after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) has benefitted from its long duration, returning 10.9% ytd. US TIPs (TIP) returned 8.7% in CAD terms, while Non-US ILBs (WIP) returned 7.5% in CAD terms.

In corporate bonds, the US investment grade bond ETF (LQD) returned 11.5% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 8.1% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned 4.1%.

Global ETF Portfolio Performance through September

In September, the Global ETF portfolios tracked in this blog posted losses, trimming their year-to-date gains, which have been boosted substantially by the weakness of the Canadian dollar.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio lost 103 basis points in September to be up 8.2% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, lost just 52 bps to be up 8.1% ytd.

Risk balanced portfolios also posted losses. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 136 bps in September, but was still up an impressive 13.9% ytd. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, returned 71 bps in August to be up 9.4% ytd.

Outlook for October

Key developments that Canadian ETF investors should be watching in October include:

• US labor market developments remain a key focus. FOMC members have begun to prepare markets for increases in the Fed Funds rate in 2015. QE is ending and a "normalization" of the policy rate is expected to follow. I wrote about "Exit Ennui" in mid-September (see here). While US employment growth remains relatively strong and US real GDP growth remains solid, growth in Europe is stagnant and growth in China appears to be weakening. This is likely to create tension within the FOMC as hawks focus on US relative strength while doves give more weight to moderate inflation and weakness outside the US.
• This divergence is pushing the USD higher against all currencies and potentially weakening S&P500 earnings for those companies with significant foreign operations. US dollar strength will continue to be fuelled by safe haven flows and by the divergent monetary policy paths being taken by the Fed and the BoE toward tightening and the ECB and BoJ toward maintaining or increasing monetary ease.  
• The Bank of Canada will find ample reason to remain neutral on the direction of the next policy rate move. Canada's real GDP began 3Q on a softer trajectory and the terms of trade continue to weaken. Further weakening of the Canadian dollar will be tolerated.
• The debate between US equity bulls, who favor buying every dip, and those advising caution due to high equity valuations (see here) continues.     
• After moderating over the summer, global disinflation concerns reemerged in September. Weaker growth in the Eurozone, Japan and China, falling crude oil and corn prices, in the dampening effect of geopolitical tensions on consumer confidence all add to global disinflationary pressures. The risk of a global deflationary shock still seems much greater than the risk of an inflationary shock. 

In recent monthly reviews, I have concluded that, “Having ample cash in the portfolio remains a good strategy until the unstable disequilibrium of weak growth, low inflation, accommodative central banks and stretched asset valuations is resolved.”

As it turned out, the ample cash cushioned losses in my desired portfolio in September. Both bond and equity prices corrected in September, but these corrections made only a slight dent in asset overvaluation (see here). What was interesting in September was that bonds led the sell-off through the first three weeks, but equities experienced bigger losses by the end of the month. The unstable equilibrium is nowhere near corrected. Prudence continues to favor an ample cash allocation.

Exit Ennui: The Sequel to the Taper Tantrum

In May and June of 2013, we had the "Taper Tantrum" in markets, sparked by then-Fed Chair Ben Bernanke's announcement that the Fed would begin to taper its $US85 billion per month quantitative easing (QE) program. Over a four week period from May 24 to June 21, 2013, returns on all major asset classes fell as markets adjusted to the expectation that large-scale Fed purchases of US Treasuries and Mortgage Backed Securities would end. With all asset classes posting negative returns, all types of portfolios experienced losses, but some portfolios lost much more than others.

In September 2014, we are experiencing the sequel to the Taper Tantrum, which I will call Exit Ennui. This sequel was triggered, I believe, by Fed Chair Janet Yellen's speech at Jackson Hole. There was nothing wrong with the speech. It was surprisingly balanced. While Yellen is widely perceived as occupying a position near the dovish extreme on the Hawk-Dove spectrum among FOMC members, she did not make a dovish speech at Jackson Hole. That was left for ECB President Mario Draghi and the main result was to highlight the divergence in economic performance between the world's two largest economies: US relative strength versus Eurozone relative weakness.

In the weeks since Jackson Hole, US economic data has retained a strongish bias and attention has focussed on when the Fed will begin to raise official interest rates and what form the exit strategy will take. In the wake of Yellen's Jackson Hole speech the 10-year US Treasury yield moved up from 2.34% on August 27 to 2.62% on September 16, ahead of the Fed decision on September 17. 

In the chart below, I compare returns on the ETFs that I regularly track during the Taper Tantrum with those seen to date (as of September 22) in the Exit Ennui. The returns are in Canadian dollar (CAD) terms and it is interesting to note that during the first four weeks of the Taper Tantrum, the CAD weakened 1.3% versus the USD, while in the Exit Ennui it has weakened a very comparable 1.4%.

Based upon this chart, we can make the following observations:

• The Exit Ennui has not yet done as much damage as occurred during the first four weeks of the Taper Tantrum.
• In both periods, all asset classes performed relatively poorly. Nominal bonds, inflation-linked bonds, credit, equities and commodities all sold off to varying degrees.
• Inflation-linked bonds were relatively hard hit in both periods.
• Emerging Market assets have fared relatively better in the Exit Ennui than they did in the Taper Tantrum.
• Long-duration bonds performed relatively poorly in both episodes.
• Commodities have performed worse in the Exit Ennui than in the Taper Tantrum
• Within equities, Canadian equities performed relatively poorly in both episodes

Portfolio choices make a big difference during drawdown periods like the Taper Tantrum and the Exit Ennui. The chart below shows the performance of the four portfolios that I regularly track.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio, which lost 3.44% during the Taper Tantrum is down just 63 basis points so far in the Exit Ennui as equities have not been hit as hard this time around. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, which lost just 2.11% in the Taper Tantrum is down 56 basis points in the Exit Ennui.

Risk balanced portfolios posted larger losses in both periods. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 7.03% in the Taper Tantrum and is down 2.42% so far in the Exit Ennui. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, lost 4.13% in the Taper Tantrum and is down 1.10% so far in the Exit Ennui.

What this highlights, is that leverage has not been an investor's friend during periods in which markets are pricing in reduced Fed monetary accommodation. During these drawdown periods, cash is often the best asset class, which is why the 45/25/30 portfolio tends to perform best during these episodes.  
   

Risk Seduction: Why Markets are Rich

In a recent post, I reviewed the evidence on equity valuations and concluded that, according to the most credible metrics, US equities are close to the richest valuations on record. But it is not only equities that are expensive. Government bonds are expensive. Corporate bonds are expensive, especially high yield or junk bonds. Real estate is expensive. In short, most asset classes are expensive. This means that, while one cannot confidently forecast short-term asset class returns, one can be fairly confident that long-term returns on these asset classes will be quite low relative to recent history.

This note discusses the two main reasons why markets are so richly priced. It examines the role of central bank policies and corporate management behavior in bidding up asset prices. When central bank policies and/or corporate behavior change, asset prices will likely move, either gradually or suddenly, toward fair value. The period of transition will be a nervous one for investors.

The Role of Central Banks

Central banks have played a central role in enriching asset prices since the Great Financial Crisis (GFC). As the GFC unfolded, major central banks cut their policy rates to close to zero and, because they felt that this did not provide sufficient stimulus, resorted to various forms of quantitative easing (QE). QE involves the large-scale purchase of government bonds or private assets such as mortgage-backed securities. As central banks engage in such purchases, the size of their balance sheets expands. The charts below, from a recent report by Nikolaos Panigirtzoglou of JPMorgan, show the growth in the size of the balance sheets of the US Fed, Bank of England (BoE), European Central Bank (ECB) and Bank of Japan (BoJ) in the left hand chart and the combined expansion in US$ of the four central bank balance sheets on the right. The result has been that the total balance sheet of the four big central banks expanded from $US 4 trillion in 2008 to almost $US 11 trillion by the end of August, 2014.  

By cutting their policy rates to close to zero and providing forward guidance that policy rates would stay exceptionally low for an extended period of time, the central banks have encouraged investors reduce their holdings of cash and to take more risk. Investors have responded by bidding up prices of equities, commodities, government bonds, corporate bonds, real estate and infrastructure assets. By undertaking QE, central banks have provided the liquidity to support investor's risk-taking. 

The result is that many equity markets are richly-valued, while government bond yields have fallen back toward post-GFC lows more than five years into the tepid global recovery. Corporate and emerging market bond yield spreads over US Treasuries are near their pre-GFC lows. Real estate prices in many countries are at record highs. As Panigirtzoglou argues, "Asset yields are mean reverting over long periods of time and thus historically low levels of yields in bonds equities and real estate are unlikely to be sustained forever."

Corporate Behavior and the Bonus Culture

The second, but much less discussed source of overvaluation of asset prices is corporate behavior, specifically what is known as the “bonus culture”. Andrew Smithers has developed the most insightful analysis of this change in corporate behavior brought about by changes in the way that management is compensated.

As Smithers explains in his new book, The Road to Recovery, the shift in executive compensation systems over the past two decades to rely heavily on bonuses combined with changes in corporate accounting rules have increased both management’s incentive and ability to overstate corporate profits. This means that profits are regularly overstated in good times and then understated through write-offs during bad times. 

The change in accounting rules that made this possible was the change from “marked to cost” to “marked to market”. With marked to market accounting, changes in asset prices, either positive or negative, make a greater contribution to reported corporate profits and thereby make profits much more volatile. This is good for corporate managers because, as Smithers points out:

As bonuses usually depend on changes in profits, companies’ managements will usually be able to benefit from both over- and understated profits. When profits are overstated, they will rise more than they otherwise would have done and bonuses will rise with them. When profits are understated in one year but not the next, the rise in profits will also be exaggerated, together with the associated bonuses. Managements therefore want profits to be volatile. As management gets what management wants and what management wants has been greatly eased by marked to market accounting, the result has been the growth of periodic write-offs.

Assets are therefore periodically written up or written down. The associated write-offs are either an admission that profits have been overstated in the past or a promise that management will try to overstate them in the future.

Smithers also explains how the bonus culture leads corporate management to favor buying back corporate equity over investing in new capital equipment and software. Equity buy-backs increase earnings per share in the short term, while investment in capital equipment reduces earnings per share over the same period. Increasing earnings per share increases management bonuses and so is the more attractive choice. 

Stock buybacks are a major cause of equity overvaluation. The chart below, from a recent article by Henry Blodgett posted on Business Insider, shows that in Q1 of this year “equity buybacks hit almost the highest level in history -- exceeded only by a couple of quarters in 2007, just before the market tanked”.

By Blodgett’s calculation, stock buybacks, which reached US$159 billion in 1Q14, have outstripped new share issuance for several years and, as a consequence, the total number of shares outstanding for S&P500 companies is now lower than it was in 2005. Share buybacks have been financed by corporate cash flows, which have been waning recently, and by issuance of debt which has levered up corporate America.

What will end the Overvaluation?

The two main drivers of asset overvaluation are central bank policies, (specifically near-zero policy rates and large-scale QE) and corporate behavior (specifically overstatement of profits and equity buy-backs). Overvaluation will likely diminish, perhaps rapidly, when these policies and behavior change.

Quantitative easing by the Fed is set to end in October and the policy rate is expected to begin to rise some time in the first half of 2015. On previous occasions when the Fed has attempted to end QE, equities have weakened and bond yields have fallen as investors feared that the economy would slump as monetary stimulus was reduced. However, in this instance, US growth appears to be accelerating, the economy is operating closer to full capacity, and the Fed is expected to follow up termination of QE with an increase in the policy rate. If the growth acceleration continues and inflation remains stable, the US Treasury bond market is likely to sell off. If the growth acceleration continues and inflation moves above target, all asset markets are likely to weaken. A potential mitigating factor is that the ECB may be preparing a new round of large scale QE, but this might just add to volatility in foreign exchange and other markets.

Stock buy-backs are likely to continue as long as corporate cash flows remain solid and bond investors remain willing to buy corporate debt at relatively narrow spreads over government bonds. However, there are signs that cash flow growth has peaked and that investors are becoming wary of corporate credit. Should corporate profits and cash flows be squeezed by the faster wage growth that Fed Chair Janet Yellen wants to see, the massive flows into high yield and investment grade corporate debt driven by investors search for yield could reverse. Strategists have pointed out recently that regulation has reduced the willingness and ability of bank-owned dealers to make liquid markets in corporate debt. Should investors decide to significantly reduce their corporate debt holdings, not only would credit markets suffer potentially serious losses, but a major source of funding for equity buy-backs could dry up.

It is, therefore, for good reason that the Fed and the Bank of England are likely to move toward tightening policy with great caution. Beginning the process of reversing years of extreme monetary ease could prove quite unsettling to richly-valued financial markets. 

Global ETF Portfolios for Canadian Investors: August Review and Outlook

Global markets provided solid returns in August as geopolitical risk seemed to ebb through mid-August, and Mario Draghi stole the show at the central bankers’ confab at Jackson Hole by hinting at further ECB monetary stimulus. For Canadian investors with currency-unhedged portfolios of global ETFs, it was another highly profitable month. Significant market and global macro developments in August included:

• Global equity ETFs were mostly higher. US, Emerging Market, and Canadian equity ETFs posted solid gains, while Eurozone equities were flat and Japanese stocks were down. 
• US and Canadian government bond ETFs posted strong gains, while European and Emerging Market Local Currency bonds performed relatively poorly as their currencies weakened.
• The US dollar strengthened against most major currencies. 
• Gold stabilized but the commodity ETF posted a second consecutive sharp monthly loss. 
• Energy prices weakened as the WTI crude oil futures price fell to $96/bbl at the end of August.
• US and Canadian GDP growth posted better than expected 2Q rebounds but Europe and Japan reported much weaker than expected 2Q growth.    
• Global inflation moderated in July after picking up in May-June, with Eurozone inflation falling to just 0.3%. 
• The Jackson Hole meeting of central bankers underscored the divergent paths of central banks, with the US Fed and BoE preparing rein in monetary stimulus while the ECB and BoJ are under pressure to increase stimulus. The Bank of Canada prefers to remain neutral as to whether its next policy move will be a tightening or an easing. 

Global Market ETFs: Monthly Performance for August

The S&P500 closed August at a record-high 2003, up from 1931 at the end of July and 1960 at the end of June. Global equity ETFs were mostly higher in August. Despite a sharp weakening in early August after an erroneous employment report, the C$ closed August with a gain of 0.2% vs. USD, slightly moderating Canadian dollar returns on USD denominated ETFs. US Small Cap stocks (IWM) were the top performers among the equity ETFs we track, gaining 6.7% in CAD terms. US Large Cap stocks (SPY) returned 3.7%, Emerging Market equities (EEM) returned 2.6%, and Canadian equities returned 1.6%. Eurozone equities (FEZ) were flat in August in CAD terms. The worst performers were Japanese equities (EWJ), which returned -1.9% in CAD terms.

Commodity ETFs were mixed. The Gold ETF (GLD) returned 0.3% in CAD terms, while the GSCI commodity ETF (GSG) returned -1.8%.

Global bond ETFs posted mixed returns. ETFs with positive returns in August included the US long government bond (TLH), which returned 2.4%, Canadian Long Government bonds (XLB), which posted a 2.3% return, and USD-denominated Emerging Market bonds (EMB) and EM Local Currency Bonds (EMLC), which returned 1.0% and 0.1% in CAD terms, respectively. Non-US government bonds (BWX) were flat in CAD terms, as weakness in the Euro and widening spreads on some Eurozone periphery bonds offset gains in Germany in other markets.

Inflation-linked bonds (ILBs) posted more modest positive returns in August as global inflation moderated. Canadian RRBs (XRB) returned 0.7%, while US TIPs (TIP) returned 0.4% in CAD terms. Non-US ILBs (WIP) returned 0.7%.

Corporate bonds performed well in August as US investment grade (LQD) and high yield (HYG) bonds returned 1.8% and 2.1% respectively, in CAD terms. Canadian corporate bonds (XCB) returned 0.8%.

Year-to-date Performance through August

In the first eight months of 2014, with the Canadian dollar depreciating 2.4% against the US dollar, the best global ETF returns for Canadian investors in CAD terms were in Canadian equities (XIU), Canadian inflation linked bonds (XRB), and US long term bonds (TLH). The worst returns were in Japanese equities (EWJ) and commodities (GSG). It seems unusual, and perhaps unsustainable, that Canadian equities are world-beaters in a year in which commodity ETFs have been among the worst performers.

In global equities, the Canadian equity ETF (XIU) performed best, returning 16.6% year-to-date (ytd). The S&P500 ETF (SPY), which hit a record high, returned 7.7% in CAD terms. Emerging Market equities (EEM), after a rough start to the year, rebounded to return 11.1% ytd in CAD terms. The Eurozone equity ETF (FEZ), which had been the top performer through May, suffered from geopolitical tensions and currency weakness in June through August and returned 1.3% ytd in CAD terms. The Japanese equity ETF (EWJ), after losses in August, returned just 0.1% ytd in CAD terms. US small caps (IWM), after rebounding in August, returned 7.5% ytd in CAD terms.

Commodity ETFs had lackluster performances this summer after strong starts to the year, dragging down year-to-date returns. The Gold ETF (GLD) has returned 9.2% ytd in CAD terms, while the GSCI commodity ETF (GSG) returned just 0.1%.  

Global Bond ETFs continued to perform extremely well for Canadian investors. Foreign bond ETFs have benefited from a combination of weaker than expected global growth, safe haven demand, and accommodative central bank policies. The US long bond ETF (TLH) returned 13.3% ytd in CAD terms. The Canada Long Bond ETF (XLB) posted a gain of +11.6% ytd. USD-denominated Emerging Market bonds (EMB) returned 11.1% ytd in CAD terms. Emerging Market local currency bonds (EMLC) suffered from EM currency weakness to return 7.1% in CAD terms. Non-US global government bonds (BWX) posted a return of 7.0% ytd. 

Inflation-linked bonds (ILBs) continued to turn in strong year-to-date gains after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) has fared best, benefiting from its long duration, returning 13.5% ytd. Non-US ILBs (WIP) returned 10.5% in CAD terms, while US TIPs (TIP) returned 8.4%.

In corporate bonds, the US investment grade bond ETF (LQD) returned 10.2% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 7.2% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned 5.2%.

Global ETF Portfolio Performance through August

In August, the Global ETF portfolios tracked in this blog posted strong gains, adding to positive year-to-date returns, which has been aided by the weakness of the Canadian dollar.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 154 basis points in August to be up 9.2% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 181 bps to be up 8.6% ytd.

Risk balanced portfolios also posted robust gains. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 240 bps in August, boosting to its year-to-date gain to 15.4%. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, returned 183 bps in August to be up 10.1% ytd.

Outlook for September

The Ukraine crisis, which seemed to stabilize through August as Ukrainian forces pushed back Russian supported rebels. But in the final days of the month, NATO reported that Russian tanks and troops crossed the Ukrainian border, taking hostilities to a new level and likely triggering a new round of sanctions on Russia. Conflict continued in Iraq, with the US launching air strikes against ISIS. Geopolitical risks, which appeared to be waning through much of August, really did not.

Key developments that Canadian ETF investors should be watching in September include:

• US labor market developments will remain a key focus because that is what Fed Chair Yellen is watching. A strong August employment report on September 5, especially if it provides evidence that wages are accelerating could add to speculation that the Fed will have to raise the policy rate sooner tan currently expected.
• US dollar strength will continue to be fueled by safe haven flows (as NATO tries to counter Russia incursions into Ukraine and the US contemplates air strikes on ISIS in Syria), and by the divergent monetary policy paths being taken by the Fed and the ECB toward tightening and the ECB and BoJ toward maintaining or increasing monetary ease.  
• The Bank of Canada’s policy rate decision on September 3, when the BoC will react to solid 2Q real GDP growth of 3.1%, an upward revised July employment report, and inflation moving closer to the 2% target. I expect that the BoC will continue to find reasons to remain neutral on the direction of the next policy rate move. Further weakening of the Canadian dollar will be tolerated.
• The debate between US equity bulls who favor buying every dip and those advising caution due to high equity valuations (see here) will continue. The S&P500 had its best August in 14 years, according to CNBC. Ironically, that takes us back to August 2000, the peak of the Tech Bubble.    
• Concerns about global inflation are more balanced than earlier this year. Inflation has accelerated somewhat in the US, UK, Japan and Canada, but decelerated toward deflation in the Eurozone. The risk of a global deflationary shock still seems much greater than the risk of an inflationary shock. 

In recent monthly reviews, I have concluded that, “Having ample cash in the portfolio remains a good strategy until the unstable disequilibrium of weak growth, low inflation, accommodative central banks and stretched asset valuations is resolved.”

As it turned out, the ample cash dampened returns in my desired portfolio in July and August, but returns were still quite acceptable. The unstable equilibrium that has allowed equity  prices to drift steadily higher this year could persist for months or it could come to a volatile and sudden end. Prudence leads me to continue to favor an ample 30% cash allocation as we await the denouement.

Eight Miles High: A Note on Equity Valuations

In previous posts, I have commented that the equity market and other markets are overvalued because of the effect of large scale quantitative easing by the US Fed and other central banks. In this post, I will summarize several warnings from highly credible analysts about equity valuations that have been published in recent weeks.

When I think about US equity market valuation, I don't give much credence to the conventional Forward Price/Earnings (P/E) measure based on the current market price of the S&P500 divided by the 12-month forward projection of S&P500 earnings. Instead, I prefer to look at more credible historical metrics like the Cyclically Adjusted P/E (CAPE), originated by Nobel Prize winning economist Robert Shiller in his book Irrational Exuberance. CAPE compares the current price of the S&P500 with the 10-year average of S&P earnings with both variables adjusted for inflation. These measures tend to be mean reverting. The chart below, taken from Shiller's website (which can be seen here) shows the current valuation of the S&P500.

The current CAPE ratio, at 25.69 on August 15, suggests that only in the periods preceding the 1929 Crash and the 2000 Tech Bubble burst has the S&P500 been more richly valued. In those two periods and when the CAPE valuation reached close to current levels in 1901 and 1966, equity returns over the next 10 to 20 years were dismal.

Another advocate of credible long term valuation metrics is Andrew Smithers, author of Valuing Wall Street. Smithers favored metric is Tobin's q, (named after Nobel Prize winning economist James Tobin), which is calculated by dividing a company’s market capitalization by the replacement cost of its assets. Smithers has recently ended publication of his periodic market outlook reports, but not before publishing a final report on July 15 (see here). In his last regular look at market valuation, Smithers combines his historical estimate of q with his own technique of hindsight value to come up with the chart below.

Smithers notes that:

As at 31st March, when the S&P 500 was at 1872, the market was 80% overvalued and only on five previous occasions (1853 71%, 1906 62%, 1929 123%, 1968 66%, and 1999 152%) has the market been more than 50% overvalued. Market swings have been long. The gap between these 50% plus overvalued peaks has averaged 49 years but, with so few observations, there is no evidence to suggest that there is any regularity in the timing of peaks or troughs.

As I was doing the research for this post, I came across a new report written by Stephen Jones of String Advisors in New York, entitled, Forecasting Equity Returns: An Analysis of Macro vs. Micro Earnings and an Introduction of a Composite Valuation Model. The paper (here) examines the ability of CAPE and other metrics to forecast 10-year equity returns. One interesting finding is that a measure of equity market valuation favored by Warren Buffett, the ratio Market Value of corporate equity to GDP (MV/GDP), is a better predictor of 10-year forward returns than is CAPE. Bloomberg (here) published a chart of Buffet's favorite valuation metric, shown below.

The following chart shows comparisons on several metrics reviewed by Jones. By all of these metrics, stocks look expensive, but they look most expensive by the MV/GDP measure.

Jones goes on to argue that the market value-GDP ratio works even better at forecasting equity market returns in a multi-variable forecasting model which utilizes a demographic variable, a personal income to book value of US corporations variable, a personal consumption variable and a real GDP growth variable. This multi-variable or composite model, which Jones refers to as demographically adjusted and market adjusted (DAMA), has been a better predictor of 10-year stock market returns than any of the single ratio metrics discussed above. A comparison of the forecasts with actual results (the black line, which is only available through 1Q04) is shown below.

The forecast S&P500 levels 10 years forward (to 2024) and the annualized rate of return from each of the metrics and Jones composite model, are as follows:

• CAPE:        S&P500 at 2600, annualized return of 2.7%
• Tobin's q:   S&P500 at 2020, annualized return of 0.2%
• MV/GDP:   S&P500 at 1120, annualized return of -5.5%
• Composite: S&P500 at 650, annualized return of -10.5%

While some Wall Street commentators have criticized Shiller's CAPE (here), it is interesting that Tobin's q (Smithers favorite metric), Buffet's MV/GDP, and Jones' composite model (which has the best 10-year forward forecasting record) are all forecasting much weaker returns than Shiller's CAPE.

The point is that, starting from the current overvalued level of the S&P 500, all of the forecasts point to dismal returns for equities over the next decade. This does not mean that equities are about to crash or that stocks can't post decent gains over the next year or two. By most metrics, the S&P has not yet reached its valuation extremes of 1929 or 2000. Central banks continue to reassure that policy will remain accommodative. But the metrics do indicate that investor caution and alertness are warranted.