I like talking to traders.
I no longer classify myself as one, but there was a time when I was a card-carrying member of the club.
Nowadays, I like to look at the macro picture and try to discern whether there’s something big on the horizon that will ultimately encompass all asset classes and thus be exploitable from a number of angles. It’s not so much that I have some deep-seated desire to hit the proverbial home run, it’s just that I enjoy trying to put all of the pieces together from a 30,000 foot perspective more than I enjoy looking at individual names. That is, for me it was simply a matter of figuring out what style of investing made me happy.
Still, I sometimes miss the trade and I often kick myself (figuratively speaking) when I have an intuition on a short- or medium-term move and don’t act on it whether in an index, an individual name or in the options on that name or index.
It’s that nostalgia for the trade that keeps me glued to valuations and flows and on that note I thought I would touch briefly on where we stand going into a possible Fed hike.
Here’s the thing. You probably don’t want to be overextended to the long side going into this. And not necessarily because of what a summer hike may or may not do in terms of reverberating through global markets, although that is most assuredly a concern.
Rather, you may want to consider the veritable double whammy that stocks could suffer as rates rise.
First, and most obviously, even a token 25bps hike will create a rather notable policy divergence between the US and Europe/Japan. Meanwhile, the Chinese yuan is near 5-year lows against the USD already. So basically you’re going into an environment that’s ripe for USD strength and that could crimp corporate profits at home.
Second, you need to at least consider what a tightening cycle will mean for buybacks. Share repurchases have played an outsized role in the S&P’s prolonged rally. Here’s a visual:
(Chart: Deutsche Bank)
And here’s a look at the percentage of S&P companies with a net reduction in share count:
(Chart: BofAML)
A you can see, that’s a post-crisis high.
What happens to the corporate management team bid when the cost of capital begins to rise? And how will investors’ appetite for corporate bonds change once rates on USTs start to become more attractive?
Those are questions you need to ask yourself, because if the buybacks dry up, that removes what amounts to a corporate management put on share prices.
So having said that, let’s look at valuations. First, note that trailing P/Es look stretched, if not on a historical basis, at least from a post-crisis perspective:
(Chart: Goldman)
And how about the US? Well, at a forward multiple of 17.2, we’re more than one standard deviation rich on a 10-year basis and we’re well above the median:
(Chart: Goldman)
Meanwhile, earnings sentiment is getting more rosy, while flows are moving in the wrong direction:
(Chart: Goldman)
Hopefully, all of the above will serve as food for thought as you position for a possible summer rate hike.
Generally speaking, you can find solace in the fact that the Fed always has your back if you’re in stocks and has since at least 1987.
But contrary to popular belief, the good folks in the Eccles Building are human. And humans make mistakes.