On Friday, we looked at the extent to which the S&P may be headed for its sixth consecutive quarter of falling EPS growth.
That’s the longest stretch since the crisis. Nevertheless, markets are riding high, most recently thanks to the Bank of England’s kitchen sink moment (rate cut, gilt buying, corporate bond purchases) and a quick rebound in crude attributable entirely to completely meaningless comments from Saudi Arabia.
Of course if earnings keep falling and stocks keep rising, that means multiples will become even more stretched. Here’s a look at where we are now:
(Chart: Goldman)
Yesterday we closed by noting that when Bank of America surveyed clients about how the paradoxical divergence between stock prices and bond yields will ultimately resolve itself, around half of respondents said it simply won’t. Meaning they believe stocks will continue to rise and bond yields will continue to stay low. Here’s an updated look at the equity-risk premium (ERP):
(Chart: Goldman)
In that same survey, 22% of respondents indicated that they believe stocks will ultimately fall to close the gap. Deutsche Bank agrees - but says it’s a long way off. Here’s some interesting color out late Friday evening:
“Stocks must fall for yields to rise – but unlikely to happen anytime soon. It is pretty much understood that we are in full on financial repression mode, as witnessed by super benign core yields lead by lower real yields with more recently the further downward drift in euro peripheral yields, including the UK. The new high in equities is consistent with our view of financial repression that necessarily has yield returns on all assets being incrementally replaced by price returns – stretched relative valuations follow already increasingly stretched absolute valuations. The last round of economic data does little to suggest any change in this dynamic. As we highlighted last week the conundrum for the US is how an overly strong labor market without meaningful wage inflation resolves itself against markedly weak productivity data with a GDP cake that if anything seems to be stagnating.”
We’ve long argued that exogenous shocks from geopolitical turmoil pose an underappreciated risk to markets. The Brexit vote both validated and invalidated that contention. We did indeed get a geopolitical black swan and markets did indeed convulse (especially cable), but subsequent expectations for further easing cushioned the blow and before you knew it, VIX was down 43% in a week.
Of course there are plenty of other potential exogenous shocks on the horizon, not the least of which is the US election which, as you can see from the following, no one is pricing in vol wise:
(Chart: Goldman)
But with the market having seemingly become immune to war and political turmoil, is it even worth hedging geopolitical tail events? According to Citi, the answer is no. Consider the following:
“Given the recent market moves, the natural inclination for many investors would be to take advantage of the lull in markets and put on some tail risk hedges. While on the surface, such a view would make sense, we believe that investors need to be cautious about how they structure these hedges, specifically in terms of the time horizon over which they hedge, and the types of tail risk events they should hedge against.”
“Drawing from our experience in the post-financial crisis era, we find that exogenous events may cause markets to react violently, but if so, the resulting sell-off and spike in volatility tends to be short-lived. Take Brexit from earlier this summer as an example. Volatility had begun to spike going into the referendum, and spreads gapped wider in the immediate aftermath of the “Leave” outcome. However, the reaction was pretty short-lived (see Figure 2) as markets rallied shortly afterwards.”
“Another example is the aftermath of the “No” vote in the Greek referendum last summer which led to increased likelihood of a Grexit event – once again, volatility spiked and markets sold off in the short term. In this case, however, the actual event did not occur, and one can only speculate what may have happened if Grexit had indeed become a reality, but the market reaction that occurred during this period was also temporary (see Figure 2).”
(Chart: Citi)
Now first of all, we’re not entirely sure we agree with that assessment. As Citi readily admits, one of those two exogenous shocks didn’t actually happen and the other is still in the works so it’s kind of difficult to evaluate.
Nevertheless, we would agree with the contention that you want to buy protection when it’s cheap. Especially given how over extended we are.
But here’s the punchline - and this is a direct quote from Citi in December:
“In the year ahead, geopolitical risks likely pose the greatest potential to disrupt markets in terms of event risk.”
See the inconsistency there? You gotta love Wall Street.