The equity market remained a bastion of tranquility in July as the S&P 500 rallied 1.9% and the volatility index (VIX) touched an all-time low of 8.84 late in the month. A telling example of the complacency was on display in a Bloomberg TV interview. The analyst being interviewed was asked how she could offer a buy recommendation on a stock with such a lofty Price/Earnings ratio. The analyst responded that yes, the stock price is expensive from a P/E perspective, but not as expensive as other stocks in the industry. We worry that when analyst’s start justifying buy recommendations on expensive stocks based on relative value, the market is at risk.
Similarly, bonds posted a benign month, with 2-year interest rates a few basis points higher and ten-year notes a few basis points lower. All eyes were on the Federal Reserve mid-month in anticipation that Chair Yellen would further flesh out the start date of balance sheet reduction. But rather than offer details, she stressed that the Fed would move slowly in normalizing policy. Despite that, we expect that the start date is likely to be detailed at the September meeting and will commence in October.
In the foreign exchange market, the action was anything but benign. The Euro staged an impressive rally, rising 3.36% in price, finishing the month at 1.1811. Recall that at the start of this year the cost to buy one Euro stood at $1.04 and the vast consensus was that the cost would ultimately fall below $1.00. The logic had been that with negative interest rates in Europe, investors and savers would sell the Euro and buy U.S. Dollars to earn the interest rate differential. As we’ve written previously, that logic is flawed due to cross-currency interest rate arbitrage. Nonetheless, there seemed to be more than enough of those Europeans in search of yield to push the value of the Euro down to near parity. In hindsight, that had become a very crowded trade and with European economic prospects brightening, the Euro shorts needed to cover. As we mentioned in last month’s update, ECB Chief Mario Draghi briefly floated the idea of trimming the emergency quantitative easing in which the central bank has been engaging.
At the time of this writing, we are about half way through Q2 corporate earnings, and they have been broadly positive, which has further served to support stock prices higher. The problem is that stock prices have reached nosebleed levels as measured by the Price/Earnings ratio. The current 2017 estimated P/E for the S&P 500 stands at approximately 19 times earnings. While elevated by historical standards, the divergence of the 500 stocks in the index brings to mind the adage that one can drown in a lake that on average is only two feet deep. That is to say that the average P/E masks the wide valuation divergence among stocks in the index. For example Intel, Ford, and General Motors, to name a few, trade well below that average, while so-called large cap value stocks like Procter and Gamble, Colgate, MMM, and John Deere all trade well above it. We sarcastically refer to the large caps as value stocks because at current prices we see no value at all. Each of the four stocks has suffered a decline in revenue over the last four years. A quick and dirty measure of value is the Profit/Earinngs ratio divided by the Growth rate (PEG) ratio. As a rule of thumb, a PEG ratio of one offers fair valuation for slow growing corporations and the ratio rises for faster growing companies. Logically investors are more willing to pay a higher price for a faster growth. Why, then, do we have slow growth companies trading at a PEG ratio of four. We believe that the answer is index fund buying. Since those companies represent large weightings in the S&P 500, they represent a bigger share of the index and hence a bigger resultant purchase when an investor buy an S&P index fund. When demand for index funds explodes as it has in recent years, demand for those shares correspondingly explodes. In essence, the index fund managers become price insensitive buyers. In that sense, who cares how expense the underlying stocks are; they need to be purchased. Price insensitive buying rarely ends well!