Nell Sloane, Principal, Capital Trading Group LP
Equity markets in developed countries whose central banks deployed unconventional monetary policies did exceedingly well in 2013. Japan’s stock market outperformed the rest of the world, largely because their currency was allowed to depreciate more than 25% in 2012-2013. Recent studies have shown high positive correlations between central bank policies and equity returns. In 2013, the Federal Reserve’s unconventional policies and the SP500 positive correlation exceeded 0.9. Though correlation does not imply causation, as the Federal Reserve embarks on a path of removing these unconventional policies in 2014, we just have to wonder if that removal of asset purchases will also precipitate a mean reversion in the US equity markets?
Goldman Sachs research team led by David Kostin recently noted the forward P/E multiple for the SP500 is “high by any historical measure.” Their research shows the average forward P/E multiple for the S&P 500 for the most recent five year time period is 13.2x. The five year average forward P/E is quite proximate to the 13.0x forward earnings multiple for the 35-year time series.
The consensus current forward earnings estimate for 2014 stands at 120.80 as of Jan 9 2014. Using the consensus forward P/E estimate of 120.80, a mean reversion to the 35 year average forward P/E of 13x implies a correction of –15% is possible in 2014.
Currencies, Commodities and Deflationary Pressures
Unlike the Japanese Yen which has been allowed to depreciate, the US dollar has shown remarkable stability over the past three years. Despite the Federal Reserve’s unconventional monetary policies, the US dollar has closed virtually at 80 cents for three consecutive years.
The annual returns of commodity prices, on the other hand, which are rarely down more than one year in a row, suffered their first ever negative returns for three consecutive years. Deflationary pressures in the global markets have been evident outside of financial assets since March 2011 (using the US PPI index as a proxy for commodity inflation). The potential for a “deflationary shock” to hit both commodities and global equities will be watched closely throughout 2014.
The Federal Reserve will also be carefully monitoring deflationary pressures during the first half of 2014. St. Louis Federal Reserve President said “should inflation not return toward target, the committee could pause tapering [of asset purchases] at subsequent meetings. Deflationary pressures are apt to put upward pressures on the US dollar in the first half of 2014.
The currencies and stock indices of Emerging Markets with high current account deficits suffered a great deal of downside volatility in 2013, particularly Turkey, India, Indonesia, Brazil, and South Africa. This is anecdotal evidence of some sort of Fed-induced “deflationary shock” resulting from their decision to reduce asset purchases in 2014.
Quantifying a Mean Reversion to a 13x Forward Multiple
The recent SP500 high this year and last was 1844-1846. The consensus current forward earnings estimate for 2014 stands at 120.80 as of Jan 9 2014. Using the consensus forward P/E estimate of 120.80, the recent forward multiple was 15.3.
The chart below of the SP500 overlays horizontal lines on the three forward multiples. The first horizontally at 1570 has been placed on the 13x Forward P/E multiple. A second horizontal has been placed at 1450 on the 12x Forward P/E multiple. The 12x forward multiple returns the stock market to where it was in Sept 2012, when the Fed first introduced QE3 to investors. The third horizontal is placed on the 11x Forward P/E multiple.
You can use these plotted forward multiple levels as a reference guide or frame of reference for determining where a mean reversion to the average annual forward multiple would take the SP500 in 2014. There is a tendency for financial markets to revert beyond the mean. Because of this tendency to mean revert beyond the average forward multiple suggests a correction in the SP500 that extend towards the 12x forward multiple at 1450. That is the baseline scenario. A return to the 12x forward multiple would entail a 21% correction, quite similar in magnitude as the 22% correction in 1998 and 2011.
In the fourth quarter of 2013, US lawmakers managed to resolve their fiscal issues for the next few years. This is an unambiguous positive for the economy that may add another 1/2% to 1% to the GDP growth rate. Economic indicators entering 2014 have been unambiguously positive as well.
On the monetary front, short term interest rates are expected to remain zero bound for several more years. NY Fed models, in a 2013 study, forecast “historically high excess returns for the SP500 over the next 5 yrs due to exceptionally low Treasury yields at all foreseeable horizons.” However, as Goldman Sachs pointed out, the forward P/E multiple in the SP500 is historically high by almost any measure.” Even with the recovery remaining on track, the stock market finds itself much less attractively valued than a year ago.
Japan’s current account deficit widened to record levels in November 2013. Strong demand for imported goods resulted from increased energy imports and pull-forward demand ahead of the value-added tax VAT that Shinzo Abe will introduce in April 2014. The widening of the current account deficit is likely to put further pressure on the Japanese Yen until after the introduction of the value added tax. A weakening Yen should continue to support exports and thus the Japanese stock market in the first half of 2014.
China’s official GDP growth rate in 2013 slowed its lowest level since 2003 on the back of tightening new credit since May 2013. More recently, Chinese policymakers have been pushing up short term interest rates in a further effort to deleverage and slow the balance-sheet explosion in recent years. The biggest challenge ahead for China is their large stock of unproductive debt, much of which will need to be rolled over. What has to be rolled over will constrain banks from lending towards more productive uses. To shift towards more productive uses, China will begin a gradual process of restructuring of unproductive debt.
Europe’s financial system managed to skate through 2013 without a scratch. “Continued buying of peripheral debt is the real story,” said Brown Brothers Marc Chandler in early January, adding that “many of the countries on the periphery are seeing much better export performance than people thought likely.”
While EU peripheral debt enjoyed low yields and narrow credit spreads in 2013, the ECB will conduct bank stress tests in 2014. ECB President Mario Draghi said in October that “banks do need to fail” and “if they do fail, they have to fail.” EU banks that fail will be bailed-in by depositors and unsecured creditors and capital controls will be implemented.
In preparation for the stress tests, EU banks have failed to absorb roughly $161 billion in peripheral debt over the last six ECB auctions since late November. There is now a growing funding gap for peripheral EU debt. To close the funding gap, either the ECB implements QE or the yields on peripheral debt will rise in 2014.
Nell Sloane is a principal of Capital Trading Group LP (CTG). Nell began her career at the Chicago Futures Exchanges more than 25 years ago, working for a grain trader at the Chicago Board of Trade. She became a featured contributor to many financial publications and eventually launched her own commodity newsletter called The Opening Belle. She has been a featured speaker at numerous financial seminars and radio shows, and was recognized by financial publications such as Hume Super Investors Files, Opportunities in Options by David Caplan, McMaster OnLine by R.E. McMaster, and The Art of the Trade published by McGraw Hill.
Nell formed CTG with Patrick Lafferty. CTG has clearing relationships with ABN AMRO, FCStone, Cunningham Clearing, RJOBrien, RCG, and OEC. In addition to being principal and an associated person of CTG, Nell holds her securities registration and matches high net worth clients with institutional traders who fit their criteria. CTG is an investment firm specializing in trade execution, account management for CTAs and matching investors with the appropriate managed futures products to provide a more diversified portfolio that the traditional stocks and bonds have to offer. In addition, Nell is the managing member of a multi-advisory commodity fund.
If you have any questions about this article, please feel free to call Nell Sloane at 800.238.2610 or email her at NSloane@CTGtrading.com