Is the Fed's Liquidity Pump Responsible for Intraday Price Action?

Yesterday we highlighted that our Weak Stock Market Close Indicator indicator had surged to the highest level since 2012 and today a client made the good point that our Weak Stock Market Close indicator seemed to give more false signals when the Fed was engaging in QE. That is of course a correct observation. In the first chart below we show our Weak Close Indicator chart overlaid with grey shaded regions during periods of QE. We got a false sell signal early in QE2 and then an even larger false sell signal in 2013 during QE3.
 

The reader will further note that the Weak Close Indicator shoots up during periods without QE such as mid-2010, late 2011 and now. To more clearly demonstrate that last point we've overlaid the Weak Close Indicator on the three month change in Federal Reserve Assets (chart below) such that we’re comparing the flow of asset purchases to weak market closes. Weak market closes seem to increase when the Fed takes its foot off the accelerator. It’s not terribly surprising then to see more weak closes of late, just like when QE ended in 2010 and 2011. 



As our regular readers have probably seen in our other blog posts, we have also observed a relationship between the deceleration of Fed asset purchases during the taper and things such as the compression in bond yields, counter cyclical stock outperformance, weakness in commodities, and narrowing stock market breath.  Fed liquidity trends have had all sorts of effects on asset prices and the ending of QE seems to go a long way in explaining recent market moves. Charts below.

Despite Large Moves in Prices, Asset Volatility Still Mostly Below Average

The last several weeks has undoubtedly seen some major moves in asset prices especially in the commodity and currency spaces. Yet, relative to history volatility in most asset classes still remains below average with the exception of the bond market.

As the first three charts below show, our volatility indicators for the FX, commodity and equity markets are just now approaching their long-term average after having been suppressed to record lows in 2014. Bond market volatility, on the other hand, remains near the record set during the 2012 euro crisis. The only difference is that in 2012 European sovereign bonds were selling off and today they are bid.  

The Median Stock Is Unchanged Over The Last Year But Sector Allocation Makes A Difference

As we noted yesterday, the US stock market has been the only game in town recently. The S&P 500 is up about 8% over the year and the median stock in the MSCI North America is up 7%. Meanwhile the median stock in the MSCI World Index has not changed over the past year.





However, breaking the MSCI World into sectors we see that performance has been pretty uneven over the past year. Energy, unsurprisingly, has vastly underperformed. The median energy stock is firmly in a bear market down over 28% over the past year. On the other end of the performance spectrum, readers of this blog will not be surprised to see that the median stock in the health care sector is higher by 17% over the past year.





Median performance for the remaining sectors separates fairly cleanly among couter-cyclicals and cyclicals. The median stock in the utilities sector is 14% higher than it was a year ago. And the median stock in the consumer staples sector is up 9%. Telecom is up 1%.







Tech is the only sector where the median stock higher over the past year (5%, respectively). The median stock in the consumer discretionary sector is unchanged. The remaining cyclical sectors are all down between 2% and 7% over the past year.

Weak Stock Market Closes Surge to Highest Level Since 2012

While the intraday performance trend of the stock market isn't everything, it often gives clues to possible directional changes in the overall trend of the market. One of the ways we measure the intraday trend of the market is to count the number of weak closes over a period of time. We define weak closes as days in which the closing price is within 25% of the intraday low.

As our Weak Close Indicator shows below, the number of weak market closes for the S&P 500 (red line, left axis, inverted) has shot up over the last three weeks or so and is now at a level not seen since the end of 2012. We note that a similar event happened in 2013-2014 and the market kept on advancing, but the move in the indicator over the last few weeks has been noteworthy.

Stock Market Leadership on a Country Basis Has Never Been Narrower

The United States stock market has been the only game in town. The US the only major developed country to have outperformed the MSCI World Index over the last year, joined only by the much smaller markets of New Zealand and Hong Kong.



Performance of Developed Market Countries Relative to MSCI World Index in USD:

To Hedge or Not To Hedge

Today the Swiss National Bank removed the CHF/Euro peg and the Swiss Franc shot up relative to the USD.  In the chart below we can see the almost 15% drop in the value of the USD relative to the Swiss Franc.



For a US-based investor with a hedged exposure to Swiss stocks, today was a bad day.  For an unhedged investors, today was a great day.  In the first table, we show the performance of the MSCI developed world countries in local currency terms.  In the second table, we show the performance in USD terms.





In local currency terms (CHF), the Swiss stock market was a nightmare, but again, in USD terms, it was a dream come true.  In the first table, we show the performance today of MSCI Switzerland companies grouped by economic sector, in CHF.  In the second table, we show the MSCI Switzerland companies in USD.





To hedge or not to hedge, this is the question. With the USD having been a decidedly one way trade for the last six months, hedging has subtracted from returns...until today.

Emerging Market Intangibles

Considering our focus on investing in the most intangible-rich companies in the world, it is no surprise that we follow investments in intellectual property very closely.  Unsurprisingly, corporations in developed countries invest more in R&D, advertising, and firm-specific resources than their emerging market counterparts.  That is not to say, however, that companies in emerging markets are not interested in creating a productive capital stock of innovation.  In fact, we find that they are investing up to 4% of sales in R&D activities and, in some cases, more than 5% of sales in advertising and firm-specific competencies:



The result?  Intellectual property represents an average of 5% of assets on these emerging market companies' balance sheets (the average for developed markets is about 8.7%).



On a sector level, we find that Health Care, Information Technology, and Consumer Staples are, in similar fashion to developed market trends, the largest investors in intangibles:




The focus on intellectual property development results in companies with quality rankings that often surpass those that come from developed markets.  In fact, when screened by the same process we use for finding knowledge leaders in the MSCI World Index (all developed), emerging market companies have a pass rate of about 20% (compared to ~35% for developed companies).  Not bad for a group with an average market cap that is about 1/5th of the average for its developed market peers.  If trends persist (see yesterday's post on EM outperformance so far this year), the emerging market counter-cyclicals (Health Care, Consumer Staples) mentioned here could be an interesting group to consider:

Navigating High Stock Valuations in a Deflationary World

As we highlighted yesterday, stock valuations jumped again in December to another cycle high. As the first two charts show, the cyclically adjusted P/E multiple has only been higher on several occasions and the median stock is trading at a record price to cash flow multiple as far back as we have data. These high valuation levels leave stocks at risk.





Compounding the risk of high valuations is the fact that world economies and financial markets continue to exude deflationary signs, which if anything are intensifying. As the below charts show, we have our World CPI Proxy at the lowest level since 2009, crude, copper, iron ore and commodity prices in general plunging, global government bond yields making new all-time lows, the US yield curve flattening and TIPS implied inflation expectations at the lowest level since the equity selloff in 2011.



















High stock valuations and growing signs of deflation pose all sorts of risks to portfolios, so an important question is what kind of asset allocation is likely to mitigate some of those risks? Specifically for stock investors, what kind of stocks will tend to outperform in periods of deflation/disinflation, and at least on a relative basis, which of these groups offer some semblance of value?

To address the first question we've plotted the relative performance of a few developed market sector indexes (blue line, left axis) overlaid on the reciprocal of the US 10-year treasury yield (red line, right axis) such that higher numbers are equivalent to lower yield. What we find is that the three sectors whose relative performance has the the highest correlation to yields are Consumer Staples, Health Care, and Information Technology. As deflationary tendencies rise we would expect these sectors to outperform the broad equity market, and they have. Since the beginning of 2014 when yields began to fall precipitously these sectors have outperformed the broad equity market by 10-20%.







Now to address the valuation question, what stocks in these groups offer at least a little valuation protection - keeping in mind of course that valuations are stretched in general? To answer that we've shown below our proprietary valuation scores at the sub-industry level for each of these sectors. Our value scores take into account company valuations relative to earnings and cash flow growth, valuations relative to their own history, and cyclically adjusted valuations, among other factors. The score range is 0-100 with higher numbers indicating more relative valuation protection.

What we find is that on a relative basis most sub-industries in these sectors offer average to below average valuation protection, but only a few areas are egregiously overvalued. These include Distillers & Vintners, Health Care Technology, Biotechnology, and Semiconductor Equipment. On the other hand, there are a number of areas that, despite the outperformance in recent years, have not priced themselves out of candidacy for new buys. Some of these areas include Food Distributors, Food Retail, Personal Products, Health Care Services, Health Care Equipment, Pharmaceuticals, Technology Hardware Storage & Peripherals, Home Entertainment Software, and Systems Software.

Consumer Staples Value Scores by Sub-Industry:


Health Care Value Scores by Sub-Industry:


Information Technology Value Scores by Sub-Industry: