Sell in May, and go away again
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By Ryk de Klerk
THE US equity market has all the makings of a “grey rhino” – a term coined by Michele Wucker and defined as “not random surprises, but occur after a series of warnings and visible evidence”.
According to the Organisation for Economic Co-operation and Development, consumer confidence provides an indication of future developments of households’ consumption and saving, based upon answers regarding their expected financial situation, their sentiment about the general economic situation, unemployment and capability of savings. Yes, their confidence about the future economic situation.
It is therefore no coincidence that there is an almost perfect correlation between US consumer confidence and the US stock market rating as measured by Robert Shiller’s cyclically adjusted price-to-earnings ratio (PE10) for the S&P Composite Index based on average inflation-adjusted earnings from the previous 10 years. It is therefore evident that the large investment houses in general use the PE10 as a general valuation metric.
Over the past 20 years there were only two occasions when the market rating of the S&P Composite diverted significantly from the US consumer confidence index: 1998-2000 and since April last year. 1998 to 2000 is still fresh in our minds as it was the famous dotcom bubble that burst in 2000/01.
We all know the sharp rise in US market valuation since the Covid-19 crisis last year was driven by a huge demand for growth stocks, specifically information technology-related. The huge gap between the real economy as measured by consumer confidence and US equity market valuation unequivocally points to a bubble.
Even if consumer confidence revisits its highs of about 140 points over the past 20 years, it implies a fair PE10 ratio of about 32. That compares to the current PE10 of 36.7, meaning that the S&P Composite is overpriced by nearly 15 percent.
Yes, I know that the coronavirus has probably changed the way we will do business in future, but I am of the opinion that consumer confidence will continue to reflect the underlying economy and the outlook for the foreseeable future. The irrational exuberance caused by the tech companies will at some stage self-correct. Mr Market will see to that.
Higher mortgage rates down the line are likely to stem the rise in consumer confidence.
While most investors are of the opinion that monetary policy tightening by the US Federal Reserve is some way off, the housing bubble in the US may see banks acting sooner. The Shiller US Real Home Price Index in February was up by 11 percent in the wake of a sharp drop in mortgage rates. After the Global Financial Crisis the Shiller Home Price Index bottomed in February 2012 and increased by 15 percent before mortgage rates were hiked in June 2013. I will not be surprised if banks are already increasing their lending standards and a hike in mortgage rates may come sooner than later.
US equities have to compete with higher bond yields.
The probability of the US Fed slowing asset purchases is increasing by the day as according to the IHS Markit Flash US Composite PMI Output Index in May, the rate of expansion was unprecedented after surpassing April’s previous series record. It will most definitely exert upward pressure on especially the longer-dated bond yields.
The US government bond yield curve will also move higher as higher inflation is here to stay. Commodity prices as measured by the Goldman Sachs Commodity Index have nearly doubled since the lows at the height of the Covid-19 crisis at the end of March last year. In contrast, it took 30 months for the commodity prices to double from its lows in December 2008.
The steep rise in commodity prices can obviously be attributed to stockpiling and speculation as it was widely expected that difficulties in sourcing raw materials would emerge as soon as other major economic zones join in China’s economic recovery.
According to the IHS Market Flash US Manufacturing PMI (purchasing managers’ index) for May manufacturers expressed concern regarding raw material shortages. Higher cost burdens are passed on to clients and according to IHS output charges are rising at the steepest rate on record. The trend is worldwide. It is no wonder that China on Wednesday announced, according to mining.com, it will strengthen its management of commodity supply and demand to curb unreasonable increase in price and prevent them being passed on to consumers.
Although some commodity prices may find themselves in bubble territory due to speculation and stockpiling, raw material prices are likely to hold up through 2022 due to shortages. Freight costs are going through the roof with the Baltic Dry Index now up 4.5-fold from its lows last year. That compares to the 5-fold increase from the bottom during the Global Financial Crisis (December 2008 to 2010).
While the reflation strategies whereby investors switch from growth stocks to cyclicals will see the cyclical stocks outperforming, they are also vulnerable when the bubble in the US equity market bursts. Emerging market assets and currencies are equally vulnerable.
With the odds starting to stack up against risk-on assets, is this a situation of “sell in May and go away”? I’m heading for the hills.
Ryk de Klerk is an analyst at large. Contact [email protected] He is not a registered financial adviser and the views expressed above are his own. You should consult your broker and/or investment adviser for advice. Past performance is no guarantee of future results.
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