The bull market that began over nine years ago marches on yawning in the face of increased risks to the global economy. The volatility spike experienced in the first quarter recycled the now Groundhog Day like cycle of markets climbing “the wall of worry” in the ever-repeatable fluctuations of investor fear and almost euphoria. All in all, not much has changed. If anything, the short-term outcome of global markets is that much more difficult to decipher as presidential tweets and growing feuds by way of trade tariffs can shift markets instantaneously.
In past commentaries we have reviewed that both quantitative easing and overall increased global debt have fueled much of this market rally. As we enter into the second half of the year, net purchases by the Federal Reserve and ECB are now slightly negative. Currently the net amount coming off the books each month is relatively small, a few billion dollars a month, but that will increase each month in the fourth quarter to as large as potentially -$50 billion per month.
The other side of the coin is expansion in stock market fundamentals. Today we’ll focus on a specific ratio – the price to revenue ratio. While earnings are at all-time highs as well, much less adjustments can be applied to overall revenue numbers. How expensive is today’s market relative to sales? The current ratio on the S&P 500 sits at 2.21; a historical chart can be found below:
In January we surpassed our March 2000 high of 2.35, and the number has come back a bit due to strong overall revenue growth. It’s also interesting to note that the economic growth experienced in the early 2000s did not coincide with massive multiple expansion, and further connects the current rally with the dot com boom.
With quantitative easing rolling off, and a laundry list of potential risks to the market, we decided to test what would happen if multiples reset to different points along this graph, assuming revenue stayed consistent at today’s levels.
It is irrational to assume revenues will stay consistent. In a down turn, revenues would be expected to drop and alternatively, without a market disruption, revenues will likely continue to climb higher (maybe not as drastically as the downside potential). Both the 2007 stock market peak and the 20-year average would bring the S&P 500 down by approximately 25% from today’s levels (again holding revenues consistent). The 2002 lows would bring is down by 45%. The 2009 and 1991 lows would bring is down by 70%. Since revenues have grown since the beginning of the year, a return to an all-time high on the S&P 500 Price to Revenue Ratio would increase it by 6.7%.
Why did we go so in depth into the Price to Revenue Ratio? To try and put today’s market environment in context. This is not a call to action by any means. A similar story could have easily been told two years ago. There is no good way to time when a market disruption will occur, its best to stick with a long term plan!
United States Equity
iShares Core S&P 500 ETF (IVV) returned 3.42% for the quarter, bringing its year to date return to 2.63% after a slightly negative first quarter. Growth continues its dominance over value in the large cap space, outperforming 3.83% for the quarter and bringing total year to date outperformance to 9.46%. The market, anxiously awaiting a FAANG drop finally saw some volatility from the group. A full drop is unlikely to occur without a larger market disruption, but we are beginning to see some divergence in performance between FAANG names. After another strong quarter of earnings growth, markets appear comfortable with future growth assumptions from this space, for now. We finally saw an outbreak from mid and small cap stocks. The iShares S&P 400 Mid Cap ETF returned 8.26%, and the iShares S&P Small-Cap ETF returned 12.86% in the second quarter.
International Developed Equity
A strong dollar lead to negative performance by most international markets in the second quarter. The iShares MSCI EAFE ETF (EFA) returned -1.01% for the quarter and is down -2.71% for the year. The Invesco DB US Dollar Bullish ETF (UUP) returned 5.69% in the first quarter hurting the whole region. The European Central Bank (ECB) begins the long-awaited balance sheet wind down in the fourth quarter and set guidance for rates to remain the same until summer 2019 to support their currency.
Emerging Market Equity
After a strong performance in 2017 and to start the year, the iShares MSCI Emerging Markets ETF (EFA) returned -7.99% for the quarter, now down -6.93% for the year. Escalading trade tensions also contributed to weakness in Asian emerging markets as well. Unlike the US, profit growth has moderated but expectations of future growth remain high.
Bonds
In an interesting turn of events, high yield debt turned around in the second quarter, as the iShares iBoxx $ High Yield Corp Bond ETF (HYG) returned 1.28% in Q2 brining its year to date performance positive at 0.14%. Longer term treasuries are still down on the year, the iShares 20+ Year Treasury Bond ETF (TLT) is down -2.99% on the year. Expectations are now pricing in 4 total rate hikes for the year, with 2 more to come.
Alternatives
Commodities continued to gain steam, with the Invesco DB Commodity ETF (DBC) returning 4.40% for the quarter, up 6.36% YTD. The strong dollar also effected precious metals and gold. SPDR Gold Shares (GLD) was down -5.64% in Q2, down -3.75% for the year. After a stellar year in 2017, bitcoin continued its negative performance returning -14% in the second quarter, bringing its year to date return to -58.8% as of June. Prices have begun to bounce back in July
Periodic table
Conclusion
As been the case for a number of years, the market has not necessarily mirrored the economy. There is no foolproof way to determine when is best to tactically lever up and down risk in a portfolio. We know two strong historic signals that have preceded recessions by 6 to 12 months, being an uptick in commodity prices and increased high yield credit spreads. While commodity prices are up, the ramp up has been insignificant compared to historical runs, and credit spreads have yet to widen in any significant manor.
This article was written by the team at Toroso Asset Management, a participant in the ETF Strategist Channel.
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