The new investing year has had an explosive start. Markets saw a strong January rally. The HCP Quant fund rose by 6.77%. The benchmark index MSCI ACWI SMID Value Total Return jumped 9.83% in euros and the S&P 500 Total Return index tracking large companies in the US popped by +8.03%. In Europe, the S&P Europe 350 Total Return index rose by 6.24%.
Especially in the US share prices came tumbling down. The correction has been strong since then. Are now done with the decline? This makes one naturally think about if December offered an excellent buying opportunity for investors or if this was just a dead cat bounce. When weighing these options, it is good to examine the reasons behind the rise. What drove share prices higher? Is the rise on a sound footing?
One perspective to the question is offered by changes in the world’s M2 money supply. Based on that, the recent rally is very much central-bank-directed. Stimulating economies through central banks is not a new cure when the economy starts gathering dark clouds above itself. We have enjoyed the wide central-bank-directed appreciation across asset classes for an unusually long period of time. When the engine starts coughing up, the solution to the problem would seem to be like the old, familiar remedy. However, before long kicking the can down the road needs to stop unless the underlying problems are fixed. But as long as central banks support markets, should investors generally speaking ride those coattails.
A few months ago I wrote in the investor letter that the Smart Money Flow index has taken a huge plunge. Being wise in hindsight is always easy, but at time the drop seems to have predicted a coming crash. It is good to keep in mind that no market indicator can predict the future with certainty. The Smart Money Flow index has at the time of this writing earned back its December losses, but is still below November’s level (13469) when I wrote about it, and clearly below the average level of the past twenty years. Based on this, the latest rise does not seem to have a very solid foundation.
My interpretation of the situation is twofold. We have behind us an unusually long central-bank-directed rally period. In this environment, the greatest gainers on the exchange have been large growth companies. By several different valuation metrics, many publically traded companies are expensively priced. Many companies have three-digit P/E ratios (does anybody even remember the year 2000?) If earnings growth does not keep up, these companies will change in a moment’s time from expensively priced to extremely expensively priced. At the same time, a part of the companies is very much undervalued.
The effects of the quantitative tightening initiated by the Fed in the summer of 2017 spread into markets in 2018. Now it looks like the Fed will refrain from raising rates this year. In Europe, the situation is no rosier. The next rate rise will be done possibly only in 2020. Central banks are clearly ready to use the printing press when needed. If this goes on, it will favor the winning streak large growth companies have enjoyed so far. Past fall shows how nervous a situation markets are in. Many signs point to informed investors being unconvinced that share prices are on a solid foundation.
My twofold interpretation is therefore that if centrals bank keep intervening in markets by stimulating, dog days are still ahead of us. Another factor supporting stocks would be positive changes in politics (for example trade war between USA and China, and Brexit.) Notice that none of these is a fundamental factor! Paradoxically, factors other than corporate fundamentals have been swinging markets for a long time. At the same time, the risk of a market crash is elevated. If we see great market turmoil, there will probably also be a change in the type of companies being favored by investors. Many star companies of previous years have quickly become pariahs. Mean reversion is one factor in the investing world.Book a virtual meeting Make a subscription
HCP Quant portfolio manager
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“Not everything that matters can be measured, and not everything that can be measured matters.”
– Michael J. Mauboussin
(This text is a translation of the Finnish-language HCP Quant investor letter.)