Short Covering Exhausted, Investor Positioning Adjusted, Difficult Fundamentals, Limited Upside
The market has weathered one of the most volatile first quarters in recent years. Since February lows recession fears appear to have faded, with the US market rallying 13% since then, the forward equity multiple re-rating back to its 2015 highs of ~17.5x, and the VIX back below 14. We think this recovery has been largely driven by fundamentally insensitive strategies and broad based short covering. Our highfrequency Utilization Ratio for stocks and ETFs has almost fully normalized to pre sell-off levels, implying little room left for further short covering. Positioning wise,
trend-following strategies (CTAs) have covered most of their shorts and are currently close to being neutral equities. Risk parity portfolios and macro funds are long equities with their exposure approaching levels seen late last year. Long/short equity strategies exposures remain above average levels, and if anything have started to come off their
mid March highs. With most of the technical factors having already run their course and with equity valuation at elevated levels, we believe a re-acceleration in earnings growth and weaker USD are needed to warrant a more constructive view on US equities.
The fundamental backdrop remains challenged. S&P500 earnings growth has contracted for the last two quarters and is expected to decline further in 1Q16 (-9.6%) and 2Q16 (-4.7%) of this year, making this a stretch of four consecutive contracting quarters. While most of this contraction has been centered in oil sensitive industries,
the weakness appears to be broadening. For the first time in this cycle, S&P500 ex-Energy earnings growth is expected to turn negative (1Q16 -4.6%, 2Q16 -0.8%). There is a plausible case that lower commodity prices may be masking fundamental weakness in low-oil beneficiaries, like parts of consumer discretionary, staples, industrials. Based on credit card data for ~57 million users, JPM Chase Institute estimates that ~80% of oil savings has already been consumed. Our economists share a similar opinion. Savings rate has remained unchanged at ~4.6% since the start of the oil decline, suggesting the oil windfall has been spent. Additional measures, such as record miles driven, above trend demand for light trucks/SUVs, suggest low oil windfall is getting put to use. With the oil bonanza largely getting consumed, it may be wishful thinking to expect a sudden lift in EPS growth from higher consumer spending.
This leaves the USD as, perhaps, the most important and plausible factor in determining the fate of the current profit cycle (see report). Further weakening in the USD could help profits re-accelerate from the current slump. However, this could come with some friction as it will likely result in higher inflation and longer-term bond yields that could start to pressure the equity multiple. We estimate that for every 2% move in USD (trade-weighted), S&P500 earnings growth moves inversely by ~1%. With USD largely a function of oil and most importantly FED policy, a more dovish
rate path should help alleviate earnings pressure and prolong the life of this cycle, while a more hawkish path will likely bring us closer to the inevitable end. The above line of reasoning implies an unfavorable risk-reward for US equities from current levels, with 5% upside potential compared to 10% downside risk.
With a dovish FED and weakening USD, we continue to favor Value stocks and US Multinationals (negatively correlated to USD, positively correlated to commodities/yields) over Momentum stocks within US, and see better risk-reward
abroad, namely in emerging markets.