I made a call for a 10% correction in the markets roughly three weeks ago, which was followed by a more-than-10% sell-off in the S&P 500
between August 17 and August 26, 2015.
Considering the uncertainty of short-term moves in the market, my call for a correction was an uncharacteristic one. What concerned me the most was the dismal earnings picture: while analysts were calling for a 10% increase in 2015 earnings late last year, estimates have progressively been shaved down to a 1%–2% earnings contraction in the course of the year. Given that the U.S. is not in recession territory, an earnings contraction is unusual. Both U.S. dollar strength and lower oil prices have been large detractors for corporate earnings. Given that 40% of profits in the S&P 500 are derived from abroad and 25% of profits come in foreign currencies, analysts estimate that 2014 earnings took a $5 hit from the stronger dollar. Furthermore, some estimate that weaker oil prices have resulted in a $7 hit. The other warning sign was the abnormally depressed Volatility Index (VIX)
, where at a 12–13 handle markets appeared fearless despite mounting uncertainties.
Speed of Correction Surprising
I was surprised by the speed at which the markets corrected. This speaks volumes about forces that have underpinned this sell-off: the Federal Reserve (Fed)
threatening to increase rates in September, a stronger U.S. dollar, weaker oil prices and collapsing global commodity prices. While cheaper commodities are a net positive for the U.S. economy, considering our commodity importer status, they are not encouraging for S&P 500 earnings. Given that the sell-off was followed by a 600-point recovery in the Dow on Wednesday—resembling a V-shaped market—I would not be surprised if we retest the lows or even surpass them. That said, I do not foresee a more than 15% decline.
Interest Hike in September Looks Less Likely
The probability of the Fed hiking rates in September has dwindled, given the global turmoil, but is not zero. What is particularly striking is the collapse in oil prices both in spot
and in the far-dated futures. The December 2019 contract is pricing oil at $55, down from $671
. Long-run oil prices do not typically move as much—this suggests a longer-term reassessment of oil prices, which could put downward pressure on headline inflation
Equity Risk Premium Still Offers Compelling Values
From a price-to-earnings (P/E)
perspective, the S&P 500 is selling at 17x earnings, where the median and average since 1954 are at 16.4x and 17x, respectively, implying fair valuations
. But these are especially good valuations if we were to consider the low interest rate environment, when 18x–20x P/E is warranted. I also believe we are in for permanently lower interest rates—I am expecting the normal Federal Funds Rate
to trade close to 2%, not 4%, and long bonds to trade closer to 3%–3.5% by the end of the tightening cycle.
and dividend stocks have been under pressure over the past 1.5 years, given that people have been trying to position ahead of the Fed raising rates, which caused momentum stocks and low-dividend payers to outperform. Consider this: The 10-Year Treasury
yields 2%–2.5%, while high-yielding stocks yield 4%. This may imply a shift to value and dividend strategies in the years to come. As a result, dividend-oriented stocks could perform well going forward.
Euro and Yen Gains Mostly Short-Term Risk Aversion
The surge in the euro and yen is primarily a function of the unwinding of carry trades
. Both currencies have been used as funding vehicles, where investors pay very little—or even get paid—to borrow these currencies. This is due to the present-day short-terms rates in the eurozone and Japan, which trade in negative territory. As a result, everyone has been borrowing in euros and yen to buy higher-yielding assets. Due to the extreme risk-off, markets have unwound their carry trades, resulting in short-run appreciation of the yen and the euro. I can see the euro trading around $1.05 again, as well as further declines in the yen.
EM Equities and FX Trading at Deep Discounts
I will admit to being too early on this call, but I believe emerging markets could potentially be the best-performing asset class in the next three to five years. Emerging market currencies look very reasonably priced compared to their history and the stocks are at depressed valuations. And even with the slowdown in China, emerging economies are growing at three to four times the rate of developed economies.
Source: Bloomberg, as of 8/26/15.