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Weekly S&P 500 #ChartStorm - 21 June 2020

Those that follow my personal account on Twitter will be familiar with my weekly S&P 500 #ChartStorm in which I pick out 10 charts on the S&P 500 to tweet. Typically I'll pick a couple of themes to explore with the charts, but sometimes it's just a selection of charts that will add to your perspective and help inform your own view - whether its bearish, bullish, or something else!

The purpose of this note is to add some extra context and color. It's worth noting that the aim of the #ChartStorm isn't necessarily to arrive at a certain view but to highlight charts and themes worth paying attention to. But inevitably if you keep an eye on the charts they tend to help tell the story, as you will see below.

So here's another S&P 500 #ChartStorm write-up!!

1. CBOE Implied Correlation Index vs. S&P 500. The mantra we often hear is when volatility spikes, correlations all go to one. It’s not totally true, but we certainly see the CBOE’s Implied Correlation Index turn elevated when panic strikes the stock market. There is often no place to hide aside from the usual ‘flight to quality’ assets like Treasuries and the US Dollar. Eventually though, stocks recover, and implied correlations drift lower. And then we start hearing about how the market is then tilted more in favor of the stock-pickers.

It’s almost part of the market cycle nowadays. But what’s happening at the moment? Stocks have recovered, but the Implied Correlation Index is still quite elevated. Looking historically, when correlations are high, forward returns are favorable. So, right now does the CBOE’s index say that returns on the S&P 500 will be still strong going forward? That could be a stretch given how the market has already come. Traders are seemingly still antsy despite the strong bounce.

But also take a look at the 2010 to 2012 period. Stocks were coming off the 2009 lows, yet the implied correlation index was often hitting the 70-80 range. Could the stock market be gearing up for a similar rocky road ahead?

Bottom line: When fear strikes, everything sells off at once. Only through time and a recovery process do stocks begin to decouple from one another.

implied correlation index chart and outlook for S&P

2. BAML Fund Manager SurveyPositioning vs. History. Thanks to @ukarlewitz for providing this look from the June 2020 BofA FMS. Investment managers are still overweight safe-haven assets like the US Dollar and Treasuries. Equities are not so appealing, apparently. And economically-sensitive areas like Materials & Energy stocks are shunned – ironically, commodities have been in demand (gold near multi-year highs and oil rallying from *negative* $40 to *positive* $40 will do that, I suppose). Cash seems to be deploying to defensive areas for now.

Looking closer at the survey results, we find some interesting trends. Growth over value is still preferred – no surprise as value can’t ever seem to catch a break. Elsewhere, defensives over cyclicals and US over global stocks are other features found in the survey.

Growth dominating value and US markets beating foreign stocks have been two themes ongoing for about a decade by now. Interestingly, large caps (typically seen as less risky) are less preferred relative to small caps; since the March 23 low, small caps have outperformed noticeably (but with more volatility), so maybe there is a little performance-chasing going on there. Take note of that as we head into the end of the first half of the year.

Bottom line: On par with the CBOE Implied Correlation Index, the Fund Manager Survey indicates some trepidation regarding the rally over the last two months. Defensive positioning appears to prevail in the current environment. The usual Q3 shakiness that comes with seasonality and an upcoming election may make it difficult for investment managers to change their stance.

chart of fund manager positioning (defensive vs growth assets)

3. Tax reform risk? S&P 500 earnings could drop 12% according to Goldman Sachs. Speaking of defensive positioning and an upcoming election, Goldman Sachs put out a research note suggesting EPS could fall by 12% should a new administration and Congress take the helm. This chart from @westermangroup via Goldman displays the breakout of the potential earnings decline. The 2021 SPX EPS decline would be from about $170 to near $150 through various tax hikes, but also from a small drop in GDP that may result from a less favorable tax environment.

Hark back to 2017 and 2018 for a moment. The Tax Cuts and Jobs Act was signed into law on December 22, 2017, but the stock market had already discounted the business-friendly policy during the prior 12 months. 2018 turned out to be a sketchy year for stocks, culminating in a rather sharp decline in the S&P 500 from early October to December 26, 2018. Small caps actually haven’t hit a new high since August 2018.

Why do I bring this up? We all know stocks discount the news (h/t as well to Charlie Dow; too bad he doesn’t have a Twitter handle), so conceivably, there may be price risk to the S&P 500 in advance of the actual tax rise that may come with a new policy next year.

Bottom line: Stocks rallied huge in 2017, then favorable tax reform passed, and stocks sort of went nowhere for a while. Could the opposite be in store? At the very least, expect to hear more about tax risk in the coming months.

chart of scenario of corporate tax reform - impact on S&P500 earnings

4. The S&P 500 Blended PE ratio has returned to pre-crash levels. It’s been a roller coaster ride for both price-action and stockmarket valuations. We prefer to use the ‘Blended PE’ ratio when analyzing stock market valuations. The Blended PE is an average of the PE10, Forward PE & Trailing PE in order to remove the noise that can come with each ratio when used in isolation.

We use this approach, and chart the Blended PE ratio across dozens of country stock markets, sectors and industries. For US large caps, we are right back to where we were in February, yet the fundamental backdrop feels much worse compared to the happy-go-lucky times of late 2019 and the first few weeks of this year, right?

This chart has frustrated many value investors. The February-March decline may have felt like the ultimate reset of market valuations, yet nearly as quickly as stocks fell, equities climbed right back. So, we are now back at one standard deviation above the long-term average. What will it take to bring down valuations on the US large cap equity space? So far, COVID-19 has not been able to do it (for more than a couple days).

Bottom line: US large cap valuations are stretched on an absolute basis.

chart of blended valuations metric for US equities

5. The PEG Ratio is through the roof. The PEG ratio, the S&P 500’s forward PE divided by the long-term growth estimate, has soared passed the prior peaks of the late 1990s and 2010s. It is nearly 2.5x.

Driving the recent spike is a sharp drop in S&P 500 earnings expectations due to COVID-19’s impacts – all the while US large cap equities recovered to be not far from all-time highs. We don’t believe the forward PE ratio and the PEG are useful market valuation tools, detailed in a recent post here.

Bottom line: The PEG has been elevated all year after suggesting the SPX was a good buy in early 2019. But an investor weighing this indicator heavily would want nothing to do with US large caps right now, nor would they have been attracted to the space back in March & April when equity analysts were slashing EPS outlooks.

chart of the PEG ratio and the S&P500

6. US versus Global Equities PE10 – a sector neutral perspective. Valuations are stretched for US stocks especially relative to foreign equities – even when adjusting for sector differences. To put it another way, global (ex-US) stocks are pretty cheap.

Using the PE10, international markets have valuations that are not far from 40+ year lows. Of course, the major rally over the last two months has turned multiples higher, so they are not the screaming buy they were in late March. Considering the world of low interest rates, USA stocks on a sector neutral basis are not overwhelmingly expensive either. Certainly some sectors in the US appear more richly valued than others. And you may find that growth stocks and mega caps have abnormally high multiples relative to value equities and small caps, but we’ll leave that discussion for another time.

Bottom line: Foreign stocks are cheaper than US stocks even when backing out sector differences. We detail the analysis here. We increasingly believe returns over the next 5-10 years will be more attractive outside of the US.

chart of sector adjusted valuations PE10 ratio for US equities and global equities

7. Perspective: US companies aren't borrowing money from banks the way they used to. Who needs banks? Just go to the capital markets, and issue corporate debt. Of course, the big financial institutions still provide investment banking services when corporate bonds are issued. The last 40 years has featured a huge drop in bank loans’ share in the total debt mix of US companies – from near 40% to under 20%.

We have seen countless articles in the last few years featuring big US firms securing relatively long-term debt at interest rates under 3%. While not very long-term, Amazon just recently locked-in $1 billion of financing for three years at 0.4% (the FT confirmed it was the lowest interest rate for any US corporate bond in history). Who knows what kind of deals we are going to hear about in the next several months considering the Fed will be around to provide some cushion in the corporate debt markets.

Another note – bank loans are usually shorter-term in nature than corporate bonds, so the duration on the debt of US firms is likely growing, though it is not shown in the chart below. Higher duration means bad news for owners of the bonds should interest rates rise.

Bottom line: Lower rates for longer terms is happy news for US firms looking to lower their weighted average cost of capital. Fewer US firms are looking to banks to provide them liquidity. They are instead going to the corporate bond capital markets and loans are being securitized, then sold-away to investors.

8. Software versus hardware investment. Companies are putting more capex spend into software and less to industrial equipment. @LizAnnSonders from Charles Schwab provides this chart from Goldman Sachs vividly displaying the trend in capex moves. As a percent of GDP, software spending has increased from essentially nil to more than 2.5% - or roughly $500 billion (using pre-COVID GDP figures).

There is so much going on behind the scenes of this chart. Technology’s share as a proportion of US market cap has increased since the 1970s while other sectors that are more capital-intensive have fallen. Growth equities have beaten value stocks, as well. Productivity has increased markedly as technology has increased. We are all aware of these themes, and the chart certainly lays out the fundamental backdrop.

Bottom line: Expect this macro theme to persist. More software & technology investment means higher productivity and less capital-intensive business operations in our evolving economy.

chart of capex by US firms on software vs hardware

9. Who owns the market? @PriapusIQ provides this chart on equity ownership. The financial media loves a good narrative. ETFs and Robinhood traders have gotten a lot of press this year, but how about we take a step back and look at the data? ETFs command just a 6% share of total US equity ownership. Household & mutual funds are still the big players.

What’s also interesting is Household & Funds have been rather steady in the last 20 years with respect to their percentage ownership. Pensions and retirement funds have seen their share dwindle while foreign investors are increasing their stake. To be sure, ETFs are quickly growing a presence, but it’s still a small piece.

Bottom line: The more things change, the more they stay the same. ETFs have a long way to go before they really drive the market. Households and mutual funds are still the kings of the castle in terms of total ownership of the US equity market. Also note that the Fed is at 0% (for now).

chart of the ownership breakdown of US equities

10. S&P 500 index funds. @SPDJIndices brings us this look at the trend in S&P 500 indexed assets. In terms of dollars, money invested in S&P 500 index funds has surged from under $1 trillion at times during the 2000s to more than $4.5 trillion today. By the way, that compares against total S&P500 market cap of about $26T (so passive comes in just under 20% of total market cap: not dominant, but certainly not immaterial either).

Passive is on the upward move, without question. Any way you slice & dice it, index funds and passive investing is a growing theme in today’s stock market – particularly for those tracking the S&P 500.

Bottom line: Passive investments tracking the S&P500 reached a new high in 2019.

chart of assets in passive investments tracking the S&P500

So where does all this leave us?

1. Positioning & correlations.

Recency bias is a tough thing to fight. Investment managers (and many other investors for that matter) remain rather defensive given the heightened volatility this year (and perhaps rightfully so). And similar trends from recent years are holding true – growth over value and US over non-US stocks. That has been the stance of fund managers, but where will they go from here considering we have an election upcoming? 2020 will continue to be interesting. Correlations also remain elevated as big risk-on and risk-off days take place. One session it seems like the bulls reign supreme, while the next it feels like the bears are ready to re-emerge – and the infamous ‘re-test’ gets tossed around every now & then.

2. Risk management & perspectives.

Valuations on the S&P 500 are very high on most metrics. Other areas of the equity world feature more compelling value, but that has been the case for a number of years by now. The PEG ratio, taught in many college finance courses, suggests the stock market is as richly valued as ever, but we don’t trust that. Taking a bigger perspective, global equities may do better than US stocks looking ahead, even when taking sector biases into account. What does your crystal ball say? What does 2021 look like? A V-shaped recovery? U-shaped? W? How about tax policy? As always, lots of uncertainty.

3. Capex, funding & ownership.

Trends in the last few decades include much more investment in technology which has led to automation and productivity gains. Technology stocks have benefited the most. US firms are largely funded by investors in today’s capital markets, not so much by banks directly. And passive investing is on the rise, but is by no means dominant. These big long term fundamental trends have a significant impact on the longer term direction of markets, so it's always good to take a step back and review.


This week we enjoyed a step back to take in some longer term perspectives, which help in framing and understanding some of the short-term moves... In the immediate term, we find ourselves in this sort of uneasy phase in the markets. Yes there is skepticism and defensive positioning and cash on the sidelines, and still a few lingering bullish signals. But there is also expensive valuations, economic uncertainty, and regulatory/political uncertainty. Back in March it seemed a much easier call to make given where the risk/reward outlook had shifted. Again, if pressed I would lean bullish but certainly acknowledge the risks and reasons to be defensive.

Thanks to Mike Zaccardi, CFA, CMT, for his help in putting this together.

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