Are we at the end of the equity cycle?
Feedback from the road: Markets are looking “toppish” – are we at the end of the equity cycle? The DBS Chief Investment Office is currently on the road for our 2H19 Investment Outlook events, and based on our conversations with clients, we gather that overall sentiment remains one of “cautious optimism”.
Investors are comforted by the fact that global macro conditions remain sound and the US Federal Reserve has taken a surprise dovish tilt. However, concerns on the US-China trade war continue to linger. More importantly, the sharp rally in the first half of the year has led to questions on whether markets are looking “toppish” and if we are currently at the end of the market cycle.
These are valid questions. After all, the S&P 500 Index has intermittently breached the 3,000 psychological barrier in recent times. Since hitting a trough in early 2009, the S&P 500 has headed in one direction – north. So optically, equity markets do look “toppish”.
But in reality, this is not necessarily the case.
What does this mean?
This is no ordinary cycle; Market rally is backed by fundamentals. Although it is perceived the US equity market is at its mature stage - given this is the longest bull run ever - our analysis does not point to the end of the cycle. Our views are premised on the following factors:
Stock rallies do not die of old age: We made this point in 2Q18 CIO Insights “Mind the Bends”. Back then, we argued that bull markets can last for prolonged periods and a clear case in point was the c.15-year rally on the Nikkei 225 during the 1970s and 1980s. Today, the US rally has been ongoing for a decade but it pales in comparison to the Nikkei 225 rally (Figure 1). A bigger determinant of market correction is the macro outlook — based on forecasts by the US Federal Reserve, the probability of a recession remains low this year.
Our analysis on the shape of the US Treasury yield curve yielded the same conclusion. In CIO Perspectives, 25 February, we concluded that the US Treasury yield curve is no longer an accurate predictor of recessions due to distortions caused by years of quantitative easing. In fact, long-term yields have been “artificially” suppressed by weak term premium as well as negative bond yields in other developed economies (Figure 2). Our view stays.
Figure 1: Markets do not die of old age – The Nikkei 225 was a case in point
Source: Bloomberg, DBS
Market rally is backed by robust corporate fundamentals: “Toppish” markets are commonly associated with market froth, a situation where prevailing market prices become detached from the underlying fundamentals. A clear case in point was the dot-com bubble. Between 1995 and August 2000, the S&P 500 rallied 230% while the 12-month trailing earnings per share was up by only 80%. The situation today is vastly different. Since 2010, the S&P 500 has rallied 164% and this is matched by a 158% gain in earnings.
The robust gains in corporate earnings explains why the S&P 500 is trading at a reasonable forward price-to-earnings ratio (P/E) of 18.1x, compared to a historical average P/E of 17x.
What should you do?
No better alternatives; Equities remain “the only game in town”. Instead of looking at equities in isolation, one should also analyse it in relation to other asset classes, namely bonds. The recent resurgence of trade tension has triggered growth concerns around the world, driving long-term bond yields lower. For instance, 10-year yield of German Bunds and Japan Government Bonds have fallen 47bps and 14bps to -0.228% and -0.141% respectively, this year.
The hunt for yield can only increase the attractiveness of equities as an asset class (Figure 3). Stay invested.
Within the asset class of equities, investors should seek “Secular Growth” opportunities through US Technology and Consumer Discretionary stocks; alongside “Income Generating” opportunities in Singapore/Hong Kong REITs and Chinese banks.
Figure 2: QE has led to the suppression of US term premium
Source: Bloomberg, DBS
Figure 3: Equities is the only game in town as government bond yields head into negative territory
Source: Bloomberg, DBS
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