When a stock market shifts from a bull to a bear market, leadership usually changes. Bear markets are often periods of catharsis. The old leaders get tired, and they have been bid up to excessive valuations. A reality check sets in and they fall. As the old leaders fail, new market leaders emerge to guide a new bull upward.
It is therefore with great interest that we have been monitoring the Big Three leadership themes in the US market, namely US over non-US, growth over value, and large caps over small caps. Of the three, growth continues to be extremely strong, US stocks have temporarily plateaued and they may be turning down, and small caps are resuming their underperformance after a brief three-month turnaround.
From a global perspective, the leadership mantle of US stocks is faltering. The following chart shows the returns of different regions relative to MSCI All-Country World Index (ACWI). All returns are in USD so currency effects are already included in performance. Within the US equity market, the S&P 500 is rolling over on a relative basis, but the NASDAQ 100 continues to soar. A look at the developed markets (middle panel) shows no sustainable trends. Japan has weakened after a short-lived rally, and Europe’s relative performance has chopped around for the past few months. It is the emerging markets (bottom panel) that has shown the greatest promise in leadership. While it is true that EM equities have soared in relative performance, EM xChina stocks are tracing out a constructive but unexciting saucer bottoming pattern. By inference, it is China that has become the global market leader.
If this is the start of a new bull, or a continuation of the old bull, can it rest on the narrow leadership of a handful of NASDAQ stocks and the Chinese market?
Is this just a double bubble, and does that imply double trouble ahead?
NASDAQ leads the way
Let’s begin by considering the internals of the US equity market. We all know by now how the FANG+ and NASDAQ 100 have been on a tear. Here is a recent heat map of the S&P 500, with individual boxes sized by weightings. Notice anything about the biggest stocks that dominate the index?
Once we exclude the NASDAQ leaders, things don’t look as exciting. As the chart below shows, the S&P 500 is trying to stage a bullish impulse after a bearish island reversal after successfully testing its 200 day moving average (dma). However, a glance under the hood of broad market indices tell a story of weak participation. The equal-weighted S&P 500, the equal-weighted Value Line Geometric Index, the NYSE Composite, as well as the mid and small cap indices are all showing patterns of lower highs since early June. Some of these indices have exhibited bearish island reversals that have not not been challenged. All are trading below their 200 day moving averages.
I have voiced my concerns in these pages about the excessive valuation of the US equity market. Forward 12-month P/E ratios are in the nosebleed region of well over 20. Even if investors were to look over the 2020 earnings valley, the P/E ratio based on 2021 earnings is 19 or more.
Goldman Sachs recently performed some revealing analysis of stock market valuation by quintile. The valuation of the cheapest quintile is only average, or not excessive, but the market’s high market valuation is mainly attributable to the sky-high multiples posted by the most expensive quintile, which are mainly the NASDAQ names.
If the US market is being held up by the FANG+ and NASDAQ stocks, how long can this narrow leadership continue? Arguably, many of the shares of these companies have benefited from the pandemic as the recent “staying in” theme.
FT Alphaville recently offered a perspective on “staying in” theme by focusing on cloud computing, or SaaS (Software as a Service) companies. Among the leaders in this group are Zoom Video and Shopify, which trade at sales multiples of 30 or more.
It’s important to note that some of the valuation premiums for these companies is justified. The idea is that once these businesses have established themselves as an intrinsic part of a company’s enterprise software stack, they can effectively extract rents from their customers — either through price increases or cross-selling. All, we should add, at an almost zero marginal cost. Theoretically, these economics should make the businesses extremely cash-generative, and capital-light, once they have fully matured.
These companies must be enjoying terrific sales growth in the current environment, right? Don’t be so sure. The FT Alphaville article cited a Morgan Stanley survey of CIOs about their SaaS spending expectations. The expected spending growth in 2020 is a measly 2.8%. Does that sound like the sort of growth that would drive stratospheric valuations?
While the fundamentals argue for a pause, the long-term technical picture is signaling a possible continuation of the NASDAQ frenzy. Consider two extremes of the current market leadership, namely growth (NASDAQ) and small cap stocks. The small cap to NASDAQ ratio is falling again after a brief recovery. We saw a similar episode in 1999 when the ratio became extremely oversold on a 14-week RSI and recycled. Then the ratio resumed its decline until the ultimate bottom in March 2000. If that incident is any guide, the analogous moment today is only mid-1999.
China’s “I can’t lose” melt-up
Over on the other side of the world, China’s stock market has gone parabolic. Bloomberg documented the “I can’t lose” mentality among retail traders.
Like millions of amateur investors across China, Min Hang has become infatuated with the country’s surging stock market.
“There’s no way I can lose,” said the 36-year-old, who works at a technology startup and opened her first trading account in Beijing on Tuesday. “Right now, I’m feeling invincible.”
Five years after China’s last big equity boom ended in tears, signs of euphoria among the nation’s investing masses are popping up everywhere. Turnover has soared, margin debt has risen at the fastest pace since 2015 and online trading platforms have struggled to keep up. Over the past eight days alone, Chinese stocks have added more than $1 trillion of value — far outpacing gains in every other market worldwide.
While it would be easy to dismiss as a replay of this year’s Robinhood rally in the U.S., China’s budding equity mania could in many ways be more consequential. Unlike in most major markets, the nation’s individual investors account for the lion’s share of local stock trading and have been prone to extreme swings in sentiment that can have ripple effects on the economy and monetary policy.
For now, indicators of market overheating are still comfortably below levels reached during the height of equity bubbles in 2007 and 2015. The risk is that breakneck gains — stoked in recent days by bullish articles in state-run media — could eventually result in a destabilizing crash.
Indeed, the Shanghai Composite went vertical until Friday, when two state-owned funds began selling to signal that the rally was overdone. Regardless, the Chinese market’s advance began well before last week’s frenzy. A glance at the stock markets of China’s major Asian trading partners shows that the nearby Hong Kong market has also staged a strong rally, and so has Taiwan, but that’s mainly attributable to the strength of the semiconductor group. The charts of the other markets, such as South Korea, Singapore, and Australia, appear to be less exciting.
How sustainable is the Chinese market rally? John Authers at Bloomberg offered the following “glass half full” perspective.
The best guess is that China has pressed the pedal on expanding credit once more, but not by using orthodox monetary policy and not in a way that weakens the currency. The following chart, from CrossBorder Capital LLC of London tells the story of the remarkable expansion of Chinese credit over the last quarter of a century as well as anything:
The stimulus applied by Shanghai’s big equity bubble in 2007, and then by the huge extra spending and credit easing that started in late 2008 to deal with the last global financial crisis, was on a different scale from the stimulus that is now being applied. Much of that was achieved via shadow banks, shown by the yellow line, whose opaque structures led to concerns that China could stage its own repeat of the Lehman crisis. The People’s Bank of China has spent the last few years in an explicit attempt to avert this risk, and now appears to have shadow banking under control. That has allowed them to unleash a 20% increase in liquidity, through traditional banks and through the bond and equity markets.
For the short term, this can only be positive. Questions will rightly continue about whether the Chinese regime, attempting to use a communist command structure to regulate a capitalist economy, can possibly endure. It is only a few months since the Communist Party’s inadequate response to the early stages of the pandemic appeared to be heralding major change. But for the short term, China appears to have been able to right its ship, and to find the money to keep its economy nicely afloat.
Greg Ip at the WSJ offered the following “glass half empty” perspective, based on the recent book by Matthew Klein and Michael Pettis, Trade Wars are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace.
Like South Korea and Japan before it, China grew rapidly by channeling its people’s savings into high-return investments in education, public infrastructure and export-oriented industries. It did so through an undervalued exchange rate and a financial system that subsidized industrial borrowers by paying savers next to nothing. Both have been reformed, but Messrs. Klein and Pettis note that many features of China’s economy still discriminate against workers and consumers: adversarial unions are illegal, taxes on labor and consumption are high, and millions of migrant workers are deprived of social benefits for lack of residential permits.
By definition, surpluses in one country must equal deficits in another, so the trade surpluses generated by China and Germany force the U.S. (and other low-saving countries such as the U.K.) to run deficits. Trade deficits don’t necessarily reduce employment, but they change its composition. In the 2000s, Chinese imports wiped out millions of U.S. jobs while Chinese savings helped inflate the housing bubble. In that sense, Messrs. Klein and Pettis write, inequality in China contributed to inequality in the U.S.
The authorities in Beijing implemented policies that suppress consumption and encouraged savings and investment. The savings and investment went into infrastructure and export industries, which channeled goods to import hungry markets like the US. The gains from the excess investments accrued to those who engineered the globalization and export boom, namely the top tier of Chinese and American society. The exports devastated manufacturing in the developed markets. Klein and Pettis concluded that Chinese inequality contributed to American inequality and those effects persists today. China’s household consumption rate is lower than it was when it entered the WTO.
Enter the pandemic. How have events developed since then? Not good.
But events are now going in the wrong direction. Through May, Chinese purchases of U.S. goods are running at just half its commitment, according to Chad Bown of the Peterson Institute for International Economics.
Spending by Chinese tourists abroad, which had offset some of the goods trade surplus, has been shut down by the pandemic. Its manufacturing has recovered faster than retail sales, suggesting surpluses are about to re-emerge. Yet the world is in no mood to absorb China’s production glut: demand is depressed everywhere. These are the ingredients of a global fight for market share fueled by protectionism and currency devaluation.
The bounce back in China was sparked by an official decision to ramp up manufacturing at the expense of consumption. With the global economy in a pandemic-induced slowdown, there is little demand for Chinese exports, and the household sector is not in a position to support economic growth. Ip concluded.
The root cause of the U.S.-China trade war is Chinese under-consumption which leads to Chinese trade surpluses. Those imbalances aren’t going away, and so risk of trade wars won’t, either.
In the meantime, China’s Great Ball of Liquidity has rolled into the local stock market, and they’re having a party on the local exchanges. The market looks technically extended in the short run. Despite Friday’s short-term cautionary signal, these bull runs can last longer than anyone expects, especially if there is official policy support.
Should traders fade China’s market rally or is it the start of a sustainable upturn? History offers uncertain clues. The Chinese stock market saw a melt-up in 2014-15. Other regional stock markets participated in that rally, though the magnitude was different. This time, while the Shanghai Composite has staged an upside breakout, the technical conditions of the other markets are less supportive of a broad based rally.
The tension between Bob Farrell’s Rules
Where does that leave us? I have no idea. What I do know is global stock market leadership has increasingly become narrow. It consists of a handful of NASDAQ stocks and a frenzied FOMO stampede in China. I am torn between Bob Farrell’s Rule No. 4:
Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
And Rule No. 7.
Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.
Investors need to be aware of the tension between Rule No. 4, which raises the possibility of a stock bubble, and the risks posed by the narrow leadership warned by Rule No. 7. Tail-risk is high in both directions. In this environment, it is worthwhile to return to basics and revisit investment objectives and risk tolerances in order to balance risk and reward. There are no perfect answers, and each will be different.
Regardless of which direction the market takes, investor can count on a climate of high volatility for the rest of 2020.