Oftentimes fundamental managers get emotionally invested in a viewpoint. Indeed, that is the primary reason our investment process begins and ends with a series of quantitative screens with a fundamental overlay applied in the middle. To take curve-shaping out of our analysis. And since we manage mostly alternative and other strategies that tend to perform better when markets sell off, the popular perception of all long/short managers, including us, is that we root for volatility and market declines. Maybe true, maybe not, but that doesn’t mean we are not objective. Take now, for example.
If you follow the popular doom-and-gloomers, you’d be reading that markets are at historically high valuation levels (maybe); that price to sales ratios are way higher than historical norms (probably true); that the recent rally in stocks has been driven by central banks, massive inflows into passive strategies, company stock buy-backs and other gimmicks (largely true); the economy is weak (not necessarily) and therefore we are due for a sell-off. Those same points have been made, and quite rationally, since 2013. And while we are as concerned as anyone about what happens when the Central Bank Bid goes away, we can make equally good arguments for continued strength.
Equity risk premiums are nothing if not steady, and they have a remarkable knack for reverting to the mean, but they also shift up and down for prolonged periods, remain at these new levels for prolonged periods, and it would be foolish to suggest that we might not be in one of those periods now. The animal spirits argument gets pooh-poo’ed too easily. It’s more real than not. The impact on earnings from Trump tax reforms could be substantial. After eight years of feckless economic policies that inhibited growth as much as anything else, it is entirely possible that a change in direction from Washington could have a material impact on corporate earnings. We would remind everyone worried about market multiples that the market was trading at 22x in 2002 before earnings lifted dramatically taking the market with it. And GDP, mostly a trailing indicator, has never correlated well with market returns.
But. . . one of the U.S. equity market directional signals that has been a reliable indicator of future returns changed this week from long to short. Our friends at FlowPoint Capital produce some of the best research we read. They note that U.S. corporate bonds’ spread to Treasury yields rose in the last 30 days, triggering their first bearish macro signal of 2017, and the first bearish signal they’ve received in quite some time. BBB Spreads rose just one basis point in thirty days, a small move to be sure, though it is the potential change in trend here that’s important, not the absolute level. Here is the visual: