Stay cool – US stocks are about to go into ‘melt-up’
Stocktake: Gains of over 50% predicted, with no sign of bull market party ending soon
Traders work on the floor of the New York stock Exchange. Twenty-seventeen was the first year in history that US stocks gained in every single month. Photograph: Michael Nagle/Bloomberg
Iconic investor Jeremy Grantham may be famous for his bearish outlook, but he reckons the overvalued US stock market is about to go higher. Grantham, who correctly called the crashes of 2000 and 2007, when equities halved in value, has long warned stocks are dangerously overvalued. However, his latest note says most indicators suggest the advance is more likely to gather pace than to falter, with stocks “showing signs of entering the blow-off or melt-up phase of this very long bull market”.
The market advance is accelerating, but at a “modest pace”; typically, stocks scream higher near market tops. There are no signs at present of the kind of euphoria seen near market peaks. Market rallies narrow near the end of bull markets as excited investors flood into a few hot stocks, but today’s advance is a broad one; most stocks are participating in the rally, so “no bubble-bursting early warning there”. Rather, Grantham says a “melt-up” – gains of over 50 per cent within the next six months to two years – is likely. If that happens, the odds of a subsequent crash are “very, very high”. For now, however, bears should remember that overvalued markets can become a lot more overvalued before the party finally ends.
Rising profits augur well for stocks
While investors may not be euphoric right now, there is much optimism that the benign economic environment will support further stock gains – a thesis underpinned by the continued improvement in corporate earnings. Earnings season is often referred to as cheating season; companies typically lower expectations prior to earnings announcements, allowing them to handily beat artificially lowered estimates. Right now, however, estimates are being revised upwards. According to Merrill Lynch’s Savita Subramanian, the S&P 500’s earnings revision ratio has just hit its highest level since 2011, when earnings estimates spiked higher following the end of the global financial crisis.
Optimism is especially obvious among financials, where the revisions ratio has hit levels unseen since 2004, although the upward trend in earnings revisions is a broad-based one evident in eight of the index’s 11 sectors. Most importantly, sales expectations are surging. For years, cost-cutting allowed companies to grow earnings in the face of stagnant revenues, but that has changed. Now, the sales revision ratio is at its highest level in over six years and way above average levels, so much so that companies are even more optimistic about sales than they are about earnings. In other words, the trends that drove stocks higher as 2017 progressed remain intact, with Subramanian concluding that rising earnings expectations continue “to suggest strong near-term S&P 500 returns”.
Double-digit gains on the cards in 2018?
Twenty-seventeen was the first year in history that US stocks gained in every single month, but 2017’s high returns – the Dow Jones Industrial Average soared 25 per cent – should not spook investors into thinking that what goes up, must come down in 2018. So says LPL Research’s Ryan Detrick, who notes that, since 1950, there have been 10 years where stocks rose by more than 25 per cent. On all but two of those occasions, stocks rose the following year, enjoying above-average gains of 12.6 per cent. Twenty-eighteen may be different, of course, and sceptics might argue stocks are much more highly valued than in the years that comprise Detrick’s sample. Still, the idea that the ongoing rally is inherently unsustainable doesn’t hold up. As Detrick puts it, “don’t turn bearish simply because ’17 was up a lot.”
Markets can remain calm in 2018
A recent Financial Times editorial cautioned it is “safe to assume” global markets “will not be as fruitful or as calm in 2018” as they were in 2017. It’s rarely safe to assume anything in financial markets, but an escalation in volatility certainly looks like a safe bet. How could it be otherwise, given volatility was freakishly low in 2017? The Vix, a measure of expected volatility, averaged 11.1 in 2017, notes money manager Dana Lyons – the lowest on record and barely half its long-term average. Stocks “enjoyed less adversity” than in any other year in history; the Dow, says Lyons, lost a cumulative 27.4 per cent on all of its down days (the average cumulative loss in an average year is 90 per cent, highlighting just how easy investors had it in 2017). Bespoke Investment Group data confirms this picture of abnormal calm. It’s been 14 months since the S&P 500 experienced a 3 per cent pullback (“easily” the longest period in history) and 18 months since stocks recorded a 5 per cent pullback (the second-longest stretch in history). Still, while some increase in volatility appears inevitable, that doesn’t mean it will be an especially nervy year. Low volatility regimes tend to last for years, suggesting things may remain relatively quiet for some time to come.