Apologists for the roaring US bull market often say, it’s nowhere near a climax because there just aren’t enough signs of euphoria to imply a major reversal on disappointing news. Yet US indices have powered ahead this month with no nod of caution to the 30th anniversary of the 22.6% one-day fall on 19 October 1987.
It’s fashionable to regard that as a market event unrelated to the real economy – accentuated by “portfolio insurance” selling index options short – although I recall it marking a culmination of 1980s excesses, not dissimilar to the 1920s.
The UK market contained a lot of speculative companies: acquirers stretched by debt, endless commercial property schemes and shell-company re-vamping. The late Sir James Goldsmith declared that summer, it had all gone too far and he’d moved into cash.
So to an extent traders were already edgy going into autumn. But in 2017, and despite record levels of debt generally, I don’t see anywhere near the same extent of flaky companies, governance reforms mostly pre-empting over-stretch as balanced boards check exuberance.
Bull market leaders are better quality
The chief dilemma is a near-decade of central banks’ stimulus adding speculative demand for equities – the fear of missing out – to investment demand for yield.
Thus an exemplary bull market sector – electronic payments, exemplified by Visa (V), Mastercard (AXP), and PayPal (PYPL) – enjoys forward PEGs (the price/earnings multiple divided by 12-month projected earnings per share) of 1.5 to 2.2 times.
Such valuations will ultimately ease yet, contrasting with the 1999-2000 tech-stock bubble, these businesses represent a long-term global revolution as payments evolve from cash/cheque to plastic/electronic.
It has taken technology longer than visionaries anticipated in 2000, to transform commerce and lifestyles, but it is happening.
Thus, compared with 1987 and 2000 market highs, bull market “leaders” like these are far more robust. You can quibble over valuation, but the underlying story is likely to remain good, amid a firm trend towards e-commerce and the US electronic payments giants looking to raise market share in China following a trade agreement last May.
Yet disappointments are creeping in
I’ve made the regular macro point that, barring a major global incident, the chief risk to equities is earnings reports not meeting expectations.
Indeed, this was why the latest US rally reversed on 25 October – though promptly attracted fresh buying – as a range of businesses from burrito’s to microchips reported weaker-than-expected Q3 earnings.
It shows that if more serious warnings do manifest, double-digit losses on stocks are easily possible amid high ratings. Yet the US economy continues to deliver robust indicators so, on current evidence, a cyclical climax looks less likely. You can but watch indicators as they evolve.
October has revealed the UK as relatively more problematic, albeit without the extent of equities’ valuation risk as the US. Macro data shows a 0.4% uptick in Q3 GDP on Q2: slight, but enough to affirm expectations of an interest rate rise next week (if only back to the extent of monetary stimulus prevailing before the EU referendum).
Yet a regular study by the consultancy EY shows 75 corporate profit warnings in Q3, up from 45 in Q2. Such a comparison conveys “change”, yet the four-year average has involved 73 warnings per quarter.
Recently, it appears firms most affected are domestic-oriented than those big overseas operators, although Reckitt Benckiser (RB.) has issued a second revenues warning of 2017 amid “a continuing challenging market environment”.
This consumer health and hygiene giant also has structural issues, and its 19% share price fall since it started warning in July exemplifies highly-rated stocks exposed to adverse narrative.
Amid the fashion for shares linked to consumer brands, Reckitt rose from an annual average historic price/earnings (PE) ratio of 18.1 in 2013, into a mid-20’s range these last few years, currently on a 12-month forward multiple of about 20 times.
It’s not a problem company, yet cautioning also of “somewhat higher fixed costs” is inconsistent with a premium rating.
Snakes and ladders in smaller UK stocks
Dialight (DIA), an industrial LED lighting specialist, and also motor trader Pendragon (PDG) have seen double-digit one-day drops in response to profit warnings, although Dialight had high forecasts attached and car-makers’ declaring bold promises for electric vehicles may be stalling new-buy momentum.
So, once again, these are specific examples rather than indicating any general trend, as yet. For the most part, updates from UK companies – big and small alike – are affirming previous guidance.
This remains the key to whether confidence in equities is sustained, or the sight of prices dropping to wipe out multiples of dividend income, disrupts it.
More examples are needed like Games Workshop, (GAW) whose stock has trebled on adept marketing – aided by a 75% overseas revenue profile and weaker sterling – driving serial profit upgrades, hence a latest expectation for 60%-plus earnings growth for its current year to May 2018.
Meanwhile, a portion of the UK business community seems fixated on getting a Brexit transition deal that mirrors existing arrangements with the EU, rather than recognise wider export opportunities to develop and capitalise on the lower pound like Games Workshop is showing a lead.
It’s quite “the Brexit stock of 2017”. Indeed, a chief reason I voted Leave was a means to reinvigorate British exports in the long run, thus rebalance an economy overly-weighted to imports and debt, with low investment as a percentage of GDP. Time will tell.
North Korea has settled down, for now
Last month, I noted the possibility of more weapons’ testing on key dates approaching: the 10 October founding of the ruling Workers Party, then the Japanese general election and currently the Chinese Communist Party Congress.
But nothing has happened in over a month, marking the longest period of quiet since a first missile launch in February.
Also, and a rare gesture, Kim Jong-un has sent a congratulatory message to Xi Jinping, wishing the Chinese leader “great success” in his future tasks as head of the nation.
Maybe such a pattern of provocation then stepping back will continue, partly to justify an authoritarian state to Kim’s subjects, also implying realism.
Yet, North Korea’s progress towards intercontinental ballistic missiles means the US will keep its military options open, hence a third aircraft carrier now being sent to the Pacific from the Middle East, where it had launched airstrikes against ISIS.
Financial markets don’t really know what to make of North Korea. As a story piece it’s akin to Chinese debt: hugely risky but ultimately inscrutable, and the deeper you try to figure it out the more stuck you’ll become.
Thus, investors generally avert it until some missile test puts Kim centre-stage and President Trump starts tweeting. It’s hardly a potential “black swan” as it’s so well-identified, but remains the biggest risk lurking.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.