It has been a big few weeks for financial markets. From the escalation and then de-escalation of the trade wars (Mexican tariffs on, then off), to deteriorating macroeconomic data, to bond market recession pricing, to the US Federal Reserve providing verbal support for the market bulls. It is times like now that a clear, rigorous investment process is most valuable.
It has been said “A process defends from chaos and whim”. For us, at the heart of our asset allocation process stands our Asset Allocation Scorecard. This is what defends us from the chaos and whim that is currently driving financial markets. We use the scorecard in conjunction with a qualitative overlay to help guide our investment decisions.
The key elements of the scorecard
Valuation is a key and important driver of markets but there are conditions attached. Research has shown that the signal sent by valuation measures of equity markets, such as forward price-earnings (PE) ratios, is weaker in the short term compared to the medium to longer term. A good paper to read on this topic was produced by Vanguard in 2012, “Forecasting stock returns: What signals matter, and what do they say now?”
The charts below use current data to demonstrate how weak the signal is from PE ratios on a one year future return basis compared with 10-year future returns.
In essence, the flatter is the red line, the softer is the relationship between PE and future returns. The charts show the strength of the signal is five times stronger over longer time periods compared to short time periods.
Charts 1 & 2
Source: Wilsons, Bloomberg data as at 7/6/19
Given the limitations of valuation as a short-to-medium term investment signal, we believe it is important to add into our dashboard other non-valuation indicators. For this we use macroeconomic, sentiment, momentum and technical factors.
In total, the scorecard summarises and distils signals from over 200 individual data series across each of these five factors.
What is the scorecard telling us at the moment?
The current reading from the scorecard is presented below. The traffic lights distil the data into indicative portfolio positioning with green signalling overweight, yellow neutral and red signalling an underweight position relative to your long-term strategic benchmark.
Three points to note. First, valuations are flashing green across all markets with the exception of emerging markets where a neutral position is being signalled. This makes sense given the 6-10% price correction across most markets in May.
Second, the macroeconomic picture for Australia, the US and Europe has deteriorated to the point where an underweight position is now being signalled. In Australia, the weakness in the housing market is continuing to make its way through the rest of the economy first through construction activity, then through job vacancies and employment and now through consumer spending. In the US, the trade war with China is weighing on exports and manufacturing activity. Residential construction activity has also declined to its lowest level since 2010 while employment growth has eased.
Third, sentiment, momentum and technical indicators are more neutral than they have been for some time. The rally in the market from the December 24 low up to late April was heavily driven by these three factors. They turned red in May before becoming more neutral currently.
Overall, the scorecard is telling us to be broadly neutral across equity markets.
Source: Wilsons, Bloomberg data as at 7/6/19
Given the extent of the sell-off recently it is not too surprising to see valuations turning more attractive. As demonstrated above, however, care should be taken in reading too much from this signal on a short-term basis. To paraphrase Warren Buffet, markets can remain cheap or expensive for longer than you can remain solvent.
The strongest signals currently are coming from the macroeconomic indicators where an underweight position is being flagged in Australia, the US and Europe. Weaker or slowing activity in each of these markets is being supported by weaker activity readings on a global basis. JP Morgan’s Global Manufacturing PMI just declined for the thirteenth consecutive month, finally dropping into contraction territory. Citibank’s global economic surprise index has been in negative territory for fourteen months, a streak previously unseen in the index’s 16-year history.
Despite what the macro fundamentals are telling us, the market is interpreting bad economic news as good given what it means for monetary policy. This is particularly the case in the US where the market is now pricing in as many as three rate cuts this year.
Historically, equities have rallied into a rate cut as the euphoria of easier financial conditions offset the prospect of weaker economic activity. This is illustrated in points (1) and (2) in the schematic above. Eventually a tipping point is reached, however, and bad news is seen as bad (points (3) and (4)). Judging by market reaction to date we believe we are close to around point (2).
Now is not the time to be taking large positions away from your neutral or strategic starting point. Uncertainty is being driven by policy flip-flops from both the White House and the Federal Reserve, both of which have become key drivers of price discovery in this cycle. Uncertainty necessarily weakens conviction. For this reason we are happy to remain slightly underweight equities and overweight cash and fixed income.