Daily Comment
By Bill O’Grady & Kaisa Stucke, CFA
[Posted: June 4, 2015—9:30 AM EDT] Global equity markets are lower this morning. The
EuroStoxx 50 is trading down 0.9% from the last close. In Asia, the MSCI Asia Apex 50 was
down 0.3% from the prior close. U.S. equity futures are signaling a lower opening from the
previous close.
It’s been a rather wild ride this morning. If you only have an opportunity to look at pricing, at
the time of this writing, nothing seems too far out of whack. However, there was a lot of
volatility overnight.
First, Chinese markets fell hard, then recovered.
(Source: Bloomberg)
This is an intraday chart of the Shanghai composite. For the first half of the day, the index
treaded water. Around midday, a broker/dealer in China announced it was ending margin loans.
The index promptly declined over 5% on the news. As no other firms followed suit, buyers
returned and the market recovered. Still, this degree of volatility suggests that investors in China
are getting nervous and any sign of a change in official policy of supporting equites will likely
trigger a selloff. As we have noted for weeks, we believe the Chinese equity market is very
frothy and a sudden pullback is increasingly likely.
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Second, the bond markets are whipping around, too. German 10-year yields, which just a few
weeks ago were trading at 5 bps, rose to just over 100 bps.
(Source: Bloomberg)
This spike is due, in part, to an improving European economy and a modest lift in inflation.
Yesterday, ECB President Draghi warned that bond price volatility is likely to rise, the EU
economy is improving and inflation is moving toward its target. As the above chart shows, the
correction in yields has been impressive.
This rise in German yields has affected U.S. Treasuries as well. Earlier this morning, the 10-year
yield lifted above 2.40%, but has steadily declined since and the yield is now lower than
yesterday.
(Source: Bloomberg)
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When faced with uncertainty, one of Bill’s old professors used to say that they were “facing an
empirical problem,” which meant that they wouldn’t know the answer to a question ex ante. The
unanswered question is this: is the economy more sensitive to rate increases now than it was in
the past? We suspect it is and, if correct, this back-up in yields will begin to weigh on the
economy later this year. However, since the recent history of the relationship between rates and
economic activity may not continue, what we used to know about the economy may not be
helpful; in fact, it may actually hurt us because policymakers will assume the earlier
relationships continue to hold. The recent rise in the dollar appears to have had a negative
impact on the economy (weather and seasonal factors caught most of the blame—we don’t buy
it). That wasn’t the case in the past. Historically, the U.S. economy wasn’t all that sensitive to
the dollar’s exchange rate. However, as the relative economic size of the U.S. has decreased, we
suspect the impact is much greater now. This led the Fed, for example, to underestimate the
impact of the dollar’s appreciation as seen in the “dots” chart and in the Fed’s GDP forecasts.
There are two other items of note. First, the OPEC meeting was not expected to bring price
relief as the cartel was expected to keep production at high levels. However, in something of a
surprise, Iran and Iraq warned the rest of OPEC that they intend to lift output and want the rest of
OPEC to accommodate their increased production. Given that there is a Sunni-Shiite “cold war”
underway, there is little chance the Saudis will cut output to support Iran’s economy. We still
expect further weakness in oil, with WTI eventually pivoting around $50 per barrel with a $5 per
barrel trading range on either side.
The other item is that talks between Greece and the EU have broken down again. The financial
markets continue to ignore this issue (we doubt German bond prices would be falling if there
were real worries about Greece). The consensus opinion is that a deal will get done, and if it
doesn’t happen, it won’t matter anyway. The key issue is contagion, a spreading of bank runs
across the EU. We fear the odds of this happening are higher than currently discounted. If a
financial event occurs, look for a retracement of sovereign yields in the U.S. and Germany, and a
weaker EUR.
U.S. Economic Releases
Preliminary Q1 non-farm productivity fell 3.1%, close to the 3.0% decline forecast. Unit labor
costs rose 6.7%, more than the 6.1% forecast. At the same time, output fell 1.6%, employee
hours rose 1.6% and compensation per hour rose 3.3%. All of this data indicates an improving
labor market.
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Nonfarm Business Sector: Unit Labor Cost
S A, % Change. Y ear. Ago
16
16
12
12
8
8
4
4
0
0
-4
-4
70
75
80
85
90
95
Source: Bureau of Labor Statistics /Haver Analytics
00
05
10
15
The chart above shows the yearly change in unit labor costs.
Initial claims came in close to expectations, falling 8k to 276k compared to the 278k forecast. It
seems that companies are holding onto their workers in anticipation of a pick-up in end demand.
FOUR-WEEK AVERAGE OF
INITIAL CLAIMS
700
THOUSANDS
600
500
400
300
200
2007
2008
2009
2010
2011
2012
2013
2014
2015
Sources: BLS, CIM
The chart above shows the four-week average, a more stable measure of labor market health.
The average actually rose 3k to 275k, but remains near eight-year lows.
The May Challenger job cuts report showed a decline of 22.5% year-over-year in the number of
planned corporate layoffs compared to a 52.8% increase in April. May’s steep decline shows
that companies are planning fewer layoffs.
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There are no other releases scheduled for the rest of the day.
Foreign Economic News
We monitor numerous global economic indicators on a continuous basis. The most significant
international news that was released overnight is outlined below. Not all releases are equally
significant, thus we have created a star rating to convey to our readers the importance of the
various indicators. The rating column below is a three-star scale of importance, with one star
being the least important and three stars being the most important. We note that these ratings do
change over time as economic circumstances change. Additionally, for ease of reading, we have
also color-coded the market impact section, with red indicating a concerning development,
yellow indicating an emerging trend that we are following closely for possible complications and
green indicating neutral conditions. We will add a paragraph below if any development merits
further explanation.
Country
Indicator
ASIA-PACIFIC
Australia
Retail sales
Trade balance (AUD)
EUROPE
France
Unemployment rate
U.K.
New car registrations
Current
Prior
Expected
Rating Market Impact
m/m Apr 0.0%
m/m Apr -3.9 bn
0.2%
-1.2 bn
0.3%
-2.1 bn
**
**
Equity bearish, bond bullish
Equity bearish, bond bullish
m/m Q1 10.3%
m/m May 2.4%
10.4%
5.1%
10.4%
***
**
Equity bullish, bond bearish
Equity bearish, bond bullish
Financial Markets
The table below highlights some of the indicators that we follow on a daily basis. Again, the
color coding is similar to the foreign news description above. We will add a paragraph below if
a certain move merits further explanation.
3-mo Libor yield (bps)
3-mo T-bill yield (bps)
TED spread (bps)
U.S. Libor/OIS spread (bps)
10-yr T-note (%)
Euribor/OIS spread (bps)
EUR/USD 3-mo swap (bps)
Currencies
dollar
euro
yen
franc
Central Bank Action
Bank of England rate
Bank of England QE
Today
28
0
27
13
2.34
11
19
Direction
down
up
up
up
Current
0.50%
375 bn
Prior
28
1
27
14
2.37
11
19
Change
0
-1
0
-1
-0.03
0
0
Trend
Neutral
Down
Neutral
Down
Widening
Neutral
Neutral
Rising
Falling
Falling
Falling
Prior
0.50%
375 bn
Expected
0.50%
On forecast
375 bn
On forecast
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Commodity Markets
The commodity section below shows some of the commodity prices and their change from the
prior trading day, with commentary on the cause of the change highlighted in the last column.
Price
Prior
Change
Cause/ Trend
Energy markets
Brent
$
63.47 $
63.80
-0.52% Increase in Iranian supply
WTI
$
59.25 $
59.64
-0.65%
Natural gas
$
2.63 $
2.63
-0.15%
Crack spread
$
24.01 $
24.11
-0.44%
12-mo strip crack
$
18.40 $
18.54
-0.78%
Ethanol rack
$
1.74 $
1.74
-0.06%
Metals
Gold
$ 1,181.17 $ 1,185.17
-0.34% Higher dollar
Silver
$
16.39 $
16.53
-0.90%
Copper contract
$ 270.55 $ 272.65
-0.77%
Grains
Corn contract
$ 357.75 $ 359.00
-0.35%
Wheat contract
$ 507.75 $ 510.75
-0.59% Russian exports set to rise
Soybeans contract
$ 937.75 $ 935.25
0.27%
Shipping
Baltic Dry Freight
598
591
7
DOE inventory report expectations of weekly change
Actual
Expected
Difference
Crude (mb)
-2.1
-2.1
0.0
Gasoline (mb)
0.0
0.0
0.0
Distillates (mb)
1.3
1.3
0.0
Refinery run rates (%)
0.7%
0.7%
0.0%
Natural gas (bcf)
123
Weather
The 6-10 and the 8-14 day forecasts call for warmer and wetter than normal conditions for most
of the country. There is no tropical activity to report this morning.
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Weekly Asset Allocation Commentary
Confluence Investment Management offers various asset allocation products which are managed using
“top down,” or macro, analysis. This year, we will start reporting asset allocation thoughts on a weekly
basis, updating the piece every Friday. We hope you find this new addition useful.
May 29, 2015
Every week, we update the latest S&P 500 P/E ratio (see below section). Currently, the P/E is
18.9x, a full standard deviation above the mean of 14.5x. Here’s another way of looking at the
data:
FOUR-QUARTER TRAILING P/E
S&P 500 1870 to 2015
70
60
# OF EVENTS
50
40
30
20
10
0
6
8
10
12
14
16
18
20
22
24
26
28
30
P/E
Sources: Robert Shiller, Haver Analytics, CIM
The gray area on the chart is the range within one standard deviation. The distribution isn’t
perfectly normal. In fact, it skews positively, meaning that it has a long tail to the right of the
mean. In its history, the P/E has been 19x or above only about 12.5% of the time. However,
there have been numerous periods when the P/E expanded well beyond the current level, which
is nearly 19x.
So, how worried should investors be about this outcome? Some concern is warranted; however,
we are not yet in dangerous territory.
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S&P 500 AND 4Q TRAILING EARNINGS MODEL
8
4
2
DEVIATION
0.8
0
S&P 500 (LOG SCALE)
6
0.4
0.0
-0.4
-0.8
-1.2
80
90
00
DEVIATION
10
20
30
40
50
60
S&P 500 (LOG SCALE)
70
80
90
00
10
MODEL FORECAST
Sources: Haver Analytics, Robert Shiller, CIM
This chart shows a simple regression of earnings (4Q-trailing) against the S&P 500; both series
are log-transformed. When the green line is above the red line, the market is undervalued
compared to earnings and vice versa. At current earnings, the market is above fair value (which
the model puts at 1730.77). Although that appears to be a rather frightening fair value, we note
that the deviation hasn’t reached the one-standard error level, shown by the top parallel line.
Given the current estimate of earnings that we use below, that level would be 2356.75 on the
S&P 500.
Therefore, although equity markets are not inexpensive, we haven’t reached levels that are
extraordinarily overvalued, either. There are three concerns we continue to monitor closely.
First, if earnings continue to weaken, it could push this model into overvalued territory. Second,
as always, recessions tend to send earnings down sharply. Thus far, we do not see evidence that
a recession is imminent. Third, when equities become extended, the market becomes vulnerable
to exogenous events, such as a military conflict, a financial crisis (e.g., Greece) or some other
geopolitical event. Since these “gray swans” cannot be easily predicted, we watch them closely
but, for now, expect U.S. equities to remain supported but sluggish.
Past performance is no guarantee of future results. Information provided in this report is for educational and illustrative purposes only
and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be
suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial
circumstances. Opinions expressed are current as of the date shown and are subject to change.
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Data Section
U.S. Equity Markets – (as of 6/3/2015 close)
YTD Total Return
Prior Trading Day Total Return
Health Care
Consumer Discretionary
Telecom
Technology
Materials
S&P 500
Financials
Consumer Staples
Industrials
Energy
Utilities
-10.0%
Telecom
Consumer Discretionary
Financials
Industrials
S&P 500
Technology
Materials
Health Care
Consumer Staples
Energy
Utilities
0.0%
10.0%
20.0%
-2.0% -1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
(Source: Bloomberg)
These S&P 500 and sector return charts are designed to provide the reader with an easy overview
of the year-to-date and prior trading day total return. The sectors are ranked by total return, with
green indicating positive and red indicating negative return, along with the overall S&P 500 in
black.
Asset Class Performance – (as of 6/3/2015 close)
YTD Asset Class Total Return
Foreign Developed (local currency)
Foreign Developed ($)
Emerging Markets (local currency)
Mid Cap
Small Cap
Emerging Markets ($)
Large Cap
US High Yield
Cash
This chart shows the year-todate returns for various asset
classes, updated daily. The
asset classes are ranked by total
return (including dividends),
with green indicating positive
and red indicating negative
returns from the beginning of
the year, as of prior close.
Commodities
Asset classes are defined as
follows: Large Cap (S&P 500
US Corporate Bond
Index), Mid Cap (S&P 400
Real Estate
Index), Small Cap (Russell
-5.0%
0.0%
5.0%
10.0%
15.0%
Source: Bloomberg
2000 Index), Foreign
Developed (MSCI EAFE (USD
and local currency) Index), Real Estate (FTSE NAREIT Index), Emerging Markets (MSCI
Emerging Markets (USD and local currency) Index), Cash (iShares Short Treasury Bond ETF),
U.S. Corporate Bond (iShares iBoxx $ Investment Grade Corporate Bond ETF), U.S.
Government Bond (iShares 7-10 Year Treasury Bond ETF), U.S. High Yield (iShares iBoxx $
High Yield Corporate Bond ETF), Commodities (Dow Jones-UBS Commodity Index).
US Government Bond
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P/E Update
June 4, 2015
LONG-TERM 4Q TRAILING P/E
30
25
P/E
20
15
10
5
P/E as of 6/3/2015 = 19.0x
0
70
80
90
00
10
20
30
40
4Q TRAILING P/E
-1 STANDARD DEVIATION
50
60
70
80
90
00
10
AVERAGE
+1 STANDARD DEVIATION
Sources: Robert Shiller, Haver Analytics, I/B/E/S, CIM
The above chart offers a running snapshot of the S&P 500 P/E in a long-term historical context.
We are using a specific measurement process, similar to Value Line, which combines earnings
estimates and actual data. We use an adjusted operating earnings number going back to 1870
(we adjust as-reported earnings to operating earnings through a regression process until 1988),
and actual operating earnings after 1988. For the current and last quarter, we use the I/B/E/S
estimates which are updated regularly throughout the quarter; currently, the four-quarter earnings
sum includes two actual (Q3 and Q4) and two estimates (Q1 and Q2). We take the S&P average
for the quarter and divide by the rolling four-quarter sum of earnings to calculate the P/E. This
methodology isn’t perfect (it will tend to inflate the P/E on a trailing basis and deflate it on a
forward basis), but it will also smooth the data and avoid P/E volatility caused by unusual market
activity (through the average price process). Why this process? Given the constraints of the
long-term data series, this is the best way to create a very long-term dataset for P/E ratios.
Based on our methodology, the current P/E is 19.0x, up 0.1x from last week and at historically
overvalued levels of 19.0x. Overall, earnings are weak, in part due to lower earnings from
energy and in part due to rising wage costs. Valuations are becoming quite stretched, which
probably explains this year’s rather sluggish market performance. As discussed in the Asset
Allocation Weekly from May 29, these valuation levels don’t necessarily mean a pullback is
imminent, but it does raise concerns that the market is expensive.
This report was prepared by Bill O’Grady and Kaisa Stucke of Confluence Investment Management LLC and reflects the current
opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking
statements expressed are subject to change. This is not a solicitation or an offer to buy or sell any security.
20 Allen Avenue, Suite 300 | Saint Louis, MO 63119 | 314.743.5090
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