Submitted by Nicholas Colas of DataTrek Research
Never short a new high or buy a new low. I learned that sitting in the trading room with Stevie Cohen at the old SAC Capital, although it is not something I recall him ever actually saying. The sentiment does, however, capture the sense of the room’s general outlook on trading. And, frankly, life…
The logic around it looks something like this:
- Someone always knows more than you about a stock, a sector, or the market as a whole.
- If that “someone” decides to bid up a stock to a new high, you really don’t want to get in their way. It takes a LOT of conviction to keep buying even as a stock breaks out, so whoever is pushing it there feels they know something. Yes, they could be wrong (just look at FB’s new high right before last quarter’s horrible earnings). But they usually aren’t.
- That makes a breakout an important “Tell” and prudent risk management says you wait for the stock to stop making fresh highs before you short it.
- The same thing applies to new lows. Someone is selling that name even though it is cheaper than at any point in the last year. Wait for it to stop going down before buying. “Seller reloads” is a bad thing to hear when you are on the buy side of the trade.
With the breakouts this week in the S&P 500, NASDAQ and Russell 2000, we now have a US equity market that, to a trader’s eye at least, is essentially “unshortable.” Pile on the fact we have a light volume week ahead of us, plus that there’s not much economic/fundamental news flow until after Labor Day, and there could be a series of new highs in the coming days.
Whenever equities break out to fresh records, we like to do a quick reality check for you. It’s not that we’re bearish; long time readers know we have been steadfastly recommending a US equity market overweight all year. But we hew to the old “Trust but verify” mantra of the late Ronald Reagan. With that, a few points:
#1. Valuations still look reasonable, especially as long-term interest rates seemed capped at 3%.
- According to the last data available from FactSet, the S&P 500 trades for 16.6x forward 12-month earnings estimates. Using consensus numbers for next year ($178/share), US large cap equities trade for 16.3x on 2018 numbers.
- With 10-Year Treasuries locked in below 3.0%, all that looks fine.
- Bottom line: as long as you believe the US economy is in decent shape (we do) and trade/tariff wars will not push the global economy into a recession (we don’t), US stocks are reasonably valued because earnings are strong/rising and interest rates remain low.
#2. Technology is still leadership, with some modest help from Health Care.
- Large Cap Tech is up 17.2% YTD (and made a fresh high today), which translates to 54% of the S&P’s 8.4% advance in 2018.
- Amazon, technically a Consumer Discretionary stock, is a large contributor to YTD market returns all on its own. Its average weight in the S&P 500 in 2018 is just 2.6%, but with a 65% return YTD it is 20% of the S&P 500’s price appreciation this year.
- Large Cap Health Care is 11.5% higher, or 19% of the S&P’s YTD return.
- Bottom line: Tech + Amazon + Health Care = 93% of the S&P’s gains for 2018 YTD.
#3. There is a broad dispersion of valuation by sector based on 12-month forward earnings estimates.
- Only 2 groups are materially cheaper than the S&P’s 16.6x valuation: Financials (12.7x) and Telecomm Services (10.2x). We like regional banks rather than large cap money centers, and outlined why last week.
- Six sectors cluster around the market mean: Materials (15.5x), Health Care (15.9x), Industrials (16.3x), Utilities (16.7x), Energy (17.2x), and Real Estate (17.6x), and Consumer Staples (17.7x).
- Two sectors show valuations well above the average: Technology (18.9x) and Consumer Discretionary (21.2x, mostly driven by Amazon).
- Bottom line: there are broad swathes of the market trading for less than market leadership (Tech). They just aren’t working, however. Cheap is expensive (in terms of opportunity cost) in the current US equity market.
#4. The best-case scenario for the S&P 500 is a further 8.7% advance into the end of the year.
- Since we can all agree that Wall Street analysts are a perennial bullish group, taking the aggregate average price targets for their coverage universes should yield the most bullish upside case for the S&P 500.
- FactSet’s latest math using those price targets bubbles up to an S&P 500 at 3,148. While most analysts publish 1-year targets, recent market strength means this best-of-all-possible-worlds scenario may happen more quickly.
- Bottom line: this aggregate price target implies a 17.1% price return on the S&P 500 for 2018 and a 17.7x multiple on next year’s earnings. If you believe 10-Year yields trend lower into December (and maybe click your heels three times), that’s certainly possible. Average total returns since 2010 are 14.2% for the S&P 500, for some historical perspective.
#5. The S&P 500’s solid YTD returns mask remarkable dichotomies in investment style performance that persist even in this latest melt-up:
- The S&P 500 Growth index was +0.84% today while Value underperformed, only 0.66% higher.
- The S&P 500 Value index is still 3.7% below its January 26th highs, while the Growth index is 5.4% above that day’s close.
- Bottom line: S&P 500 Growth is +14.5% YTD, while Value is only 2.1% higher on the year. While it would be logical to expect some reversion to the mean in any further rally, there doesn’t seem to be any catalyst to make that happen.
If one does appear, it will most likely come in the form of a market shock. That means Value will decline less than Growth, not that it will deliver positive absolute returns.
Summing up: today’s breakout to new highs was a function of a baseline assumption (further corporate earnings growth and low rates) and a fresh input (a US Mexico trade deal means other trade/tariff negotiations are also likely). Trade has been the biggest overhang on US stocks, so the latter point has some runway to shove large caps even higher in the near term. You know our thoughts: stay long US large cap stocks. And if you disagree, don’t short them until they stop breaking out.
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