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The S&P 500 ekes out a gain as oil goes slip slidin’ away

Brian Nick, Chief Investment Strategist, TIAA Investments


June 23, 2017

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Quote of the week

“But life is just a party, and parties weren't meant to last.” Prince, from his song “1999”

The Lead Story: U.S. stocks are partying like it’s 1929

One popular method for valuing the S&P 500 Index is the cyclically adjusted price-to-earnings (CAPE) ratio, developed by Nobel-prize winning economist Robert Shiller. The Shiller gauge seeks to smooth out cyclical distortions and short-term market volatility by dividing a stock’s share price by its average annual earnings per share over the past 10 years. In contrast, traditional price-to-earnings ratios use projected earnings over the next 12 months.

During the week, the CAPE ratio made headlines by briefly topping 30, well above its long-term average of around 17. (A lower number suggests stocks are more attractively priced.) This lofty figure was partly due to its including the Great Recession years, during which earnings briefly turned negative, within the trailing 10-year observation period. Valuations based on 12-month forward earnings don’t paint a much brighter picture for investors: share prices are at their highest levels since the early 2000s.

Brian Nick, Chief Investment Strategist, TIAA Investments

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Here’s the kicker: the CAPE ratio has topped the 30 mark only twice before, in 1929—just prior to the Depression—and from 1997 to 2002, a stretch encompassing the formation and destruction of the Tech bubble. 

Shiller’s metric, like all valuation measures, tells us very little about short-term expected market returns. However, it has been a reliable predictor of five- to 10-year equity performance. The S&P 500’s best average annual return in the five years following a CAPE ratio of 30 or more has been 6.3%, respectable but far below what investors have become accustomed to during the current bull market. The average five-year return from such a level has been closer to zero.

Compared to low-yielding Treasuries, municipal bonds, or cash, stocks still may look like the most promising U.S. asset class. While we’re not recommending that investors abandon their domestic equity allocation, we continue to believe that European stocks remain a better value than their U.S. counterparts even after Europe’s outperformance so far this year.

We also favor emerging-market equities. Recent upward revisions to forecasted earnings growth over the next 18 months have been significant enough that, despite their strong year-to-date rally, these shares look no less attractive today than they did a year ago.  

In the U.S., the S&P 500 rose about 0.2% for the week in the face of falling oil prices. Amid doubts that output cuts by major producers will be sufficient to reduce the global crude glut, the West Texas Intermediate benchmark entered bear market territory on June 21 by trading at $42.50/barrel , more than 20% below its February highs. Europe’s STOXX 600 Index fell 0.2% in U.S. dollar terms, its third consecutive one-week decline.

In other news: Argentina goes long

While the U.S. fixed-income market was quiet, Argentina made noise by issuing $2.7 billion of U.S. dollar-denominated bonds with a 100-year maturity. Income-hungry investors jumped at the bonds’ 7.9% yield, as the deal was nearly five times oversubscribed. In so doing, markets cast aside concerns over Argentina’s poor track record on paying creditors; the country has defaulted eight times since gaining independence from Spain in 1816, most recently in 2001. Although there are reasons for optimism about Argentina’s future prospects, we will need to carefully monitor President Mauricio Macri’s ability to deliver economic changes and reform. Only if he does will Argentina firmly reestablish credibility in global markets.

In Europe, the spread between German bunds and French government bonds continued to narrow, to 0.35%, after reaching 0.79% just four months ago. This compression reflects capital flowing into France following Emmanuel Macron’s victory and his party’s strong showing in the recent parliamentary elections, which should support efforts to change French labor laws, and overhaul unemployment benefits and pensions.

Current updates to the week’s market results are available here.

Below the fold: This week, the Fed speaks

With few economic data releases to digest, markets turned their attention to several speeches made by several Federal Reserve officials. Vice-Chairman of the Federal Open Market Committee and New York Fed President William Dudley expressed confidence that the tight U.S. labor market will eventually spur higher wages, triggering a rebound in inflation. He also added that this process will likely be gradual, meaning the U.S. economic expansion still has far to go. The Conference Board’s index of leading economic indicators seemed to reinforce his view by rising in May for the fifth consecutive month. This suggests the economy is likely to remain on, or perhaps modestly exceed, its long-term trend of 2% growth for the rest of the year. 

Chicago Fed President Charles Evans was far less bullish in his inflation outlook, preaching patience in analyzing the data. In his view, the Fed could wait until December before deciding whether to raise rates for the third time in 2017. This is our expectation as well.

Back page: For China A-shares, the fourth time’s a charm!

Citing concerns over market accessibility and monthly limits on capital repatriation for foreigners, among other issues, for the past three years MSCI has refused to include China’s A-shares—yuan-denominated stocks traded on the mainland’s equity exchanges—in its global benchmarks.

That all changed on June 20, however, when MSCI agreed to add the shares of 222 large-cap Chinese companies to its All-Country World, Emerging Market, and Asia ex-Japan indexes by mid- 2018. Growing interest among asset managers, combined with the recent success of the Stock Connect program that allowed foreign investors access to nearly 1,500 mainland-traded stocks via the Hong Kong exchange, paved the way for this highly anticipated move.

The inclusion will boost China’s existing 28% slice of the MSCI Emerging Markets Index,    by just 0.5%, or roughly $8 billion. Nonetheless, this marks a new era for investors seeking broader exposure to China’s financial markets.   Exchange-traded funds and index-linked vehicles will finally gain access to a key portion of the Chinese equity market without quotas or the need for prior approvals from Chinese regulators.

It’s important to note, though, that significant capital controls still exist in China. But as Beijing relaxes trading restrictions, MSCI will consider adding more A-shares to its indexes. MSCI estimates that under a full-inclusion scenario, China could represent over 45% of the Emerging Markets benchmark. 

Valued at today’s levels, such an allocation would come to greater than $765 billion, over 10% of Chinese companies’ current market caps. This will take time, however. The complete opening of China’s capital markets will be an evolution, not a revolution.