Making Sense of Market Pulse

As the equity market shifts gear to the middle of the seasonally weak quarter, Aug-Oct period, analysts are viewing September as a period of possible pullback. The S&P 500 had a long good run. Over the past decade, it has returned about 376% or a compounding 17% per annum.

We had seen news of Morgan Stanley predicting a 10% to 15% decline in S&P 500 before the end of the year, although it wasn’t based on a bearish bet. It was more on a historical statistic basis that in most 12-month stretches, there seems to be an episode of pullback, and we just have not seen one since March 2020. A keen observer would notice that tech giants seem to have traded along with Treasuries, suggesting that investors viewed such counters as havens.

Then, we have Bank of America Securities that issued a mixed signal. While it has raised the year-end target for S&P 500 from 3800 to 4250, it is still lower than the current level.

Guess the Trigger and Stir the Soup

The market correction, which typically means a 10% drop from a recent high, does not just happen. Similarly, the bull market does not tend to die due to old age. Therefore, the search for a reason must be a precise trigger point for any basis of discussion.

Market participants, at times, look to time and valuation as signals to a potential risk of a correction. Indeed, these pointers have merit, but they do not hint at the tip of the market entering a correction.

Undoubtedly, this week has been a rocky one. We have seen how indices had fallen on almost every day for this holiday-shortened week. The Dow declined by around 2.2%, S&P 500 tumbled 1.7%, and Nasdaq dived 1.6%. The high valuation has put investors on their toes. The market capitalisation for S&P 500 has reached around 175% of US GDP, which is a record.

The peak performance has its ground. The vaccines are working, the economy is growing, and the federal government is spending money like water. Another plus is the Fed being highly accommodative. Thus, the combined twin effect of fiscal and monetary support is the foundation of the elevated valuations.

Maybe Stocks are Still Cheap?

The interest rate remains low. After all, the Fed is committed not to raise interest rates even as the tapering noise is on the horizon.

The S&P 500 earnings yield is currently at around 4.8%. The earnings yield is the inverse of its Price-to-Earnings Ratio. The 10-Year Treasury note has a yield of about 1.34%. The net difference sets at 3.5%.

This is a wide spread, and if we use this metric, then stocks look cheap and appear to be more attractive than bonds.

And since stock market correction has occurred during various valuations in the past, it seems unlikely that valuation is a potent trigger for the market’s death.

What about time?

Historically, time does help in making predictions in the loose end. Based on Dow Jones Market Data, it seems that correction happens every 17 months. Of course, we cannot omit the possibility of a bear market (a 20% drop from a recent high), although that is less likely given the current economic climate. The recent epic bear started in March 2020.

Debt Crisis as A Trigger?

The new spending plan of $3.5 trillion needs a financing plan. And Senate Democrats appeared to have found one on Friday: to tax corporate stock buybacks. And this would place a tax on buybacks that have helped sustain the long bull market and enriched the pockets of highly compensated executives.

A 2% excise tax will be placed on shares that are bought back and retired. However, shares that are re-purchased to fund employee stock ownership plans are exempted. It is projected to bring in about $100 billion in tax revenue over 10 years.

There are morally fundamentals in this proposal as Pika World sees it fitting to the social infrastructure bill. First, instead of driving up stock prices to better the executives’ compensation pay out, it motivates reinvesting in workers. As we know, most companies had used the windfall from Republican’s 2017 tax cut to sweeten their stock prices. This provides splendid rewards to their wealthiest investors and high-level executives.

Pika World does not see this tax as a killer of the bull market since it is a smaller driving force compared to more critical catalysts such as earnings growth and valuation. A stock buyback has the effect of reducing the share count and boosts earnings per share, which by research has only added 1% to the S&P 500 growths for earnings per share over 8 years.

The relatively widening pay gap between the executives and employees is likely to receives general support for the proposal. In addition, most executives are not taxed on their gains in shares until they are realised and paid with capital gain tax. They can also borrow tax-free from their stock holdings and further accentuates the wealth disparity between the classes of workers.

The Defensive Hedge Continues

Given a highly uncertain and increasingly volatile market, investing in index funds appears to be the trend, and it is seen as a defensive strategy. At Pika World, we have tilted more towards offensive strategy with a dose of defensive counters, as discussed in our writing.

While it is enormously challenging to predict short-term stock market returns, nor is it a desire of our analysis, we see a possible route map ahead. We expect the interest rate to rise as the economy crawls out of the pandemic shadow and supply chain constraint while persistent starts to ease progressively given a high inventory replenishment could further boost GDP growth.

If the above conditions hold, Pika World would expect some upside surprises in earnings and potential stock performance for sectors like the financials, industrial, energy and selective counters of consumer services and healthcare.

Likewise, we continue to favour small-cap stocks as they are more sensitive to US economic growth compared to large-caps and have a valuation that reflects positive 10-year returns.

As we move towards the final month of the 3^rd quarter, Pika World remains nimble and set sight on the broader macro trend, which hopefully lifts our return for the year.

Your friend,

Pika Nat