The market, buoyed by favourable economic conditions, has experienced an extraordinary nine-year bull period. The FTSE 100 and S&P 500, however, has recently fallen below important moving average indicators (100- and 20- day respectively). Does this indicate that the market is entering a transition period?
“Be fearful when others are greedy. Be greedy when others are fearful.”
How Does a Bear Market Start?
Ken Fisher of the Financial Times suggested that bear markets do not start with a correction, such as the one experienced by global markets at the end of January, but instead start “slowly, softly and quietly” in alignment with “grinding economics”. If grinding economics means shifting indicators, could it be argued that the current conditions warrant some concern?
Why Do Markets Move? Cash Is King!
In 1995, Steven Kaplan and Richard Ruback completed a study of the relationship between different fundamental indicators and the share price of a company. They discovered that changes in the Discounted Cash Flow (DCF) could explain 92% of the variance in share prices. This showed that a company’s free cash flow is significant in calculating its value, and changes in projected and current free cash flows will influence the share price of a company.
Market movements occur due to, among other factors, the fundamental concept of supply and demand. Macroeconomic and industry-specific factors cause investors to speculate about future company performance, affecting that company’s share price, and ultimately shifting the value of markets.
Shifting Landscape: The Factors
There have been some significant changes in the economic landscape of both the US and UK throughout the bull market, with some of these seeming to artificially elongate the gains in both the S&P 500 and FTSE 100.
The weak performance of both the pound and the dollar is a factor that is often not considered when reviewing the value of markets. The GBP is currently 26% below its 2015 bull market high of 1.44 euro and the dollar is 20% below the 2016 bull high of 0.95 euro. One of the primary reasons for the weak rates in both the UK and USA is the uncertainty associated with Brexit and the Trump administration.
Interest rates remain close to record lows, encouraging investors to seek greater yields elsewhere. Basic economic theory suggests that a weak currency is good news for domestic companies, as their exports become relatively cheaper and more competitive. This could be another reason for the performance of the S&P 500 and FTSE 100, with the constituents experiencing inflated demand for their products.
With both the Federal Reserve and the Bank of England broadcasting their intentions to raise rates multiple times this year, the era of weak currency is likely to be over. However, while the Trump regime is still viewed with uncertainty, the UK has finally started to make a number of breakthroughs with Brussels. Doubts about Brexit have abated somewhat and because of this, the pound may strengthen. Could this signal a reverse in demand for US and UK exports? If yes, then this will impact the market elements’ cash flows and share prices.
The Fixed Income Market
Interest rates throughout the bull market have been kept at historic lows. Quantitative easing measures have been used to a massive degree in both the UK, amounting to £435 bn, and the US, at a staggering $2.5 trn. This has driven prices on government securities to record highs and yields to record lows. Fundamentally, this has severely limited low-risk bond opportunities for investors and forced them to look towards investment in the FTSE 100 and S&P 500 companies, as these generally have a lower volatility and little risk. This has created excess demand within the equity market, ultimately inflating the price of markets well above their intrinsic value.
The fixed income market has already started to transition into an era of tighter credit, with both the Federal Reserve and the Bank of England ‘unwinding’ their quantitative easing programs and slowly increasing rates. This will undoubtedly begin to attract risk-conscious investors back into the bond market, at the cost of the equity market, as investors rebalance their portfolios. This transition period is projected to last for at least the next three years, with the Fed and the BoE publicising an intention to raise rates steadily in the foreseeable future.
One of the major areas of differentiation between the FTSE 100 and the S&P 500 is the tax reforms from which US corporations will benefit. The cut to corporation tax rates, from 35% to 21% in the US, will mean that corporations listed on the S&P 500 will see their effective tax rates tumble. In theory, this tax cut should increase the earnings that can be reinvested into company operations, thus further stimulating company growth and the American economy. This has clearly boosted confidence in the S&P 500, with investors adding this extra revenue to their discounted cash flow valuations. In practice, however, institutions and other large investors are likely to demand fat dividends from this additional income, ultimately limiting its effectiveness. This becomes a real issue when considering the fact that the $2trn deficit created by the reforms over the next 10-years, will allegedly be paid for by increased tax revenues.
In the short term, Trump’s tax reform will almost certainly inflate the free cash flows of American multinationals. Based on the cash flow/share price correlation, this will almost certainly boost the value of the S&P 500. From a long-term perspective, however, is this reform just another example of political gamesmanship and rent-seeking behaviour that avoids analysis of the long-term consequences? The S&P 500 acts as a very effective marketing tool for Trump and increases in the index will be hailed as a victory by the President. Does this represent an artificial increase in the S&P 500? Maybe, though this will not be corrected in the short term, but remains a real concern in the long run.
Are the Markets About to Go Bear?
With the tax reforms, the US markets have a real expected increase in cash flows to support them through the short to medium term. Whilst interest rate rises are likely to chip away at the demand for the equity markets and competitiveness of multinationals, this will happen gradually, especially with a new Federal Reserve chair who will probably avoid any immediate drastic decision. In the long term, however, the widening US tax deficit is particularly concerning. The prospects for the FTSE 100 is worrying in both the short and long term. Unlike the S&P 500, there is no significant redeeming factor and with uncertainties surrounding Brexit, significant questions exist about the UK markets value.
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