After having correctly called the January plunge, JPM's Croatian "duo of doom" of Kolanovic and Matejka predicted a modest bounce. This is what Matejka said in the middle of last month: Clearly, equities are unlikely to keep falling in a straight line, with periodic rebounds likely... However, we believe that one should be using any bounces as selling opportunities, adding that "one should not overstay one’s welcome in the bounce."
Today, Matejka followed up his call for a short-term bounce with a piece in which the JPMorganite warns that the window to buy stocks has closed and that it is almost time to start fading this bounce:
- Equities rebounded from recent lows, with SX5E moving up 6%, to be back above 3000, and SPX is back above 1900. We argued two weeks ago to look for a tradeable bounce, as most technical indicators were flashing oversold, and as policymakers were opening the doors to further stimulus. It is encouraging to see that equities are responding to these supports.
- The technical oversold picture has not completely changed, but indicators are not in “Buy” territory anymore. RSIs have moved to high 40’s, from sub 30. VIX has fallen back, Bull-Bear sentiment indicator has rebounded from -28% to -10%. The S&P500 put call ratio has come off, as did equity skew. Positioning still appears tentative, though, as HF beta remains in negative territory.
- We originally looked for up to half of past losses to be recovered. We believe that we are perhaps 2/3rds of the way through the bounce, and would look to start fading it within days. We stick to the overriding view that one should use any strength as an opportunity to reduce equity allocation. On 30th November ’15, we had advised to cut equity overweight in a balanced portfolio to a minimal one, at 5%, the lowest we have had so far in the current upcycle, and are advising to use the most recent stabilisation in order to cut the weight of equities further, bringing it to Neutral. This marks the first time we are not outright Overweight stocks since the ’07–’08 period, when we were 10% Underweight.
- We are concerned that the strategic OW on equities is not appropriate any more, and it should give way to a much more tactical positioning. Policy response is likely to keep getting ever more dovish, but over the medium term, we believe markets are likely to continue to worry about the stage of the global cycle we are in.
Matejka then explains why JPM is further lowering its equity weighting due to the following five reasons. Specifically, Matejka notes that "equities are unlikely to perform well on a 12- to 24-month horizon" and bunches headwinds into the following 5 groups:
- Equity valuations are not offering much room for error. P/E multiples have come down somewhat, but on most valuation metrics, stocks are at best fair value, in our view. The P/S metric is higher today than it was at any time in ‘07-’08 period – slide 13. Peak P/S on peak sales? True, relative to fixed income, stocks still look interesting, but credit spreads are widening, and the asset reflation regime might start to reverse.
- The gap between credit spreads and equities remains stark, with deterioration spilling over into real economy. The widening is not just due to energy; all the subsectors are seeing an increase in spreads. The latest US bank lending standards have worsened for the first time since ‘09. Net debt-to-equity ratios are higher now than they were in ’07 – slide 19
- US profit margins are showing increasing evidence of peaking. Profitability improvement was one of the key drivers of the 7-year-long equity rally. This might be finished, as the profit margin proxy – the difference between corporate pricing and the wage growth – turned outright negative in Q4 for the first time since 2008. Buybacks have flattered earnings for a while now, but we would be surprised if these stay a potent support. Buybacks as a share of EBIT are already at ‘07 highs, and credit spreads are widening.
- Fed tightening started very late in the cycle. The initial Fed hikes were normally interpreted as a confirmation of improving sentiment, but this time around, it might end up being a policy mistake, in our view. The Fed started to raise rates into a clearly worsening credit market, something which doesn’t happen often. In addition, the trade-weighted USD is up 25% over the past two years, a significant tightening in itself. Finally, the US yield curve is flattening post the hike, which is a problem. More fundamentally, asset reflation worked during ZIRP to help equities. This could start to unwind
- Medium-term Chinese and EM backdrop remains challenging, in particular in terms of credit excess. CNY could resume its depreciating trend post the Chinese new year, as the benefits of the past stimulus roll off.
But the most damning assessment is that as a result of the US cycle getting "long in the tooth", risk-reward has worsened and that "Equity markets could be down this year irrespective of the US growth trajectory." Matejka write that his "view since November ‘14 was that the Growth-Policy trade-off has deteriorated significantly for the US, limiting its upside." Here's why:
- Our concern is over the potential reversal of the following three powerful forces that led to the tripling of S&P500 over the past seven years: 1) profit margins moving from record lows since World War II to record highs; 2) HY and HG credit spreads tightening dramatically; and 3) the Fed expanding its balance sheet.
- All three of those drivers are finished from a medium-term perspective. US HY credit spreads have widened since June ‘14, and this move is not only due to the Energy sector. Ex-Energy, spreads are 340bp wider, in effect they doubled. US corporate balance sheets are starting to deteriorate, in contrast to Europe. Profit margins could come under pressure, given signs of increasing wage growth and weaker top lines than expected. As productivity stays low, ULCs could move up even without a big acceleration in wage growth.
- The interesting point to make is that one doesn’t necessarily need weakening activity in order for equities to be under pressure. Of course, if the US is starting a slowdown over the next 12 months and profit margins are headed lower, we think the bearish call is rather straightforward.
- In our view, the pressure on equity markets will materialise even if the US activity backdrop remains resilient. In that case, Fed is likely to persevere with the tightening bias, especially if the anticipated productivity rebound doesn’t come through. Given the easing stances of the rest of the world, the USD is likely to remain supported. This, in turn, would continue to weigh on commodities and would pressure China to resume its’ devaluation. Credit markets could remain weak in this environment, hurting equity valuations. This is the power of the adverse risk-reward for stocks. Equity markets could be down this year irrespective of the US growth trajectory.
And, what JPM did not add, is that there are increasingly louder rumblings that China may launch a major Yuan devaluation at the Shanghai G-20 meeting at the end of February. If that happens, replace "could" with "will" as China unleashes a massive deflationary and capital flight wave around the globe, which will drag risk assets lower unless, of course, the Fed finally relents, admits it made a mistake, and cuts back to zero, or more likely, to negative.