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‘We’ve had our correction’

Welcome to Authers’ Note, in which I will attempt to provide some context and analysis on the world of investment each day, and provide you with a handy guide to the best coverage on offer, both here in the FT and elsewhere. All feedback is welcome, particularly of the constructive variety, as we try to get this right. (Email to authersnote@ft.com).

Daily moves of more than one per cent in global stock indices are back to being almost routine. Following Monday's latest rally, US stocks are only 7.5 per cent below their recently set all-time high. Meanwhile, debate bubbles over whether this was an overdue correction (which long-term bulls and bears alike could agree was coming), or the start of something more profound.

For a characteristically interesting and dispassionate take on this, listen to Robert Shiller of Yale (who gave his name to the Shiller price/earnings ratio and the Case-Shiller housing index among others), talking on Bloomberg TV this morning:

Bob's take was that there had been a widespread conviction that a correction was coming. "We've had our correction." Now the problem is that it is "very ambiguous" as to what will come next. His key point is that the big change compared to a few years ago is that people now believe the market is overpriced. When people believe a market is overpriced but buy anyway, which is what had been happening before the correction, "that's almost the definition of a bubble. If you think it's overpriced but think it still has time to go, that's the definition of a bubble".

In many ways this is in line with the widespread fear ahead of the correction of a "melt-up". This chart from Michael Hartnett of BofA Merrill Lynch as part of the regular monthly survey of fund managers demonstrated exactly this point back in November. Portfolio managers were growing convinced of over-valuation, even as they cut back their cash:

Yale also keeps regular surveys of investors' confidence. These also show that among both institutions and individuals, belief that stocks are fairly valued had plummeted ahead of the correction. A momentary sell-off and rebound is unlikely to "correct" this:

But one data point from Yale's survey appears encouraging. This next measure covers confidence that a market crash can be avoided in the next six months. Remarkably, it dropped to an all-time low immediately after the crash of 2008, and has never shown much of a robust recovery. At this point, confidence that a crash can be avoided remains low — and far below the all-time high in institutional confidence that there would be no crash which came, of course, on the eve of the last stock market crash in 2007-08. The continuing nervousness about the possibility of an imminent crash remains one of the most positive indicators in suggesting that such a crash can be avoided: 

Beyond sentiment, what other tells should we be looking for? David Bowers of absolute strategy in London suggests that we should keep an eye on credit, and particularly the high-yield market. 

The plus points, suggesting that this is not anything more than a correction, in his view, are that many people have already dismissed it as a merely technical event, and that faith in economic fundamentals remains very strong — and unlikely to be challenged by any data releases in the next few weeks. Most importantly, contagion has been minimal — David points out that while this was an extreme event for volatility, there has been little knock-on effect to other asset classes. Credit remains largely unaffected, and equity bear markets usually involve a credit event. So everything is consistent with a return to the broader conjecture that the market would "melt up". Similar sharp corrections were seen in early 2007, more than six months before the 2007 top, and in early 1997, some three years before the top of the dot com bubble, so last week's events remain consistent with a melt-up. 

But there are broader questions here. Vix-related products were just one of a whole constellation of investment products that flourish in a "QE" environment of ample liquidity. If this is indeed the beginning of a roll back of the QE conditions and a change to a new investment regime, then a range of assets that have flourished since the crisis and which embed an ample use of leverage (like Vix products) could come under pressure. The areas of concern include alternatives, perhaps led by private equity and real estate. 

But for such worries to have much traction, we need to see high-yield begin to move and tighten. That is David's argument, and it is a sensible one. 

Meanwhile, I offer one last data point that is intriguing. Over the past few days, inflation breakevens have fallen back a bit. That means that real yields, over and above inflation, on treasuries have increased sharply. They are still at a low level, but do not need to go much further before they begin to tighten conditions noticeably. Here is the chart:

That is quite an adjustment since election day. They remain very low, but the move has been quick. If real yields rise much further from here, they will have an effect on other markets. 

Meanwhile, Earnings . . . 

Yes, earnings were good. Even though analysts had attempted to upgrade their forecasts in the light of the tax cut, Bespoke Investment shows that most of them undershot both on earnings,

where the proportion of companies beating their estimates was the greatest in more than a decade, and also on sales:

The revenues figures are undeniably impressive. Companies plainly did better than brokers had anticipated. What makes those earnings surprises particularly impressive is that forecasts were already rising as the announcement season began. And the rise in earnings expectations, largely a direct reaction to the tax cut, was nothing short of extraordinary. This remarkable chart is from BofA Merrill Lynch: 

The tax cut was plainly at the very least a one-off game changer. Whatever happens next, it was necessary to make one big adjustment for the tax change, and brokers had not made enough of an adjustment by the time the results became official. BofA Merrill also included an analysis of 100 S&P 500 companies' spending announcements which should be part of the Republicans' campaign literature for the next elections:

Investment in employees a key use of the tax windfall . . .

Inside we highlight major spending announcements by ~100 companies. Nearly 40% have announced one-time bonuses, nearly a third have announced higher wages and a third announced other benefits (401k contributions, etc.). Several plan additional hiring. We see labor costs as a risk to labor-intensive companies' margins, given base wage increases, prior signs of wage pressures, and the recent strong employment report.

. . . while cos also reduce debt, up cash return, buy & build

Nearly one-fourth of the 100 companies above plan charitable donations, and several (such as TMO, COP) have highlighted a focus on ESG. And over 15% cited debt paydown. While many are still deciding how to spend the windfall (or communicated no change to priorities), a third announced increased capex and several explicitly target M&A. While firms have generally been less explicit on whether buybacks/ dividend raises are the result of tax reform or simply better growth, announced S&P 500 buybacks in Dec. and Jan. were the largest of any Dec. or Jan. in our post-crisis data history. We expect half of repatriated cash to be spent on buybacks, less than during the last repatriation holiday.

Are there any flies in the earnings ointment? Not many, but it is noticeable that the greatest improvements have come from multinationals. The weak dollar is a big part of this (and the dollar has turned around and started to strengthen again since equities started to correct):

One other problem is that when earnings change as suddenly and drastically as this, it can be difficult to assimilate. Equity markets had spent much of the time since September trying to discount the impact of a corporate tax cut. The speed with which markets accelerated in January, and then reversed this month, may owe something to the sheer difficulty involved in assimilating a change like this in a hurry. Even though brokers were behind with their estimates, it looks like the equity market got ahead of itself with share prices. Now we need to find out if the market has also gone too far ahead of itself in the subsequent correction. 

Wall St v Main St, Round 2

Wall Street's reaction to the best increase in average hourly earnings in almost a decade has already secured a minor place in market history. That was the spark that at last set fire to the first correction in two years. Great news for Main Street was bad for Wall Street.

Inflation data will rightly now hog a lot of attention, but I might suggest that one data point due shortly after you receive this might yet be the sequel in the great battle between Wall Street and Main Street. Tuesday sees the publication of the National Federation of Independent Business' monthly survey of small business optimism. It is widely regarded as a good economic leading indicator, and it has one very interesting data series on tightness in the labour market. Here it is:

The proportion of small businesses saying they are finding it hard to fill job openings has been oscillating just below an all-time high for the survey set as long ago as 2000. This episode of the NFIB survey will have been taken in the aftermath of the tax cut and before the stock market correction, when business owners were excitedly viewing the return of animal spirits and the beginning of a very positive season of earnings announcements. 

I have no inside insight on this, but a left-field risk for Tuesday might be a break-out in this survey. Any headline that an all-time record number of small businesses were finding it hard to fill job openings would be just what Main Street wants to see. It might even justify a self-congratulatory presidential tweet. Wall Street, in the current environment, would not be happy about it at all. 

One to keep an eye on.

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