This is the February 2020 investment conditions report. It includes both a written version and audio commentary.
- Investment conditions are low neutral in YELLOW territory.
- Global stocks fell just over 1% in January as uncertainty regarding the severity of the coronavirus that originated in China weighed down markets.
- Interest rates fell in January in a flight to quality that was spawned by coronavirus uncertainty.
- Economic trends are RED as of early February 2020 for the eighth straight month. The coronavirus pandemic has clearly disrupted a global economy where growth was bottoming and beginning to show improvement. There remains a high degree of uncertainty regarding how contagious and deadly the virus is and what mechanisms will be effective in containing it.
- With the stock market selling off in response to the coronavirus uncertainty, trend data deteriorated last month, but there has not been longer-term trend damage as most markets and stocks remain above their 200 day moving averages. Global and U.S. stocks fell over 3% in January for the first time since October. On a positive note, the sell-off reduced much of the excessive investor optimism, according to recent investor sentiment surveys.
- Market valuations are neutral and in YELLOW territory. Despite improvement in earnings expectations, earnings revisions and positive earning surprising, actual earnings for the global stock market have fallen 1.5% in the past year, which has resulted in higher valuations given global stocks appreciated over 15% over the trailing twelve-month period.
- Overall investment conditions are low neutral due to uncertainty regarding the financial impact of the coronavirus. Previous pandemics saw economic growth return to trendline and financial markets rebound after it became apparent the outbreak was contained. Ideally, that will be the case this time with renewed economic strength boosting corporate profit growth, eliminating one of the factors (i.e. falling profits) that has made it difficult for investors to confidently increase exposure to the stock market.
Listen To The February 2020 Investment Conditions Audio Commentary
The audio commentary is an integral part of the Investment Conditions report as it provides additional context to the written report.
The following spreadsheet contains monthly valuation, economic trends, and market internal data used in the investment conditions report from December 2015 through the most recent report period.
Purpose of the Investment Conditions Report
The purpose of the monthly investment conditions report is to objectively look at market valuations, economic trends, central bank actions, and market internals such as price trends, momentum, and investor sentiment data to determine if there is a regime change that suggests investors should make adjustments to their asset allocation and portfolio structure.
In other words, are the risks of bad times in terms of bear market losses and higher volatility increasing or decreasing, suggesting investors should modify their exposure to certain asset classes.
Monitoring investment conditions is helpful for scaling exposure to risky assets such as stocks as favorable investment conditions generally align with positive investment returns while unfavorable investment conditions have generally been associated with sub-par investment returns.
In this report, investment conditions are segmented into three areas:
- Market valuations – measure how inexpensive or pricey the global stock market, bonds, and other asset classes are.
- Economic and central bank trends – measure the anticipated direction of the economy based on purchasing managers indices (“PMI”) and other economic indicators and how accommodating central banks are in terms of their interest rate policies.
- Market internals – measure market trends and momentum and the level of fear and greed exhibited by investors.
Market valuations, market internals, and economic and central bank trends can be thought of as traffic stoplights that are each individually flashing red, green or yellow.
When all three are red as they were in early 2008, that warrants extreme caution and a more conservative investment approach.
When all three are green as they were in mid-2009 coming out of the Great Financial Crisis, then that provides an opportunity to increase portfolio risk and generate higher returns.
By design, the metrics covered in this report are streamlined to focus on the most relevant data for navigating an uncertain world. Having more data does not necessarily lead to better investment decisions. Rather, this report focuses on building blocks that influence future returns for asset classes such as:
- Current dividend yields, earnings yields, and interest rate yields relative to historical trends. Higher yields equate to higher future returns.
- How investors are valuing cash flows and earnings. When investors place a low value on earnings and cash flows that can lead to higher future returns.
- Whether the risk of a recession is increasing or decreasing, as measured by PMI and other leading economic indicators. Economic trends impact corporate profits, financial stress, and investor expectations.
- Whether central bank actions are putting upward pressure or downward pressure on interest rates, which can lead to changes in asset class valuations and investor expectations.
- How broad or narrow is the prevailing market trends in terms of the percentage of stocks and stock markets in an uptrend or downtrend? A healthy market is denoted by broad participation with investors neither overly fearful or overly zealous. An unhealthy market has divergences or movements opposite the existing trend that can be a sign of mounting risks that may warrant adjusting exposures.
Historical Investment Conditions
Overall Global Investment Conditions Are Low Neutral (Yellow)
As of early February 2020, investment conditions are low neutral in YELLOW territory. Economic trends remain RED for the eighth straight month. There was enough improvement in leading economic indicators and PMI survey data to shift economic trends into low neutral territory, but then the coronavirus pandemic hit, casting a shadow over the global economy. Both global manufacturing and services PMI are in expansion territory, but many of the survey responses were received prior to the jump in coronavirus related illnesses. There remains a high degree of uncertainty regarding how contagious and deadly the virus is and what mechanisms will be effective in containing it. Until there is greater clarity regarding those factors, it is difficult to get overly confident that the global economic recovery will accelerate from here.
The coronavirus’s impact has yet to be reflected in lowered expectations for corporate earnings which analysts expect to increase at a 9% pace in the next 12-months after declining 1.5% in the past year. A lack of earnings growth has led to higher stock market valuations given the strong appreciation over the past year. A continuation of the stock market advance will be closely linked to corporations ability to meet earnings expectations.
The good news is previous pandemics saw economic growth return to trendline and financial markets rebound after it became apparent the outbreak was contained. Ideally, that will be the case this time with renewed economic strength boosting corporate profit growth, eliminating one of the factors (i.e. falling profits) that has made it difficult for investors to confidently increase exposure to the stock market.
Complex Adaptive Systems
It is important to recognize stock markets are part of a complex adaptive system which means unexpected market sell-offs can occur irrespective of investment conditions.
Investors should never have such a large allocation to stocks that their lifestyle or retirement plans would be seriously undermined due to unexpected severe market losses.
The remainder of the report provides an overview of market returns and more detail regarding market valuations, market internals, and economic and central bank trends.
Global stocks fell just over 1% in January as uncertainty regarding the severity of the coronavirus that originated in China weighed down markets. Global stocks rebounded back into positive territory year-to-date in the early part of February in response to upbeat economic releases.
The following table provides an overview of equity market returns:
Global Stock Market Returns For the Periods Ending January 31, 2020
|In USD||In Local|
|ACWI All Country World Index||-1.1%||-1.1%||-0.6%||-0.6%|
|AC Asia Pacific Ex-Japan||-3.7%||-3.7%||-2.5%||-2.5%|
|Emerging Latin America||-5.6%||-5.6%||-1.3%||-1.3%|
|Emerging Europe & Middle East||-3.0%||-3.0%||-1.7%||-1.7%|
Bond Market and Income Strategy Returns
Interest rates fell in January in a flight to quality that was spawned by coronavirus uncertainty. Global bonds returned over 1% for the month while U.S. bonds returned close to 2%.
The following table provides an overview of bond market returns:
Fixed Income Returns For the Periods Ending January 31, 2019
|U.S. Corporate High-Yield||0.0%||0.0%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.2%||0.2%|
|Emerging Markets USD||1.5%||1.5%|
|Emerging Markets Local Govt||-0.4%||-0.4%|
|Pan European Aggregate||2.3%||2.3%|
|Asian Pacific Aggregate||0.2%||0.2%|
Commodities and MLPs declined in January in response to the coronavirus outbreak. Real estate investment trusts returned approximately 1%.
REITs MLPs and Commodities Returns For the Periods Ending January 31, 2019
|Alerian MLP Index Total Return Index||-5.6%||-5.6%|
|Down Jones Equity All REIT Index||1.3%||1.3%|
|S&P Global REIT Total Return Index||0.8%||8.8%|
|S&P GSCI Commodity Index||-10.8%||-10.8%|
Source: Alerian and S&P Dow Jones
Market Valuations – YELLOW
Market valuations are neutral and in YELLOW territory. Stock valuations were essentially unchanged from last month as measured by earnings and dividend yields. On a cyclically-adjusted basis, U.S. stocks got more expensive and now sell for 30.1 times average 10-year earnings compared to the long-term average of 20.3. The U.S. stock market is the most expensive in the world.
Forward earnings expectations continue to increase with one year expected earnings growth of 9.9% for the MSCI All Country World Index compared to 9.6% last month. Forward one-year earnings expectations for the MSCI U.S. Index improved to 9.9% compared to 9.8% last month. Emerging market earnings expectations over the next year are 15.1% compared to 14.7% last month.
65% of global companies had positive earnings revisions in line with 66% of companies at year-end. The number of U.S. companies with positive earnings revisions was 72%, the same as last month.
With 21% of global companies reporting fourth-quarter earnings, 60% have exceeded analysts’ earnings estimates compared to 59% for the third quarter. That is slightly below the long-term average of 62%. In the U.S. with just about one-half of companies reporting, 72% have exceeded analysts’ earnings estimates for the fourth-quarter earnings season. That matches median beat rate of 72% going back to 1995.
Despite improvement in earnings expectations, earnings revisions and positive earning surprising, actual earnings for the global stock market have fallen 1.5% in the past year, which has resulted in higher valuations given global stocks appreciated over 15% over the trailing twelve-month period.
The above-average valuations provide a headwind for stocks to gain more than their dividend yield and expected earnings growth in 2020.
Earnings Yields as of February 1, 2019
|Dec Earnings Yield||Jan Earnings Yield||Feb Earnings Yield||Historical Average Earnings Yield||Historical Average Starting Year||Standard Deviations From Average|
|All Country World||5.3%||5.2%||5.2%||5.3%||1995||0.1|
|World ex U.S.||6.2%||6.1%||6.2%||6.1%||1970||0.1|
|Asia Pacific Ex-Japan||6.6%||6.2%||6.3%||6.4%||1995||0.1|
|Emerging Latin America||6.9%||6.6%||6.7%||6.9%||1995||0.2|
Source: Ned Davis Research and MSCI
Note: The earnings yield figures are based on trailing twelve-month earnings. Earnings yield is the inverse of the price-to-earnings ratio. The lower the earnings yield, the more expensive the valuation. Standard deviation measures how far outside of the norm the earnings yield is. The higher the standard deviation the further the current measure is from the average. Standard deviations listed in red denote a market that is more expensive than average while those in black are at their average or cheaper than average.
Dividend Yields as of February 1, 2019
|Dec Dividend Yield||Jan Dividend Yield||Feb Dividend Yield||Historical Average Dividend Yield||Historical Average Starting Year||Standard Deviations From Average|
|All Country World||2.4%||2.4%||2.4%||2.3%||1995||0.3|
|World ex U.S.||3.2%||3.2%||3.2%||3.0%||1970||0.3|
|Emerging Latin America||3.4%||3.1%||3.2%||2.9%||1995||0.3|
Source: Ned Davis Research and MSCI
Note: The dividend yield figures are based on trailing twelve-month dividends. Standard deviation measures how far outside of the norm the dividend yield is. The higher the standard deviation the further the current measure is from the average. Standard deviations listed in red denote a market with a dividend yield lower than average while those in black are markets with dividend yields that are at their average or higher than average.
Equity Cyclically-Adjusted Price-to-earnings Ratios as of February 1, 2019
|Dec Cyclically-Adjusted Price-to-Earnings||Jan Cyclically-Adjusted Price-to-Earnings||Feb Cyclically-Adjusted Price-to-Earnings||Historical Median Price-to-Earnings||Standard Deviations From Median|
|All Country World||21.4||22.3||22.3||20.7||0.3|
|AC Asia Pacific Ex-Japan||14.7||15.6||15.1||17.3||0.4|
Source: Ned Davis Research and MSCI
Note: Cyclically-adjusted P/E Ratios also known as Shiller P/E’s are based on the previous 10-year average earnings using MSCI Indices. One important consideration when making valuation judgments using 10-year earnings is whether the previous decade reflects the earnings potential going forward. In other words, are there outliers in the historical earnings record that are not repeatable? Standard deviation measures how far outside of the norm the dividend yield is. The higher the standard deviation the further the current measure is from the average. Standard deviations listed in red denote a market that is more expensive than its historical average while those in black are markets that are at their average or cheaper than average.
Select Bond and Income Strategy Valuations as of February 1, 2019
The following section reviews the absolute yield and the incremental yield or spread for bonds and other income-oriented strategies. The comparisons allow you to see whether the spread is higher or lower than its long-term average. An asset category is more attractive when its spread is wider than its long-term average and less attractive when the spread is narrower than its long-term average.
|Alerian MLP Dividend Yield||10.1%||8.8%||9.4%|
|MLP Incremental Yield Above 10 Year Treasuries||8.3%||6.9%||7.9%|
|20 Year Median Incremental MLP Yield Over 10-Year Treasuries||3.4%||3.4%||3.4%|
|NAREIT All REIT Dividend Yield (includes mortgage reits)||4.0%||4.1%||4.0%|
|20 Year All REIT Dividend Yield Average||5.3%||5.3%||5.3%|
|NAREIT Equity REIT Dividend Yield||3.6%||3.7%||3.6%|
|20 Year Equity REIT Dividend Yield Average||4.8%||4.8%||4.8%|
|Equity REIT Yield Above 10-Year Treasuries||1.8%||1.8%||2.1%|
|20 Year Average REIT Yield Above 10-Year Treasuries||1.4%||1.3%||1.3%|
|REITs Price to Funds From Operations||20.0|
|REITs Price to Funds From Operations Long-term Average||16.3|
|MLP Incremental Yield Above REIT Yield||6.1%||4.7%||5.4%|
|20 Year Median Incremental MLP Yield Over REIT Yield||1.8%||1.8%||1.8%|
|U.S. Corporate High Yield Bonds Yield To Worst||5.6%||5.2%||5.5%|
|U.S. High Yield Incremental Yield (i.e., Spread) Above 10 Year Treasuries||3.8%||3.3%||4.0%|
|Average Incremental Yield Since 1983||4.9%||4.9%||4.9%|
|U.S. Bank Loan (i.e., Leveraged Loan) Yield||6.1%||5.6%||5.7%|
|U.S. Bank Loan Yield Above 3 month Eurodollar Yield||4.1%||3.7%||4.3%|
|Average Incremental Yield Since 2012||4.3%||4.3%||4.3%|
|U.S. Investment Grade Corporate Bonds Yield To Worst||2.9%||2.8%||2.6%|
|U.S. Investment Grade Incremental Yield (i.e., Spread) Above 10 Year Treasuries||1.1%||0.9%||1.1%|
|Average Incremental Yield Since 1973||1.1%||1.1%||1.1%|
|U.S. Mortgage-Backed Securities Yield To Worst||2.5%||2.6%||2.3%|
|U.S. MBS Incremental Yield (i.e., Spread) Above 10 Year Treasuries||0.7%||0.7%||0.8%|
|Average Incremental Yield Since 1989||0.6%||0.6%||0.6%|
|Emerging Market Yields||5.1%||4.8%||4.8%|
|Emerging Market Incremental Yield (i.e., Spread) Above 10 Year Treasuries||3.3%||2.9%||3.3%|
|Average Incremental Yield Since 1997||4.1%||4.1%||4.1%|
|U.S. Real 5-Year Yield||0.0%||-0.1%||-0.2%|
|Nominal 5-Year Yield minus Real 5-Year Yield||1.5%||1.5%||1.6%|
|U.S. Real 7-Year Yield||0.1%||0.0%||-0.1%|
|Nominal 7-Year Yield minus Real 7-Year Yield||1.6%||1.6%||1.6%|
|U.S. Real 10-Year Yield||0.1%||0.0%||0.0%|
|Nominal 10-Year Yield minus Real 10-Year Yield||1.6%||1.6%||1.6%|
|U.S. 10-Year Treasury Yield||1.8%||1.9%||1.5%|
Source: Ned Davis Research
Economic and Central Bank Trends – RED
The most robust data set for understanding global economic growth trends is Purchasing Manager Indices (PMIs), which are monthly surveys of businesses conducted by Markit and other providers.
There are both Manufacturing and Non-Manufacturing PMI surveys conducted each month. Generally, a reading above 50 suggests an economy is expanding while a reading below 50 suggests an economy is contracting.
This report focuses on Manufacturing PMIs as they are more cyclical have a longer and more accurate history of predicting global recessions.
The following table provides an overview of global PMI as well as select regions and countries.
PMI Data As of February 1, 2019
|JP Morgan Global PMI||49.3||49.5||49.7||49.8||50.3||50.1||50.4|
|U.S. PMI provided by Markit||50.4||50.3||51.1||51.3||52.6||52.4||51.9|
|U.S. PMI provided by ISM||51.2||49.1||47.8||48.3||48.1||47.2||50.9|
|Share of PMIs Above 50||37%||40%||47%||40%||34%||49%||53%|
|Share of PMIs Posting Monthly Increase||46%||49%||40%||54%||57%||44%||65%|
|Share of PMIs Posting Annual Increase||20%||23%||17%||26%||26%||27%||29%|
Source: Markit, ISM and Ned Davis Research
Economic trends remain in RED territory as of early February 2020. The JP Morgan Global Manufacturing PMI improved for the second straight month to 50.4, the highest level since last April. 53% of countries are in expansion territory. Yet many of the survey responses were received prior to the jump in coronavirus related illnesses and deaths. With many Chinse factories closed, global supply chains could be negatively impacted unless the factories reopen soon. The coronavirus pandemic has clearly disrupted a global economy where growth was bottoming and beginning to show improvement. There remains a high degree of uncertainty regarding how contagious and deadly the virus is and what mechanisms will be effective in containing it. Until there is greater clarity regarding those factors, it is difficult to get overly confident that the global economic recovery will accelerate from here.
The Conference Board Leading Economic Index (LEI)
|6 Month Rate of Change in the Leading Index||Percent of Subcomponents Higher Than 6 Months Earlier|
Source: The Conference Board and Ned Davis Research
The six-month rate of change for the Conference Board’s Leading Index of U.S. economic indicators was -0.4% last month. 55% of the index’s underlying components were lower than six months ago. U.S. recessions are typically preceded by the six-month rate of change for the Conference Board’s Leading Index declining by at least 2% and more than 80% of the leading index underlying components lower than the six months prior. While U.S. recession probability remains low, leading economic indicators are still weak and much lower than they were a year ago.
On a positive note, the ISM manufacturing PMI returned to expansion territory with a level of 50.9 compared to 47.2 last month. Now the ISM manufacturing PMI is more in line with Markit’s U.S. manufacturing PMI which came in at 51.9.
The U.S. ISM non-manufacturing PMI improved slightly to 55.0 from 54.1 last month. Taken together, the U.S. manufacturing and non-manufacturing PMI are consistent with annualized economic growth of 1.5%. That is lower than 2.1% annualized gain in U.S. fourth-quarter GDP. Consumption growth in the final quarter of the year slowed to 1.8% from 3.2% in the third quarter while business investment contracted.
The U.S. employment report showed 225,000 non-farm payrolls were created last month as unseasonably warm January weather boosted construction job growth. The employment report benchmark revisions discussed in Plus episode 185 were not as severe as anticipated. Employment levels were actually revised up between April and December of last year. That means the six-month average employment gain through January 2020 is 206,000 jobs compared to the six month average of 137,000 last July. This if further evidence the U.S. economy appears to be strengthening rather than weakening.
The Federal Reserve has not changed its policy rate since last fall. It cut rates three times in 2019. The Fed, however, continues to provide liquidity to keep short-term interest rates in line with its target of 1.75%. It does so by lending to banks, security firms and hedge funds via repurchase agreements (repos). These short-term loans are secured by U.S. Treasuries which serve as collateral. The Fed currently has $170 billion repos outstanding. In addition, the Federal Reserve has been directly purchasing $60 billion in U.S. Treasury bills each month. As a result, the Federal Reserves’ U.S. Treasury holdings including collateral for repos have increased by over $300 billion since September. This effectively means the Fed bought up the new net issuance of U.S. Treasuries from the past four months. The Fed indicates it will continue to participate in repurchase agreements through April and end Treasury purchases in the second quarter, but those dates are subject to change as it depends on market conditions, specifically whether money market mutual funds are able to digest much of the new Treasury bill issuance that has resulted from the United States’ trillion-dollar budget deficit.
Market Internals – Yellow
Market internals, such as trend, momentum, and sentiment, are fast variables since they are driven by investor emotion whereas valuations and economic trends tend to change more slowly.
At times, market internals can act as an accelerant that magnifies the prevailing long-term secular trend that is driven by valuations, economic trends, and central bank actions.
At other times, market internals can dampen the prevailing long-term trend.
Adjusting investment portfolios based exclusively on market internals is a trading strategy that can be effective, but is not compatible with the longer-term focus of the Money For the Rest of Us Plus.
Instead, we can combine the faster variables of market internals with the slower variables of valuations and economic and central bank trends in order to identify regime shifts that suggest the risk of a major equity market sell-off is high or, conversely, conditions are in place for a major equity market advance.
Market internals are essentially a swing vote that reinforces or dampens the primary message coming from the slow variables of market valuations and economic and central bank trends.
The following table shows the percentage of stocks and markets that are priced above their 50-day and 200-day moving averages. In other words, how does the current stock price or level of the index compare to the average price over the previous 50 and 200 days. The reason to monitor this is markets are said to be in gear when there is broad participation in most markets and stocks around the world. For example, data from Ned Davis Research shows that when less than 35% of markets are above their 200-day average that the MSCI All Country World Index has returned -11% per annum. When 85% of markets are above their 200-day moving average the MSCI All Country World Index has returned 19.4% per annum.
Global Equity Market Trend Data as of February 1, 2019
|Percentage of Global Markets Above 50 Day Moving Average||13%||57%||29%||88%||51%||86%||47%|
|Percentage of Global Markets Above 200 Day Moving Average||45%||53%||41%||71%||55%||76%||67%|
|Percentage of Global Stocks Above 50 Day Moving Average||27%||49%||43%||71%||55%||64%||38%|
|Percentage of Global Stocks Above 200 Day Moving Average||42%||49%||46%||61%||57%||67%||55%|
|Percent of Global Markets With Rising 200 Day Moving Averages||55%||57%||63%||76%||69%||71%||69%|
Source: Ned Davis Research
Market internals as measured by trend, sentiment, and momentum are in YELLOW neutral territory as of early February 2020.
With the stock market selling off in response to the coronavirus uncertainty, trend data deteriorated last month, but there has not been longer-term trend damage as most markets and stocks remain above their 200 day moving averages. Global and U.S. stocks fell over 3% for the first time since October.
On a positive note, the sell-off reduced much of the excessive investor optimism, according to recent investor sentiment surveys. Meanwhile, momentum, which measures the degree to which the market advance or decline is accelerating or decelerating, slowed but remains in neutral territory.
In January, U.S. investors continued to be net sellers of U.S. and non-U.S. stock ETF and funds while adding to their bond holdings. Much of that was probably rebalancing after the strong 2019 stock market return. A sustainable stock market rally requires more participation by the investing public with regard to adding new funds to stocks.
Global valuations and market internals are rated YELLOW while economic trends are rated RED. Overall investment conditions are low neutral due to uncertainty regarding the financial impact of the coronavirus. Previous pandemics saw economic growth return to trendline and financial markets rebound after it became apparent the outbreak was contained. Ideally, that will be the case this time with renewed economic strength boosting corporate profit growth, eliminating one of the factors (i.e. falling profits) that has made it difficult for investors to confidently increase exposure to the stock market.
The following tables provide a summary of market conditions by region.