This is the September 2017 investment conditions report. It includes both a written version and audio commentary.
Listen To The September 2017 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.
Purpose of the Investment Conditions Report
The purpose of the monthly investment conditions report is to objectively look at market valuations, economic and central bank trends, and market internals such as trend, momentum and 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 market losses and higher volatility increasing or decreasing.
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 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 indicators and how accommodating central banks are in terms of their interest rate policies.
- Market internals – measure market trends and momentum and the level 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 Recession, then that provides an opportunity to increase portfolio risk and generate higher returns.
Currently, global valuations, economic trends and market internals are YELLOW with investment conditions neutral.
Overall Global Investment Conditions Are Neutral (Yellow)
Investment conditions are neutral or YELLOW as of early September 2017, consistent with the continuation of the cyclical bull market within a secular bull market. This cyclical bull market for stocks has been in place since 2011, which was the last time global stocks as measured by the MSCI All Country World Index fell by more than 20%.
The MSCI All Country World Index continued its stretch without a decline greater than 5%. It has now gone 314 days, its longest stretch since 1996. A greater than 5% decline for global stocks occurs on average about every 60 days.
U.S. stocks have gone 303 days without a decline greater than 5%, its longest stretch since 1996 when it went over 350 market days without a correction.
Market volatility remains near historic lows.
While the global stock market is due for a correction, it does not mean one is imminent, particularly against the backdrop of improving earnings and solid economic fundamentals. Any pull back is likely to be in the single digits, consistent with normal market volatility within a secular bull market.
Economic trends improved in August to their best level in six years as measured by manufacturing purchaser manager indices. 97% of countries around the world are in expansion territory. Given the broad based economic expansion and low risk of recession, economic trends have been updated to GREEN.
While global stock valuations continue on the low side of neutral, the good news is a rebound in corporate earnings has resulted in the most attractive valuation for global stocks in over a year as the earnings yield for the MSCI All Country World Index rose to 5% as of September 1, 2017. The higher the earnings yield, the more attractive the valuation.
Year-over-year earnings growth for the MSCI All Country World Index is 16.7%, its fastest pace since 2011. Analysts expect corporate earnings to continue to rebound with overall global earnings expected to increase 11.2% year-over-year, led by emerging markets which are expected to grow their earnings by 14.6%.
Global valuations, economic and central bank trends and market internals are all rated YELLOW and in neutral territory. Investors with a long-term time horizon should keep their portfolio allocations in line with their long-term targets.
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 stock markets were up slightly in August, adding to their double digit year-to-date returns.
The MSCI All Country World Index gained 15.0% through August in U.S. dollar terms and 11.4% in local currency terms.
Emerging markets posted a solid 2.2% gain in August and has returned over 28% year-to-date.
89% of countries (i.e. 41 out of 46) that comprise the MSCI All Country World Index have posted positive returns year-to-date.
The following table provides an overview of equity market returns:
Global Stock Market Returns For the Periods Ending August 31, 2017
Bond Market and Income Strategy Returns
Interest rates declined in August, leading to price appreciation for bonds of about 1%.
The weakening dollar has had a favorable impact on global bond performance year-to-date when measured in USD as evidenced by the 7.4% year-to-date return for the Global Aggregate Index.
Favorable global economic prospects have led to tighter yield spreads for higher risk bonds such as emerging markets and non-investment grade bonds, which are the leading bond sectors year-to-date. U.S. non-investment grade bond spreads did widen a little bit in August leading to a flat return for high yield bonds for the month.
The following table provides an overview of bond market returns:
Fixed Income Returns For the Periods Ending August 31, 2017
Note: Bloomberg no longer makes index yield and duration data readily available.
Commodities and MLPs declined in August and remain in negative territory year-to-date due to the decline in oil prices.
Meanwhile, REITs while not performing as strongly as stocks have posted sold returns year-to-date.
MLPs, REITs and Commodities Returns For the Periods Ending August 31, 2017
Market Valuations – YELLOW
Market valuations remain on the low side of neutral as of early September
The earnings yield for the MSCI All Country World Index rose to 5.0%, its highest level since August 2016. This compares to historical average earnings yield of 5.4%.
The lower the earnings yield, the more expensive the market valuation.
Global stocks earnings yield is about 0.3% standard deviations from its average. Standard deviation measures how far outside the norm valuations are with standard deviations greater than 1.0 a sign of either an overvalued market if earnings yields are lower than average or an undervalued market if earnings yields are higher than average.
The U.S. and Europe are richly valued with earnings yields of 0.9 or more standard deviations lower than their average while Japan is attractively valued with its earning yield 1.1 standard deviations above its long-term average.
Cyclically adjusted price-to-earnings ratios which are based on the current price of the market indices divided by the average earnings over the previous 10 years held steady in August.
With the above average earnings levels in 2007 just prior to the Great Financial Crisis falling out of the 10 year average, cyclically-adjusted P/E’s have increased. The cyclically-adjusted P/E for by the MSCI All Country World Index is above its long-term historical average as of early September.
The U.S., which comprises half of the global stock market is the most overvalued area based on cyclically-adjusted P/E.
Global corporate earnings growth has been a strong driver of the 2017 market advance as expectations of a corporate earnings rebound has come to fruition. Trailing 12-month earnings growth for the MSCI All Country World Index was 16.6%, its fastest pace since 2011.
Emerging markets earnings growth increased 14.8% year-over year while developed markets earnings growth rose 18.1%. U.S. year-over-year earnings growth was 13.9%.
Analysts expect corporate earnings to continue to rebound with overall global earnings expected to increase 11.2% in the next year, led by emerging markets which are expected to grow their earnings by 14.6%.
Currently over 77% of global stocks have positive earnings revisions by analysts. That means most analysts are increasing their estimates of earnings growth rather than reducing their estimates. Historically, according to data from Ned Davis Research when more than 60% of stocks have positive earnings revisions, actual earnings came in at 18% a year later. When less than 60% of stocks have positive earnings revisions, earnings fell by 9%.
Earnings Yields as of September 1, 2017
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.
Source: Ned Davis Research
Dividend Yields as of September 1, 2017
Note: The dividend yield figures are based on trailing twelve month dividends. 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.
Source: Ned Davis Research
Equity Cyclically-Adjusted Price-to-earnings Ratios
Source: Ned Davis Research, 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 judgements using 10-year earnings is whether the previous decade reflects the earnings potential going forward. In other words, are their outliers in the historical earnings record that are not repeatable?
The following section provides some additional valuation metrics for select U.S. bond and income strategies.
Select Bond and Income Strategy Valuations as of September 1, 2017
Source: Ned Davis Research
Valuations for REITs remain high with dividend yields at 4.1% and price-to-funds-from-operations (i.e. the REIT equivalent of a price-to-earnings ratios) above their long-term averages.
Valuations for private real estate projects owned by REITS are also high, pushing down yields.
U.S. non-investment grade bonds are also richly valued with the incremental spread relative to U.S. Treasuries below its long-term historical average.
Emerging market bond yields incremental spread relative to U.S. Treasuries also remains below average.
Economic and Central Bank Trends – GREEN
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 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 September 1, 2017
The Global Manufacturing PMI increased to 53.1 in August, its highest level in six years. The global PMI is comfortably above its long-term average of 51.4, suggesting a continuing economic expansion.
PMI breadth improved sharply with 97% of the world having PMI’s above 50, the most since January 2011. 93% of countries show a positive year-over-year increase in PMI and 73% show a monthly increase.
Developed markets continue to lead emerging markets in terms of PMI with developed market’s manufacturing PMI at 54.2, its highest level since February 2014. The emerging markets PMI climbed to its highest point since January 2013.
The JP Morgan Global Manufacturing and Services PMI is at 53.9, solidly in expansion territory.
Given the solid breadth and high levels in global PMI, global economic conditions have been upgraded to GREEN, suggesting the risk of a global economic recession is very low.
U.S. second quarter GDP was revised strongly upward to 3.0% as consumer spending and business investment came in higher than first estimated.
The six month rate of change for the Conference Board’s Leading Index of U.S. economic indicators was 2.3% while 80% of the index’s underlying components were higher then six months ago, conditions that suggest the risk of a U.S. recession is low.
The U.S. ISM Non-Manufacturing PMI rebounded in August to 55.3, after dropping 3.5 points to 53.9 in July, its biggest decline since November 2008.
The September U.S. employment report came in soft as 156,000 new jobs were created, but the three month average remains robust at 185,000 jobs per month. The unemployment rate is low at 4.4%.
With the U.S. close to full employment, the Federal Reserve should begin to normalize its balance sheet at its September meeting, but given low inflation levels the Fed is likely to hold off raising its policy rate until its December meeting.
Central bankers outside of the U.S remain generally accommodative in terms of keeping policy rates low and continuing with quantitative easing.
Economic trends are positive and rated GREEN.
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 and economic and central bank trends.
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 changes 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 provides and overview of prevailing global market trends, which measure the direction of markets:
Global Equity Market Trend Data as of September 1, 2017
Market breadth deteriorated a bit in August in terms of the percentage of markets and stocks above their 50 day and 200 day moving averages, but given August and September are typically the worst performing months of the year for the global stock market, trend data is holding up well.
Longer-term trends remain in place with most stocks and markets above their 200 day moving average and over 90% of markets showing rising 200 day moving averages, conditions that have historically been associated with an advancing stock market.
Trend is a measure of the direction of markets while momentum data measures the rate at which markets change. Most momentum measures remain neutral to bullish.
Meanwhile, while U.S. investors remain quite bullish measures of global sentiment are more neutral, suggesting that markets have not hit an extreme in terms of investor frenzy.
One note of caution is the global stock market has now gone 314 days without a 5% correction, its longest stretch since 1996 where markets went over 325 days without declining 5%. The global stock market has not experienced a bear market decline of 20% or more since 2011.
World stock market volatility remains extremely low. Still, volatility regime shifts usually don’t occur until credit conditions and economic conditions deteriorate and there is no evidence of that at present.
As of early September 2017, global valuations, economic and central bank trends and market internals are all rated YELLOW and in neutral territory.
This suggests investors with a long-term time horizon should keep their portfolio allocations in line with their long-term targets.
The following tables provides a summary of market conditions by region.