After climbing nearly 30% in 2013, the S&P 500 (SPY) was due for a correction. This was the opinion of most market participants in early 2014, and many trendspotting investors were placing heavy bets on that correction happening. While some hedge funds attracted headlines for buying thousands of puts on SPY at the end of 2013, other asset managers took to financial media outlets to say that valuations remained fair, moderate, and that underpriced stocks remained available, albeit harder to find than a year ago.
Early 2014’s harsh winter combined with the need for a correction, and stocks fell at the end of January as a result. Add in the threat of geopolitical unrest, signs of manufacturing slowdown in China, and currency woes in the developing world, and there was plenty of reason to withdraw money from the market.
The mini-correction of the beginning of the year did not last long, however. February ended very up, and after a flat end to 1Q and beginning to 2Q, stocks began to rally in May. In June, the stock market resembled all of 2013, ending an annualized 26% up excluding dividends.
The rally has depended on two trends: stock buybacks to push up earnings and macroeconomic indicators that justify confidence in overall GDP expansion in the U.S. (Foreign markets, for the most part, remain secondary in many investors’ minds.)
On the buyback front, this development has pushed down P/E ratios while P/S ratios rise. The psychologically important barrier of a 20 P/E ratio for the S&P 500 has loomed for months, but it has not come, because companies keep buying back stock to raise earnings and thus lower the overall P/E ratio. Looking at the monthly P/E ratio of the index, we see that the actual P/E ratio has fallen below 19 throughout 2014 until June, although in early 2014 the estimated forward P/E ratio for SPY was around 19.6. That was revised downwards over 100 basis points, meaning stocks in January were cheaper than they were in May 2013.
At the same time, the P/S ratio has kept climbing. After falling in the last quarter of 2012, this metric has risen steadily for nearly two years, and is slated to continue to rise to its highest level since 2000. In other words, buying sales has gotten more expensive even as buying earnings has gotten cheaper.
This points to more financial engineering behind the bull run in assets than actual growth in aggregate demand. Macroeconomic investors may debate what this signals, but they will agree that a bullish call on stocks must depend on an understanding of money supply, access to credit, and the Federal Reserve’s moves on interest rates than it depends on fundamental growth of revenues from greater demand for products.
This insight means that analysts will need to be more macroeconomically inclined than they have been in the past, particularly when it comes to hedging a long/short book. In the past, short positions were a great way to hedge against an overall market decline, but long/short funds have massively underperformed the market in the past few years, while long-only funds are laughing all the way to the bank.
Additionally, macroeconomic expectations amongst macro fund investors have needed to be revisited, because the old world assumptions about aggregate demand, the impact of the bond market on asset demand, and company valuations do not apply to this new world. A few funds have caught on to this and, for instance, aggressively bought bonds in early 2014 when many investors were expecting the taper to cause rates to rise. They outperformed those who rotated out of bonds and went heavy on stocks.
Going forward, a deeper understanding of how changes to the money supply and bond rates will impact stocks will provide a stronger return than a mere fundamental analysis of a company’s revenue stream and market expansion potential. This means financiers will need to become part-time economists, and they will need to read more than ever before.