Equity investors should extend their holidays

It's always nice to come back from holiday to realise that markets haven't done much in your absence. Economic data in my neck of the woods have been mostly uninteresting. Q2 GDP growth in German was a tad higher than expected, and French unemployment declined to a four-year low in the second quarter. This is encouraging for certain, but these data merely confirm that the cyclical recovery in the Eurozone is alive and well, consistent with virtually unchanged survey data in recent months. In markets, global equity indices have either continued to slowly melt higher or traded sideways in the past two weeks, and U.S. 10-year yields have been locked in a tight range around 1.5%-to-1.6%. In fairness to other markets, I should note that the spot dollar index has declined 2.5%, and that the the oil price has staged a convincing rally. But overall, we have seen no major break-outs in the key asset classes. 

I fear the calm will end soon, however, at least in equities, which is where your humble scribe is mainly exposed. One of the first sets of charts I look at after being away is my equity valuation scores. They rarely fail me, and are currently sending an ominous tactical message for global equities. 

Brace for a decline in global equities?

The first part of the bad news is simply that the MSCI World index already has re-rated significantly following its plunge in the first quarter. The index is up about 20% from its lows in February, and the smoothed six-month trailing return, shown in the chart above, has surged accordingly. History shows that it can move higher, but mean-reversion alone points to a more challenging Q3 and Q4 for equity investors. The second part of the bearish argument is that the valuation score has rolled over. Put briefly, the model assumes that trailing returns mean-revert in accordance with deviations in valuation metrics from their long-run median. In layman terms, it currently implies that trailing 12-month price-to-earnings and price-to-sales ratios of 22.4 and 1.5 are too demanding to keep returns supported. Other anecdotal evidence is sending the same message. The VIX and the put-call ratio on the U.S. S&P 500 have collapsed, and investors face the daunting prospect of tighter monetary conditions in the U.S. 

To drive home the message, the next chart shows static valuation scores for all the main global equity indices. In a pinch, Eurozone equities are probably at fair value, and could see more multiple expansion in the short run. The remaining global equity markets, though, are expensive. We greatly sympathise with multi-asset allocators' plight in a world where bond yields are at ridiculously low levels. Compared with bonds, anything looks cheap. Compared with their own historical fundamentals, though, equities quite simply aren't that attractive here. 

Will the last value investor please turn off the light?

Before you file this post in your folder devoted to perma-bear views, though, I should point out that I am not trying to gain entry into Hussman's and ZH's inner circles. That would require me to predict the S&P 500 to tag 666 during the next sell-off, which is silly. Searching for the end of the world is futile; it will find me in the end. I am sure of it.  In addition, the bulls also do have some indicators to hang their hats on. In particular, the divergence between surging global real narrow money growth and still-poor trailing year-over-year returns suggest that risks to stock markets are tilted to the upside. 

Can investors look to monetarism for hope of higher global equity prices?

Two aspects of this framework, though, point to caution. Firstly, the increase in global M1 growth almost exclusively is driven by China, while momentum in the U.S. and the Eurozone has rolled over. This implies that investors relying on M1 growth to inform their equity allocation should be betting on further upside in global equities in EM/Chinese markets. 

China is driving growth in global M1 growth, overweight EM?

Secondly, even if the MSCI World moves sideways in the coming months, year-over-year returns will rebound due to base effects from the sell-off in Q3 last year. This primarily suggests the bar for a further short-term rise is high, but it also indicates that last year's swoon has changed the seasonality of the market. Last year, equities wobbled in late August and September, and rebounded into November. The market then defied hopes of a Santa rally by declining almost uninterruptedly into the first week of February, a sell-off which culminated in fears of a global recession and a new financial crisis. Relying on seasonality is not enough to suggest a repeat of this sequence. But it adds to the evidence that equity investors would do well to extend their stay in the hammock.