Via Zero Hedge:
What’s driving the equity rally?
According to Deutsche Bank, despite the confusion, the rally has been in line with what the bank’s demand-supply framework has predicted: large sustained buybacks and rising systematic strategies positioning have offset fund outflows, even as risks are rising on the horizon.
Here is Thatte’s explanation:
Our simple framework combining, on the demand side, inflows into equities (mutual funds and ETFs) and changes in positioning with, on the supply side, new issuance and buybacks, has historically explained quarterly returns for the S&P 500 quite well, and the rally has not been out of line with our estimate of the demand-supply balance.
The first component of the stock “demand” equation – buybacks – has been extensively discussed for much of the past decade on this website and elsewhere, and has now become a controversial political point; more importantly, Thatte asserts that buybacks are likely to sustain at elevated levels outside of a large decline in earnings. Furthermore, as regular readers know very well, from a demand-supply perspective, buybacks have been the most important driver of S&P 500 price increases during this cycle.
They have been running at over $200bn a quarter (gross) over the last year. While announcements remain noisy, they do not suggest a slowing yet. The level of corporate earnings is the primary driver of buybacks. Earnings have been flat this year and are on track to be down slightly in Q2. But absent a large decline, companies are likely to maintain the pace of buybacks, as they did in the previous earnings slowdowns in 2011-2012 and 2015-2016. And while concerns around leverage continue to fester, it is worth recalling that for now at least, the bulk of buybacks are carried out by companies with very low, not high, leverage, especially the tech sector most recently.
At the same time, after record months of outflows since December, equities have seen modest inflows since June but weak growth and data remain a risk, according to DB. After outflows of over $240bn since December, equity funds have seen a respite over the last 5 weeks with modest inflows (average $1bn per week). Still, the inflows have been primarily into US and Japanese funds, while Europe and EM continue to bleed. The recent inflows have occurred despite weakening data surprises and remain vulnerable to a continued growth slowdown
Third on the list of key technical factors, investor positioning remains elevated, especially for systematic strategies. Equity futures long positions, combining asset managers and leveraged funds, are at the top of their historical range while other near-term indicators like the put/call volume ratio also point to bullish equity positioning. Meanwhile, across systematic strategies, exposures are very elevated across the board, and risk remains asymmetric to the downside.
Vol control is already at max equity allocations and have little room to buy even if vol were to decline further while they would quickly turn to selling equities if vol spikes.
CTAs and risk parity funds have continued to add to equity allocations which are high but not as much as in early 2018.
Recent negative correlation between bonds and equities has aided in the low volatility of cross asset portfolio.
Given that these managers are relatively slow moving, markets would need a sustained vol event for significant de-allocations. Net beta for long-short equity funds, however, remains very low, while retail positioning indicators also remain subdued.
Finally, according to the latest CFTC breakdown of spec accounts, net positioning in US equity futures fell for the second week but remains near the top of its historical range. Positioning across most US indices fell except for the NASDAQ which saw long positioning inch higher and Russell 2000 which saw short positioning fall slightly.
Finally, as JPMorgan summarizes, “as the Q2 reporting season begins, corporate profits growth and Equity/Credit performance versus Bonds have come to an important crossroads. Multi-asset investors and many other readers know the following:
- US earnings growth and margins peaked in late 2018 and have been slowing since, in line with the deceleration in global activity
- consensus expectations anticipate Q2 EPS growth of -2% year-on-year, which would mark the first such contraction since the 2015-16 earnings recessions that persisted for four quarters;
- the balance of earnings pre-announcements has been the most negative since that 2015-16 earnings recession (70% negative, 19% positive, so -51% net); but
- Investor positioning is mixed, with Equity Long/Short hedge funds holding well below-average exposure but Macro, Systematic and Risk Parity funds holding above-average exposure. ETF flows mirror the conservatism of Long/Short funds, with net purchases favoring Defensives over Cyclicals this year.
And yet, even as equity Long/Short funds hold below-average exposure to stocks but Macro, Systematic and Risk Parity funds hold above-average longs.
In other words, the one catalyst that will push stocks higher this earnings season will be earnings “wall of worry”, with consensus now expecting a -2% drop, while the final print, somewhere just around +1 to +2% (all on a non-GAAP, adjusted basis) will be sufficient to send the S&P to 3,200 or so… just as the Fed cuts rates by as much as 50bps at the end of the month.
So long as the yield curve flattens then the rally can continue. Ironically, it is any kind of economic recovery that will threaten it if inflation fears return. That said, Damien Boey at Credit Suisse sees more a possibility of curve steepening resulting in sector rotation:
On Friday night, we witnessed a long overdue bounce in value factor performance in the US time-zone. As argued in our previous articles, the correlations suggest that value should work well (poorly) when the slope of the US yield curve steepens (flattens), while lower (higher) interest rates support (undermine) quality. But in early July, value has consistently underperformed, despite meaningful curve steepening, and a sell-off in long duration bonds. Our thesis has been that historical relationships should re-assert themselves, and that value factor performance should catch up to the rising slope of the yield curve.
But there is more. It is not just that we are increasingly positive on value as the yield curve steepens. We are also negative on momentum because global uncertainty has been very high of late, undermining confidence that yesterday’s trends will continue tomorrow. Momentum and value are natural opposites, but not complete opposites. The combination of a long value position, with a short momentum position is almost like a very long position on value.
Quality remains in vogue, reflecting the inversion of the US yield curve, and the catching down of activity growth to bond market expectations. However, the style is becoming very fully priced, and our screens suggest that even if we care much less about value than quality, if value matters at all, a number of familiar quality names are shorts. This is because multiple dispersion within the market has blown out to quite extreme levels. To be sure, some might argue that the multiple dispersion argument was present throughout the past few years, but value has consistently underperformed quality, suggesting that multiple dispersion is not a reliable leading indicator of performance. We have a lot of sympathy for this point of view. In a multi-factor process, where momentum, value and quality are all present to varying extents, bottom-up multiple dispersion adds no new information, because value is already priced in the process. To really time value, we need to go one level up to asset allocation land from stock picking land, to obtain new signals and new insight. With this in mind, the new information now, compared with previous years, is that value has started to work in the multi-asset space, outside of equities. And our backtesting suggest that the outperformance of value “ex-equities” should start to carry over to value within equities.
What is surprising about this finding? Historically, value has tended to fail when there is de-leveraging risk in the system. And de-leveraging risk is highest when there are many asset price bubbles present, waiting to be pricked by overly zealous central bankers. But at the turn of the year, asset price bubbles became bigger from already stretched valuation starting points – yet volatility fell, because central bankers decided to embrace easier, rather than tighter policy settings. It is the decoupling of “val” from “vol” which is very interesting, and has led to our more constructive view of value of late, despite the many bubbles that are out there.
One day’s worth of data does not make a trend. We are still waiting for confirmation of re-coupling between value factor performance and the steepening yield curve, let alone further curve steepening. But taking a slightly longer view, we note that value has stopped underperforming as aggressively as it was earlier in the year, and in recent years. The bottoming out process seems to have started at the end of May. As for momentum, factor performance became a whole lot more volatile over the same time frame.
I remain concerned that the trade war is going to get worse before it gets better leading to further curve inversion and, eventually, stocks falling anyway.