Is it QE or is it earnings?
With the Dow starting off the final quarter with a bang, surging to new all time highs alongside the S&P, few care what is prompting the latest surge in risk assets, which is a problem because as One River CIO Eric Peters noted yesterday, we have gotten to the point where measures of market performance have mutated into trading vehicles (and price targets) - such as the VIX, which drifted lower after an early spike today that appeared to briefly break the Nasdaq, and launch today's buying spree. And with everyone selling vol, the implication is that there is nothing to be worried about, even if the actual indicator of implied vol is no longer relevant as it itself has become the most actively traded product by retail and institutional investors alike (hardly surprising to anyone who has read Soros' 10+ year old ruminations on market reflexivity).
Whatever the reason though, stocks continue to levitate and not just in the US, but across the world, with SocGen's Andrew Lapthorne reporting that the MSCI World index surpassed 2000 for the first time and in turn has delivered its eleventh successive month of positive total returns. This ranks as the second longest period of consecutive gains for MSCI World since its formation in 1969, with realised volatility collapsing as a consequence.
Echoing his SocGen colleague, Arthur van Slooten, who last week said that selling vol here is like "dancing on the rim of a volcano. If there is a sudden eruption (of volatility) you get badly burned", Lapthrone says that "such a long period of gains, coupled with exceptionally low volatility, inevitably builds up risk in the financial system; low volatility is simply high price confidence and when confidence in asset prices is high, investors do risky things."
We are not there quite yet (although according to BofA's Michael Hartnett we will be soon), and instead Lapthorne does what all investors should do, and ask whether these fresh records are deserved, i.e. due to rising profits, or due to liquidity injections. As he says, "the bulls will claim that this latest rise in equity markets has been supported by resurgent profits, and they would not be wrong. MSCI reported profits rose by 20% over those 11 months and the actual reported P/E has fallen a shade."
There, is however, a big but: "EPS levels are merely back to where they stood in November 2014, when MSCI was 15% lower, and overall profits have yet to exceed 2008 levels when the index was a third lower." Which, as the strategist explains, means that essentially "QE sustained equities levels in anticipation of a profit recovery, but rather than de-rating as those earnings came through,
markets are simply being propelled to ever higher levels." And while stocks are in a bubble, it was "created during the 2011-15 era when global profits went nowhere, yet equities rose 30%", something Goldman Sachs pointed out over a year ago.
Finally, Lapthrone looks at the small cap, US-focused Russell 2000 index, and writes that the acceleration in equity markets that started around 18 August has seen several previously weak areas rebound strongly. Of course, this is not the first time we have seen just this kind of move, the last time being right after the Trump election, only for the entire euphoria to fade soon after when it emerged that the Trump tax plan was just a pipe dream. Will this time be different? Here is Lapthorne's answer:
The Russell 2000 in particular has been bolstered by renewed Trump ‘Tax Talk’, and the stocks of those companies with the weakest balance sheets (which we think will be in the eye of the storm in the next downturn) rallied strongly, gaining 20% from their mid-August lows. Short investors in the Russell 2000 have already been burned by Trump’s election, so it remains to be seen if the latest reversal of short positions in the ‘bad balance’ sheet segment is simply profit-taking until tax plans are digested or a genuine fundamental reappraisal of US small cap balance sheet risk. For the timing being we are inclined to think it is the former.