- Valuation is a necessary starting point of any drawdown risk analysis. At 16.7x the forward P/E multiple of the S&P 500 index ranks in the 86th percentile relative to the last 40 years. Most other metrics paint a similar picture of extended valuation. The median stock in the index trades at the 99th percentile of historical valuation on most metrics. The most likely future path of US equities involves a lower valuation.
- Supply and demand trends also suggest downside risk. During the first quarter, the lack of investor positioning in domestic equities was the most bullish argument for a share price rally. Even as the S&P 500 index rebounded from its February 11 low, institutional and hedge fund US equity futures positions remained net short and our Sentiment Indicator hovered near 10 (out of 100, see page 5). A low sentiment reading represents a bullish trading signal for the subsequent 4-6 weeks. Sentiment has shifted sharply during the past few weeks. Since the end of March, investors have bought $23 billion worth of futures positions, lifting our Sentiment Indicator to 32, a less bullish level compared with mid-winter.
- Corporate buybacks represent the single largest source of equity demand but may wane during coming months. Most firms completed 1Q earnings season by early May and have now resumed their discretionary buybacks, providing near-term support for the market. The month of May typically witnesses 10% of annual repurchase spending. However, spending normally decelerates in June and again in July, when just 7% of buybacks occurs as companies enter a blackout window ahead of 2Q earnings reports.
- The fed funds futures market currently implies an 83% probability of zero (41%) or one (42%) rate hike in 2016. Our economists expect two hikes this year. The two upcoming FOMC meetings (June 14-15 and July 26-27) and the July Humphrey-Hawkins testimony to the House and Senate will offer opportunities for Chair Yellen to guide the market in the direction of the FOMC central tendency, which also anticipates two hikes in 2016. Put differently, given current futures market pricing we believe more likelihood exists for an incremental hawkish surprise than a dovish surprise.
- Now-dormant economic growth concerns could awaken at any time and provide a catalyst for a sell-off. Official “total social financing” data shows China credit growth surged by $1 trillion in 1Q but acceleration in credit creation is needed to prevent a slowdown in activity by 3Q (see Asia Economics Analyst, May 3, 2016). Decelerating growth in China would cause investors to re-focus on the prospect of a US recession, a topic that has receded from client conversations after dominating discussions in 1Q. Our US-MAP index of economic data surprises has slipped back into negative territory and reinforces the risk of a slowdown (see page 20). The UK “Brexit” referendum on June 23 represents another imported economic risk.
- The US presidential election is now part of every client conversation. The closeness of the race appears to be underpriced by the market given polls in prior presidential elections tightened as voting day approached. History shows that during a typical presidential election year, the S&P 500 index remains relatively range-bound until November (see Exhibit 4). But thus far 2016 has hardly followed a regular election playbook. The upcoming party conventions (Republicans on July 18-21 and Democrats on July 25-28) will almost assuredly raise political uncertainty and weigh on equity valuations.
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Then, overnight, one of the few remaining optimists on the market, BofA’s equity and quant strategist Savita Subramanian joined the “fiction peddling” dark side when she released an uncharacteristically bearish report titled “Put your shorts on…it’s summertime”, in which she lays out not just six but nine “reasons to worry” about a summer slump.
As she admits, “an increasing number of trends worry us as we head into summer. Of additional concern, May-October has historically been the seasonally weakest six-month period of the year. Why are we worried?”
Her answer: the following big picture concerns:
Warnings from fundamental, behavioral and credit signals
An increasing number of charts in our work depict levels that are only prior to a bear market. The distress ratio is at levels that led the last two bear markets. Corporate buybacks, in aggregate, tend to top-tick the market, and the proportion of companies buying back shares is near all-time highs, at the same levels as the ‘07 peak. And the number of companies for which analysts forecast losses is at levels never seen without a bear market.
Fed tightening into a profits recession doesn’t end well
The Fed is in tightening mode despite a recession in corporate profits. Since 1971, the Fed has begun tightening during a bona fide profits recession only three other times – 1976, 1983, and 1986; two out of those three instances saw stocks drop over the next twelve months. The S&P is just 1% off its 12/16/15 level when the Fed initially hiked.
Capital markets are tightening
Even if the Fed stays on hold, other markets are tightening: equity IPOs year-to-date are near an all-time low (Chart 4), and Commercial & Industrial (C&I) lending standards have tightened for the last three quarters.
Get ready for the second leg down in the oil price “W”
Our house forecast for a W-shaped recovery in oil prices suggests seasonal weakness in 3Q with WTI falling over 15% before it recovers in the fourth quarter. The S&P has moved in lockstep with WTI, suggesting near-term downside (Chart 8).
Politics at home….
The EU referendum is coming. Our UK team expects the UK to remain in the Eurozone, but uncertainty could roil the markets as June approaches (while the odds and many polls are in favor of “remain”, some are close to 50/50). Under our UK team’s risk scenarios, UK and European equities could see a 15% drop if the UK leaves, which on a beta-adjusted basis spells a 10%-ish pullback for the S&P 500.
And here is the full list of nine explicit reasons why BofA is now selling rapidly in May and staying far, far away.
1) Stress in the HY market
The high yield distress ratio—though it declined last month—is at levels well above those seen at prior market peaks and is a hair’s breadth from levels not seen without bear markets.
2) Buybacks are at levels last seen at the prior market peak
Corporates have been propping up EPS growth via a near-record proportion of buybacks. 65% of companies in the S&P 500 have taken out share count vs. the previous year, the highest since when the market peaked in late 2007.
3) Tick-up in expected negative profits
Similarly, the proportion of S&P 500 companies with negative expected (forward 12-month) EPS is at its highest levels since late 2009.
While the majority of companies with negative expected EPS are concentrated in Energy, spikes in this indicator to current levels have historically led to a similar pick-up six months later in companies reporting negative actual EPS.
4) Risks around Fed tightening
The Fed has only embarked on a tightening cycle during a profits recession three other times, which typically spelled downside for the S&P 500.
Currently, the implied probability of a June hike is 4% vs. 17% in July, 34% in September, 37% in November and 53% in December. Our economists forecast the Fed will hike in September, though they have said that this summer is not off the table.
5) Weak capital markets backdrop
Just 12 IPOs have occurred year-to-date (through 4/30), the lowest since 2009. And IPO proceeds (as a percentage of S&P 500 market cap) to date are below ’09 levels, and the lowest we’ve seen since ’03.
6) Tightening lending standards
According to Senior Loan Officer Opinion Survey data, banks have reported tightening lending standards for three consecutive quarters—the last time we saw this happen was in late 2007/early 2008.
7) Seasonal weakness in oil
While the market has risen along with the rebound in oil prices so far this year, our commodity strategists expect a W-shaped recovery in oil due to seasonal weakness.
They forecast WTI will fall to $39/bbl in 3Q16 before recovering to $54/bbl by year-end. If the S&P 500 remains correlated with oil prices, this could suggest near-term risk to equities.
8) Uncertainty around the US election
By February of this year, US policy uncertainty had increased to its highest levels since the 2013 US government shutdown (Chart 7).
While uncertainty has come down since then (in tandem with the narrowing of the presidential candidate field), we expect uncertainty will pick up again closer to the election, as it typically has in prior election years (Chart 8). This is likely to result in higher volatility, particularly from September- November, before subsiding post-election.
9) Risks around the EU Referendum
On June 23, a majority vote will decide whether the UK leaves or stays in the EU—an event around which we could see heightened market volatility.
Polls are generally in favor of “stay”: the Financial Times’ “Brexit poll tracker” (which summarizes opinion polls) suggests a 46%/43% Stay/Leave split; WhatUKThinks.org—run by Britain’s leading independent social research agency—suggests 50%/50% based on opinion polls; and the odds (according to oddschecker.com) suggest 70%/30% in favor of “stay”.
Our UK economists and strategists’ base case is for the UK to remain in the Eurozone, but have outlined possible risk scenarios and implications. They expect UK and European equities would see a 15% sell-off if the UK leaves, which we expect could translate into a 10%-15% (low teens) pullback for US equities.