According to the recent BAML Fund Manager Survey, investors are holding more cash and have reduced equity holdings compared to last month. The proportion of asset allocators overweight equities has fallen to a net 37% from a net 45% last month.
Currently, the most overweight equities are European and/or technology-based. The most underweight assets are emerging market equities. Fund managers see two major risks to market stability, 36% say a geopolitical crisis is the greatest threat while slightly less believe Chinese debt defaults pose the largest risk.
The question is, are we on the verge of a multi-year 1980’s-style boom, driven by latent demand and rising wages and employment or is the economy just treading water? Sales growth over the last three years has been about 2% per annum in the US and UK, and that trend is not forecast to change. Inflation has continued to be positive but subdued over the last year, and market watchers are increasingly anxious of any change that could lead to a stagflationary, or even deflationary, economic environment.
Catalysts to the downside appear to overshadow catalysts to the upside.
The S&P500 price/sales multiple has now exceeded levels set in 2007. The rate of expansion of the multiple in the last year has been significantly greater than that experienced over the 2004 to 2006 period, and has followed a period of considerable expansion that started mid-2011. From a valuation perspective, the S&P 500 appears stretched. Further expansion of the multiple is therefore unlikely to be a tailwind for equity prices.
Q4 2013 and Q1 2014 GDP growth in the US was an annualised 2.6% and 0.1%, respectively. Q4 2013 and Q1 2014 GDP growth in the UK was an annualised 0.7% and 0.8%, respectively. Current growth is lower than in prior periods of economic expansion. Therefore a return to 1980s or 1990s style growth may be an overly bullish sentiment.
Earlier in May, investors again fled to government bonds amid growing fears of stagflation. An ECB survey of economists jolted financial markets as they cut their inflation outlook in the eurozone region. Despite ECB comments stating that they are open to a Fed-style quantitative easing programme, markets were not quelled.
Seasonality presents a compelling argument for downside in the US markets over the coming months. Over the past decade in the US, there has been a sizable drop in equities during the May to July period in every year except one. The sole exception came after the S&P 500 had already dropped circa 8% coming into May. This May the S&P 500 started at a high.
Even if a destabilising world event does not materialise, an equity market correction could still occur. Fund managers have been decreasing their allocation to risky assets, and the summer months have typically seen declines (“sell in May and go away”). A correction would washout excesses in sentiment and valuation. If we also consider current economic growth prospects and the S&P 500 price/sales multiple, equity returns from the year-to-date highs do not look imminent.
David Mitchell is head of valuations and Shailen Taylor is manager, valuations, at BDO
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