Equities

Earnings season is in full swing, and rock bottom expectations for most sectors will prove once again a low bar to surpass. Earnings ultimately matter for stock returns. As a reminder the SPX drubbing in March predicted a collapse in 2020 EPS below $110, and the subsequent 1000 point S&P 500 rebound since the lows signals a return to EPS trend near $162 in 2021. The top panel of the chart shows that this is more or less what the Street expects. Our updated four-factor macro model corroborates this V-shaped rebound in profit growth and should continue to underpin stocks on a cyclical time horizon (bottom panel). In the near-term however, we would be cautious and not chase stocks higher. The steeper the short-term rise in the SPX, the steeper the eventual snapback will be. The risks we are monitoring are the high concentration of returns in a handful of tech titans, the Fed’s balance sheet leveling off, a potential fiscal cliff, and a “blue wave” risk that is not at all priced into equities as we recently posited. Bottom Line: While our cyclically sanguine broad equity market view remains intact, we are cautious in the short-term prospects of the S&P 500, until the election uncertainty lifts in November.    

Highlights Chinese stocks are still in the “public participation phase” of a cyclical bull market and have not yet reached the “excess phase.” Economic fundamentals should provide support for more upside in Chinese stock prices in the next 6 to 12 months. Even if Chinese stocks evolve into a boom-bust cycle reminiscent of 2014-15, near-term technical price corrections should provide good buying opportunities. We remain overweight Chinese equities in both absolute and relative terms, and recommend investors increase their exposure to beaten-down cyclically-geared stocks, particularly in China’s domestic market.  Feature Chinese stocks rallied by 15% and 13% in the onshore and offshore markets, respectively, in the first 10 days of July. However, both markets gave up almost half of their gains in the third week of the month. The above-expectation Q2 GDP growth figure, which was released last Thursday, only exacerbated the market selloffs. This month’s rollercoaster ride in Chinese equities reminds investors of the boom-bust stock market cycle in 2014-2015, and raises the inevitable question: is it too late to buy or is it too early to sell Chinese stocks? We believe Chinese stocks are still at an early stage of a cyclical bull market.  While the recent near-vertical escalation in equity prices was clearly overdone, any near-term technical corrections will provide good buying opportunities. Three Phases Of A Bull Market Chinese bull markets typically last 2-2.5 years and involve three phases.1 The length and boundaries of each phase in a bull run are often blurred and are best identified in hindsight. However, this framework helps put the ongoing market rally in both A shares and investable stocks into perspective. In our view, the A share market is currently in the early stage of the “public participation phase”, whereas investable stocks seem to be halfway through (Chart 1A and 1B). Chart 1AA Shares In Early Stage Of The “Public Participation Phase (PPP)” Chart 1BChinese Investable Shares May Be Halfway Through PPP We think that the current bull market started in January 2019, following a bear market from 2016 to 2018. We upgraded Chinese stocks from neutral to cyclically overweight in April 2019, which was a couple of months into the “accumulation phase” of the bull market underway. The accumulation phase is the start of an uptrend, typically after a bear market, when smart money begins to buy stocks; fundamentals still look bleak and valuations are at exceptionally depressed levels. Chart 2China’s Economy Should Be On Track To A Cyclical Upturn The public participation phase typically exhibits a massive increase in trading volumes and explosive growth in new investor accounts. This phase begins when the market is already off the bottom and negative sentiment begins to wane on signs of economic improvement (Chart 2). As the bull trend is clearly established, technical and trend traders also begin to pile in, generating a self-feeding cycle. The market begins to feel overheated, making value investors uncomfortable, but valuations are not yet extreme (Chart 3). This phase tends to last longer than the other two stages in a bull market primary trend. The expansion of multiples remains the dominant driver for the broad market while earnings struggle (Chart 4). Chart 3Valuations In A Shares Are Not Too Extreme For investable shares, we believe that the bull market is probably more than halfway through the public participation phase (Chart 5). The market has decisively broken out of its key technical resistance and entered into expensive territory (Chart 6). Still, neither A-share nor investable markets seem to be in the “excess phase” as witnessed in 2015 (Table 1). Chart 4Market Returns Between Multiples And Earnings Growth: Chinese A Shares Chart 5Market Returns Between Multiples And Earnings Growth: Chinese Investable Shares Chart 6Valuations In Chinese Investable Shares Are Becoming Expensive, But Not Too Stretched Table 1Multiples In Chinese Stocks Are Not Yet In The “Excess Phase” China's short and volatile stock market history provides some classic examples of equity boom-bust cycles. The massive bull market in Chinese A shares between 2013 and 2016 fits the three phases perfectly: stock prices jumped by a whopping 93% in the three phases of the bull market between early 2013 and May 2015. The bull market eventually marched onto the excess phase in the first half of 2015 and reached the ultimate top in May 2015 with a trailing P/E of 25 and price-to-book of over 3. Bottom Line: Both the A-share and investable bourses still have room for upside in the ongoing bull market. Remain overweight on both investable and domestic shares, but domestic stocks have more latitude for rally as China’s economy and earnings continue to recover. Pullbacks Not Enough To Turn Bearish On July 1 we upgraded our tactical (0 to 3 months) call on Chinese stocks and initiated long Chinese domestic and investable stock trades relative to global benchmarks. While it is impossible to predict whether the current market will supercharge into a boom-bust cycle as seen in 2014-15, we intend to keep the trades given our conviction that cyclically there is still upside to Chinese stock prices. To turn cyclically bearish on Chinese shares, the following conditions need to develop: First, the broad market should reach an overvalued extreme, at which point gravity would set in. Some sectors and small-cap names, particularly in the ChiNext board, are currently stretched (Chart 7).  However, overall market valuations still appear reasonable, based on our composite valuation indicator. Historically, major peaks in the market occurred when the valuation indicator reached much higher levels. Further, cyclically-adjusted equity risk premiums (ERPs) in both Chinese onshore and offshore stocks are materially higher than their historical means (Chart 8). This suggests investors have already priced in extremely high uncertainties surrounding the Chinese economy. Perhaps overdone, in our view. As China's economy continues to recover, their ERPs should shrink, pushing stock prices higher. Chart 7A Structural Bull Run In Chinese Tech Stocks Chart 8Equity Risk Premium In Chinese Stocks Are Extremely High And Will Likely Shrink, Pushing Stock Prices Higher   Secondly, liquidity should tighten. An important liquidity source is margin lending, which has gone up exponentially since late June and invited regulatory attention (Chart 9). Instead of waiting for overleverage in the market to form a momentum like in the 2014 cycle, Chinese regulators seem to be more vigilant and restrictive this time. By acting early and removing some steam from recent market velocity, a healthier secular bull market can develop.   China’s overall monetary conditions are another important source of liquidity. If the policy stance turns from easing to tightening before the economy fully recovers, then it will lead to a compression in multiples in the equity market before stock prices can gain support from an earnings recovery. Historically, Chinese authorities tend to maintain an easing stance for at least three quarters following a nadir in the economy (Chart 10). The track record of Chinese policymakers suggests that the PBoC will likely keep monetary policy accommodative through the end of this year. Chart 9Chinese Authorities Have Been Cracking Down On Overleverage Early In This Bull Run Chart 10Easy Policy Should Sustain Through End Of 2020 Finally, the economy should weaken significantly, which would elevate the equity risk premium and threaten the earnings outlook. A second wave of COVID-19 would have to be severe enough to substantially impact China’s economic recovery, however, the pandemic situation in China seems to be contained and earnings recovery is on course (Chart 11, 12A, 12B, and 12C). Additionally, a major pandemic-triggered shock would only force Chinese authorities to up their ante on reflation and revive domestic demand, which could benefit stocks. Chart 11COVID-19 Virus Spread Has Been Largely Contained Within China Chart 12AA Share Prices Are Not Too Far Ahead Of Earnings Recovery Bottom Line: Chinese equities will likely experience technical corrections in the near term, but the downside risks are not enough to turn bearish.   Chart 12BChinese Investable Stock Prices Seem A Bit Ahead Of Its Own Historical Performance… Chart 12C…But Still Not Too Expensive Compared With Global Benchmarks Investment Conclusions Regardless of the direction of Chinese stocks in absolute terms, we recommend investors overweight equities within a global equity portfolio (Chart 13). Investors should also tilt their exposure to battered cyclicals, particularly in China’s domestic stock market (Chart 14). We favor consumer discretionary, materials and industrials in the next 6 to 12 months. Chart 13We Remain Overweight On Chinese Stocks Chart 14Cyclical Stocks Are Likely To Prevail Over Defensives Chinese equity prices have run ahead of economic fundamentals and setbacks will be likely in the near term. Still, these setbacks are buying opportunities and we recommend buying on the dip if Chinese equities, in either onshore or offshore markets, were to fall by 5% to 10% from current levels. However, consecutive selloffs accumulating to a 15% or greater fall in Chinese stock prices within a short period of time (e.g. 2 to 3 weeks) would prompt us to close our long Chinese equity trades. Historically, when the prices of Chinese equities fell by such a magnitude, the selloffs tended to trigger panic among China’s massive retail investors and, in turn, form a self-reinforcing downward spiral and push Chinese stocks into a prolonged bear market (Chart 15). Chart 15Oversized Selloffs Historically Tend To Push Chinese Stocks Into Prolonged Bear Markets   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Three Phases Of A Bull Market," dated April 22, 2015, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Two Friday’s ago we highlighted that the tech sector’s (plus FANG: FB, AMZN, NFLX & GOOGL) market cap weight in the SPX was high and rising to uncharted territory near 40%, and such narrowing breadth was a clear risk to the market rally. Today we compare the five tech titans’ market cap weight in the SPX with five GICS1 cyclical sectors (industrials, energy, materials, financials and real estate). The results are staggering: five tech stocks are worth as much as 224 deep and early cyclical stocks in the S&P 500 (top panel). Such high concentration is worrisome and represents a near-term risk to the equity market recovery run. While the drubbing in the 10-year US treasury yield is propelling the tech titans’ forward multiple to the stratosphere (bottom panel), we fear that gravity will sooner-rather-than-later push these stocks back down to earth. NFLX recent earnings fired a warning shot that uncharacteristically high expectations are being built into tech stocks, making them vulnerable to sizable pullbacks. Bottom Line: We remain cautious on the short-term prospects of the S&P 500, until the election uncertainty lifts in November.   ​​​​​​​

The drubbing in the US/EMU sovereign bond spread is cause for concern for the SPX’s slingshot recovery off the March 23 lows, especially given the tight positive correlation of these two series over the past three decades (top panel). Typically, higher relative yields attract capital to US shores and vice versa, and some of that capital inevitably leaks into US stocks. Moreover, theory would suggest that relative yields move with the ebb and flow of relative return on capital. Indeed, the bottom panel of the chart highlights such an empirical relationship. Currently, euro area return on assets is narrowing the gap with the US which usually happens in recessions. The persistent unresponsiveness in the 10-year UST yield near the zero line which stands closer to the ECB’s NIRP, likely spells short-term trouble for the SPX. Bottom Line: We remain cautious on the near-term prospects of the S&P 500 until the election uncertainty lifts in November.