With earnings season upon us, it is worth looking at how the equity market is interpreting today’s economic climate. While equity prices continue to hit record highs, the 10-year treasury rate, now trading at 2.70%, has yet to break the 3.46% 10-year average – or 4.80% if we ignore the past five years.
Aside from US Federal Reserve policy, the key question is are we in a bull market or bear market? Equity price rises paint a rosy picture. Conventional wisdom sees a positive correlation between trading volume and stock prices: in bull markets, it increases, during bear markets, it falls. Since the end of the recession in the US in April 2009, equity market indices have rocketed: the Dow Jones is up 105%, the S&P 500 117%, and NASDAQ 146%: some of the strongest increases since 1945.
Contrarily, single-stock trading volumes have drifted lower. This phenomenon is being cited by bears who believe the rally is fragile and about to reverse, to explain their short positions. Interestingly, in the past five years, trading volume has risen relatively on days when the market has fallen. One explanation for a fall in single-stock trading volume amidst rising stock prices may be the post-financial-crisis advent of the Dodd-Frank, Basel III, and Volcker regulations, which have forced banks to reduce the risk their proprietary trading desks hold, or increase capital allocated to these activities.
Not surprisingly, banks have reduced or disbanded these operations. Many hedge funds no longer trade single names or baskets; they are taking the same positions using options and other derivatives, resulting in lower volumes. This is confirmed by the fact that, over the same period, single-stock transaction trading volume has fallen, but options and futures volume has risen.
Nobody knows if the bull market in equities is sustainable, but it has certainly led to alarmingly rosy company valuations by equity analysts, given only slowish growth and high PE ratios of 25x, compared with a 15x historical average. The fragility is highlighted by a recent dip in equity prices due to weaker-than-expected earnings, risk to global growth due to a slowdown in China and dovish Federal Reserve minutes.
The best insight into how the Fed will affect share prices comes from former chairman Ben Bernanke. He once said: “First, news that current or future dividends will be higher should raise stock prices. Second, news that current or future real short-term interest rates will be higher should lower stock prices. And third, news that leads investors to demand a higher risk premium on stocks should lower stock prices. Unanticipated monetary policy changes affect stock prices mainly because they affect stocks’ risk premiums. A surprise tightening of policy raises risk premiums and lowers stock prices, and a surprise easing lowers the risk premium, raising stock prices.”
Ten-year US Treasuries are trading near the 2.667% five-year average, indicating fixed-income investors’ caution about the recovery. The March employment report showed gains of 192,000, plus a 37,000 rise for both January and February, confirming that this winter’s lacklustre economic reports were attributable to severe weather. Though unemployment was unchanged from February, at 6.7%, it is quite close to the Fed’s now abandoned 6.5% target threshold for raising interest rates.
The FOMC minutes reflected dovish sentiment, but the expectation for future rate hikes has increased. They revealed a median forecast of the Fed Funds rate for 2015 rising to 1%, then to 2.25% by the end of 2016. While raising the prospect of healthy rate hikes during 2015 and 2016, the FOMC is at pains to assert that this is only a forecast and, no doubt, will change once they decide what indices to use for forward guidance as a replacement for the unemployment rate.
While April’s minutes revealed that the tightening cycle will be slow due to the slack in the economy, if we see positive and strong economic growth in the next few months, reflected in lower unemployment and wage growth, the markets will be easily led to expect a steeper yield curve.
Joseph Lewis and Danny Fung work at financial risk and debt advisory firm JC Rathbone Associates