With the S&P 500® reaching new all-time highs, we compared nine key market characteristics to the 2000 and 2007 market peaks — in both of those cases all nine were flashing red. Notably, today we only see one flashing a warning, and it is pretty weak. To be clear, we are not perennial optimists. A core belief of our investment process is that financial markets are complex, dynamic systems. We think it would be naïve to think all cycles are identical; however, broad characteristics tend to align at market peaks. We remain mindful of the advanced age of this business cycle and the slow-but-steady drumbeat of recession risks on the rise.
As the S&P 500 passes its September 2018 all-time high, we also look at market signals compared to that point in time.
Simply put, at 16.8 times (x), the forward price-to-earnings ratio (P/E) of the S&P 500 is not overly expensive, as the 30-year average is just 16.0x. Recall, we entered 2018 at 4-5 multiple points above this level, but the strength of earnings growth helped pull down valuation multiples as the year progressed — a healthy sort of multiple contraction. At the peak of the dot-com bubble in March 2000, the forward P/E was 23.8x. In 2007, when lower multiple sectors were the primary drivers of performance, the forward P/E peaked at 15.1x.
Heavy Equity Market Inflows
Public equity inflows in general are lower than in previous cycles. That may be due to rising assets under management in private investments. However, in spite of the strongest first-quarter performance on the S&P 500 in more than 20 years, we are still seeing larger net inflows into fixed income products. Typically, equity flows should be dominating with this kind of performance backdrop. This reinforces our view that investor sentiment remains pretty fickle. This is an “unloved” recovery and an unloved market bounce year to date. We don’t see any signs of “fear of missing out” from retail investors, in particular.
Vigorous Initial Public Offering (IPO) Activity
The dot-com bubble ushered in over 400 and 500 IPOs in 1999 and 2000, respectively. In 2007 that number had fallen to just 250, and last year only saw 186 IPOs. Some well-known companies such as Uber Technologies Inc., Airbnb, Inc., and Palantir Technologies are expected to go public later this year. However, first-quarter 2019 had the lowest IPO volume in three years, and that includes the $2.3 billion raised during the Lyft, Inc. IPO. It should be interesting to see if the pick-up in higher profile IPOs later this year will be enough to bring retail investors off the sidelines, given the general lack of risk appetite.
Rising Real Interest Rates
Rates have been lower for longer this business cycle, so it should not be a surprise that inflation-adjusted interest rates are well below the long-term average. Based on core Consumer Price Index, the real interest rate of the 10-year Treasury is not even 0.4%. At its peak in 2007, that number was 3.0%, and in early 2000 the real rate of the 10-year was as high as 4.75%. Interestingly, the inflation-adjusted 10-year had a negative yield for most of 2016.
Weakening Earnings Revisions
Revisions have obviously declined relative to 2018 estimates. However, we believe that was largely affected by the tax package; its significant impact helped drive 2018 revisions higher. Revisions for calendar-year 2019 have flattened over the last few months, and next-12-month EPS estimates have even reaccelerated.
Narrowing Market Breadth
Typically at market peaks, stocks struggle to make new highs. However, over 70% of the S&P 500 stocks are above their 200 day moving average — breadth has expanded significantly during the year-to-date rally. At its peak in 2007, more than 90% of the S&P 500 was above its 200-day moving average, only to see that fall to just 15% a year later. The dot-com bubble saw that number peak in mid-1999 at 80%, and by the March 2000 market high, that number had declined to less than 20%.
Defensive Stock Leadership
The rally to start the year has been driven by the usual suspects within the Information Technology sector, and mega-cap Internet-based companies. Furthermore, cyclical sectors such as Financials and Industrials have provided outsized returns relative to their weighting in the S&P 500. Consumer Staples, Health Care, and Utilities are still lagging behind. We just haven’t seen market leadership shift or rotate toward defensiveness yet.
Widening Credit Spreads
As risk aversion builds, one might expect that to show up in widening corporate bond spreads. However, the spread on both investment-grade and high-yield bonds continues to make new year-to-date lows. Spreads on investment-grade bonds reached more than 600 basis points (bps in) November 2008, compared with today’s spread of 109 bps over Treasuries. High-yield spreads have narrowed about 200 bps. If the bond market thought an economic slowdown was imminent, we’d likely see it show up here. But, so far, things appear to be very well contained.
Mergers & Acquisitions (M&A) Uptick
The only item on our list that we see as a warning sign is the sharp uptick we’ve seen in M&A. That being said, after the tax package provided new opportunities to allocate capital, we hoped it would lead to an uptick in net-new capital expenditures. However, it appears the shift has been to a new M&A cycle. We would point to the fact that not only has there been a general uptrend in M&A activity (in volume, and deal count) since 2016, but the average purchase premium has also been on the rise. In first-quarter 2019, the average premium was 27%; a year earlier, the average premium was 21%.
What about Relative to September 2018?
At the market’s all-time high in September of last year, the forward P/E was 16.8x —it would be hard to argue peak multiples, especially when we started 2018 at more than 20x forward P/E. There was no “blow off top” that we can really point to, as opposed to what occurred in 2000 and 2007. The equity flows story (or lack thereof) wasn’t any different than it is today. IPO and M&A activities were lackluster. Rates were rising, and market conditions were beginning to tighten rapidly, but that was more a function of Federal Reserve (Fed) policy actions than an inflation-driven scare. Breadth was narrower than it is today — recall, the market was still very much a Facebook, Amazon, Apple, Netflix, and Google (FAANG)-driven story. We didn’t see a sharp reversal in sector leadership until well past the September peak. Spreads were widening, particularly in the leveraged loan portion of the market; this turned out to be more a function of a liquidity drought (that is, lack of issuance) than a sign of real trouble.
The Fed “pause” has likely provided a welcome reprieve. BUT, Brexit is still in limbo, global trade negotiations remain delicate, and investor sentiment has proven to be volatile. Lest we forget, the U.S. election cycle is also already beginning to take shape. We continue to experience a complex backdrop characterized by numerous cross-currents, but we think there’s still some runway left.