Citywire printed articles sponsored by:
View the rest of this gallery online at http://citywire.co.uk/wealth-manager/gallery/a699078
In Graphs: why reality is beginning to break US equity prices
by David Campbell on Aug 23, 2013 at 09:30
Any resumption in the US equity rally will have to overcome a severe handicap
The last week has been torrid for US equity investors, but by a lot of metrics the correction was pretty well flagged.
The Smart Money Flow index above, which subtracts the final hour’s gain from the opening hour of each day (on the basis that trading at the start of the day is more emotional and reactive than the closing) showed the S&P 500 off almost 3% since April, only beginning to close the gap since the main index began to fall from its record high.
Investors have appeared determined to ignore a lacklustre earnings season, ambitious valuations and an imminent slowing in monetary easing. But there are signs that they are now beginning to wake up.
For instance, it has taken the correction to pull trade volumes back to anything approaching a historical average for August. Even as the DJI broached 15,600, momentum was being sustained by half the number of shares actually changing hands compared to the 10-year average. All the additional liquidity which has come back into the market since then has been behind the downward pressure.
So what has been the catalyst?
While the fundamental trajectory of the US economy appears (moderately) upward, equity prices appear to have run hard ahead of them. Some of the more cyclically sensitive subsectors beloved of technical analysts – such as the DJ Transports – appear to have rolled over.
Adopting one of the most simple and straightforward tools of the technical analyst, the DJ Transport index has broken below what appears to be a support line
There is an element of relative valuation. Comparators such as the DAX and FTSE 100 failed to rally above their May highs before falling again. This is in itself a moderately bearish indicator, but given the relative solidity of the DAX 30 suggests the tidal wave which has flowed into the US in recent months, at points approaching 80% of total global equity flows, is becoming more discriminating.
This is supported by the latest passive fund flow data showing that investor appetite for relative European value was overcoming residual risk aversion.
More fundamental however is the removal of some of the yield bid from the market. Having spent the best part of two years well below the S&P yield, the recent dramatic fall in US benchmark 10-year treasuries now means they are yielding almost 30% above it.
The rapid movement in the ‘risk-free’ rate means a substantial increase in the discount measured against future equity earnings – earnings that were already being priced to a sharp premium to the historical average.
This can be most dramatically demonstrated by the S&P High Yield Dividend Aristocrats index, which has borne the brunt of the sell-off, having previously led the main index. The yield premium lifted the index 45% over the three years to the mid-August sell-off, versus 39% on the S&P 500.
While it is by no means clear whether the treasury yield will keep on moving at the recent pace this looks like a pretty significant Achilles heel for US equity valuations heading into the autumn.