More on PEs and earnings

Monday largely went according to plan.   The dollar softened a bit, gold broke its losing streak, and equities evidently decided that with Fed tightening looking like a high probability, it was time to eject a few toys from the pram.  The obvious (and sad) question is how far would equities have to fall over the next month to get the Fed to turnabout yet again?

If we were talking about the Bank of England, the answer would be "one basis point", but the Fed is made of sterner stuff.  Macro Man reckons a 5% dip would still be manageable, given the starting point: even Evans and Rosengren are currently onside with a December lift-off, it would appear.  However, if Spooz were to drop below 1900 over the next few weeks, that price action- and more importantly, the faux narrative that would accompany it- could well be enough to dissuade the Fed from going.  It's absurd that the SPX is even a consideration for monetary policy, let alone a reason not to lift off, but there you go:  your author's best guess is that a 7.5%-10% decline in equities over the next five weeks would probably be enough to get the Fed to "wait for more data."

Interestingly, high yield is already singing from a different hymn sheet than either stocks or investment grade credit.  Thanks largely to the impact of an energy sector wracked by lower oil prices, the rolling one year returns of the high yield index have been negative for most of the second half of 2015.  It's quite a contrast from last year, when even a blind monkey could make money owning dodgy credit.  Curiously, Macro Man's caveat emptor warning last June coincided with the top.  (He's not sure why last year's chart looks so different from the current one.   Was the index re-formulated or something?)

It's interesting to note that both of the previous post-crisis downdrafts in high yield rolling performance lasted approximately 11 months before the bull market reasserted itself.   The current performance dip is now.....11 months old.  While history need not repeat, of course, if high yield does not bounce soon it will appear as if the nature of the market has changed.

The obvious hypothesis is that thanks to the oil debacle, high yield has fallen off of the wagon of "credit-worthy borrowers", for whom there is apparently no limit on borrowing capacity, and acquired the taint of the "have nots" for whom credit will not flow.   If so, high yield would hardly be the first to fall off that wagon; over the last year and a half, for example, the [Edit: the price} total return index of leveraged loans has fallen back to levels last seen in late 2011.  Unfortunately, monetary policy has no easy answers when it comes to directing the flow of credit to where it is most acutely needed.

Indeed, Macro Man would argue that maintaining a super-easy monetary policy in the hopes that credit might eventually flow to sectors currently denied credit is counterproductive, insofar as it is rarely the price of money that's an impediment to the transmission mechanism, and overly-easy policy can lead to distortions in other areas (including important public policy touchstones such as income inequality.)

Macro Man included a chart in yesterday's post of NDX earnings versus the PE, but in many ways it was unsatisfying.  Not only did Bloomberg not have the data history before 2001, but it is generally inappropriate to compare a trending series (earnings) with a mean-reverting/stationary series (P/E ratios.)

He recomputed the data, this time for the SPX, going back to 1971...and using y/y changes in both the P/E and earnings to create an apples-to-apples comparison.  As you can see, there has been a generally strong negative correlation:  when earnings go up, P/Es go down, and vice versa.  (This chart was linked in yesterday's comments section.)

The full sample correlation is -0.64, but it was actually quite a bit stronger before the Fed became a serial blower of financial bubbles; from 1971 until the timing of Alan Greenspan's "irrational exuberance" speech, the correlation has -0.83; since then, it's been -0.34.  The increased volatility of PEs relative to earnings during the Internet bubble and its aftermath is particularly notable; thanks Fed!

It is interesting to note that in contrast to the Nasdaq, SPX PEs have actually not expanded as much as one might expect given the rollover in earnings.  This certainly supports the notion of a two-speed equity market, with Buzz Lightyear winning "forecaster of the year" for tech stocks and the rest just kind of treading water.  We've seen this sort of thing before, albeit to a greater degree than presently observed.

What's the implication?  From Macro Man's perch, if you're trying to call a top you want to sell the laggards; once the broad market turns, however, it will be time to short the high-fliers.  From where he sits, we're not there yet.