We are right smack dab in the middle of what has been an impressive earnings season. Although strong EPS has been a constant for quite some time, we are finally starting to see the commensurate revenue growth that has been noticeably absent. Without question, that is a good sign. But will the baton pass from eight years of extraordinarily market friendly monetary policy to the long awaited and highly anticipated fiscal policy—in the form of tax reform, infrastructure spending, repatriation of US dollars domiciled overseas—be as seamless as the market’s performance seems to indicate?
Many of you know me and understand that I am always a skeptic. I was raised on Wall Street to look at the glass as always half empty and to view the markets through the critical eye of “what can go wrong will go wrong.” But for a few instances over the last eight or so years, that line of thinking has come into question.
Perhaps the best way to illustrate confidence in the market is to look at the Volatility Index measured by the VIX. Although north of $10 today, we quite recently put in an all-time low of $8.84. I have an opinion as to why this is, but I will preface this by saying I have no idea whatsoever if I am right or wrong. There have been many unintended consequences of the policies of our Federal Reserve. However, it is my opinion that there have been many intended consequences of those policies as well.
One such intended consequence has been to extract the volatility from the market place. Since peaking north of $80 in the fall of 2008, the VIX has been on steady decline. Although we have seen spikes in volatility along the way, each move higher has been less intense than the prior, as well as shorter in duration. Market participants, in a very Pavlovian way, have been conditioned to “buy every dip in stocks” and “sell every rally in volatility.” Why? Because the Federal Reserve has our collective back.
Let me take it one step further. For years, market participants were encouraged and taught to “buy protection” against their individual stocks and portfolios. It seemed logical at the time, and those activities helped to keep volatility at an elevated level. But over the last five years or so, as each selloff in equities has become shallower and less frequent, these same participants are questioning that philosophy. Why buy protection when it will just expire worthless? While this new logic seems to make sense, let me ask you this: Do you buy flood insurance hoping for a flood? Do you buy auto insurance hoping to be involved in an accident? Of course, the answer is an emphatic no.
Few, if any, market participants buy put protection in the hopes that the market will crater. They buy it with the knowledge that it may. However, if the Federal Reserve has our back, there is nothing to worry about. So why bother? Of course, that lack of protection buying takes the bid away from volatility and greases the skids for it to move lower. Something alarming has been taking place over the last year to 18 months. Not only have market participants stopped buying protection, but many have instituted a strategy of selling volatility. In this never-ending search for yield in the low interest rate environment that we find ourselves in, people have been selling options to create synthetic dividends.
The logic goes something like this: I would be thrilled to own XYZ stock down 10% from its current price, so I am going to sell a naked put against it and take in that premium, which is effectively a synthetic dividend. If the stock does nothing from here to expiration, that premium is mine free and clear. And if I put the stock at the strike price, then I am happy to be long anyway, because the market always comes back because the Fed has our back. The numbers suggest this is a great strategy, as it works over 75% of the time. What the numbers don’t say, until one further investigates, is that 25% of the time it doesn’t work. Not only can it eliminate all the gains you enjoyed, but it can also put you in quite a deficit. One has to ask the following question: In a 10 vol market, are you being paid enough to take on that kind of market risk? I would submit my answer as a resounding no, but that’s what makes markets.
Now quickly on the bond market. Very quietly we have seen the spread between two-year treasuries and 10-year treasuries narrow to about 75 basis points. 2’s versus 10’s doesn’t seem to matter until it does. Clearly with the stock market being at an all-time high, 75 basis points is not the trigger. But again, the question that begs to be asked is “what level is?” I will point out that although I’m certain the Federal Reserve thinks they can control the yield curve, the only thing they really have control over is the front end. The market controls everything else. So as they embark on what I’m certain will be a well-thought-out methodical move toward normalization, there is no guarantee the back end of the curve will cooperate. Ask yourself the following question: Why are 10-year yields in the United States still so stubbornly low? While the stock market suggests a surging economy, the bond market seems to indicate something a bit different. I would submit the chasm between the stock market and the real economy continues to grow.
In terms of sectors, there are some encouraging signs. Energy, which has been a laggard for the last couple of years, is finally showing some signs of life. One of my assertions has been that the turn for energy will come when the big cap integrated names start to rally in the face of continued weakness in the underlying commodity. We finally saw this play out in late August. Exxon Mobil held $76 on the downside for a number of sessions despite weakness in crude. The stock actually turned higher before the commodity, and it has been grinding higher since. That is an encouraging sign. On a side note, Exxon is due to report before the opening on October 27. We have seen similar moves with BP, Chevron and Conoco Phillips.
Biotech has also been a noted outperformer. Since bottoming out right around $250 or so around Election Day in 2016, the IBB has staged a rather impressive rally. I have maintained that the political rhetoric around the space was misguided, and sooner or later the market would realize that the stocks were too cheap on valuation, and that the science behind many of these companies actually works. That played out in spades on August 28, when Gilead announced their purchase of Kite Pharma for $11.9B. Now, one can argue that given the underperformance of Gilead since its all-time high in the summer of 2015, they had to do something. Many will also say that Gilead overpaid for Kite Pharma. While both statements are true, the purchase illustrates that the science does in fact work, and the space is once again in play.
Citigroup just reported a book value of $78.81 during their 3rd quarter release on October 12. At 1.7 times book, we get to a stock price of 133.97.
Bank of America just reported a book price of $23.92 during their 3rd quarter release on October 13. At 1.7 times book, that gets us to a stock price of $40.66.