While our memories of an extremely volatile September – five years ago – remain fresh, the last four have been exceptionally tame. It is not as if there weren’t plenty of potential sources of volatility, most of which were related to public policy uncertainty: two fiscal cliffs, two highly emotional elections, a sovereign debt downgrade and the collapse of a Congressional Joint Select Committee to fix the budget. Based on the president’s speech on Monday and the recent collapse of a GOP continuing resolution plan, another period of fiscal uncertainty seems likely. But there is a key difference from the surprisingly low volatility Septembers in 2009-12. In that period, the Fed was either buying assets or had pre-announced a new program; this year, it is preparing to weaken the portfolio balance effect. In our view, for equities to overcome unfavorable seasonality and another round of fiscal concerns, fundamentals, which have been mediocre for over a year, due primarily to weakening global and soft domestic growth, will have to improve considerably.
The equity market’s reactions to the monetary policy inflection point, when the Fed takes the first step to normalize monetary policy following easing in response to recession, have been reasonably similar, irrespective of the pace of policy accommodation removal – the average policy normalization-related correction during the prior six business cycles is 8.9%. It is after those periods when key fundamentals, such as earnings and valuation, play a greater role in determining equity market returns.
The last three cycles (1983, 1994 and 2004) are instructive. In 1983, valuation was exceptionally attractive; however, a volatile earnings recovery, similar to this business cycle, left earnings growth at a comparatively slow rate of 5% when the Fed began normalizing policy. The correction was mild compared with the average, and it was five quarters before the advance resumed when earnings growth accelerated in 1985. In sharp contrast, when the ‘measured removal of policy accommodation’ began in 2004, the S&P 500 was still exceptionally expensive, but robust earnings growth shortened the post-correction range to two quarters. The correction in 1994 was steeper than in 1983 and 2004, yet the duration of the subsequent trading range was between those two at three quarters, with relatively strong earnings growth of 15% and low valuations helping equities withstand an aggressive tightening cycle. Valuation appeared to be a larger driver of share prices after the advance resumed. Returns in 1995 were the strongest at 37%, followed by 1985’s 27%, while 2005 returns were in the mid-single digits as rich valuations constrained returns.
Before we move on to the current environment, it is notable that in addition to a seemingly poor mix of earnings growth and valuation in this cycle relative to the previous three, the average advance from the recession low, prior to Fed policy normalization, from 1971-2004 was 53%; this cycle, it is nearly 160%. Earnings volatility this business cycle is similar to that in the early 1980s: a robust early-cycle rebound followed by a mid-cycle slowdown to nearly zero before reaccelerating. The source of the volatility this cycle is foreign sales: the strong recovery of emerging market economies in 2009-10 deteriorated, with foreign sales growth falling below domestic revenues, which have been growing steadily, albeit at a slow rate close to nominal GDP, which has, of course, been weaker than prior in business cycles.
There are some encouraging signs: domestic revenues are turning higher, foreign sales appear to have rebounded slowly from zero growth in 3Q12 and global PMIs, which typically correlate well with leading indicators for earnings such as analyst revisions, have improved considerably. However, our global growth forecasts do not suggest foreign-sourced earnings growth will return to prior-cycle levels. Our domestic forecast will not help much in the near term either, as 3Q13 GDP is tracking slightly below trend for the recovery, which is likely why analyst revision momentum is flat and lagging ISM new orders.
So while for the moment falling geopolitical and Fed Chair succession risks triggered a rally back to the highs, if Wednesday marks the first step in the exit from the second period of FOMC financial repression, as we expect, the equity market will likely require some improvement in earnings growth to drive share prices higher. We believe an improved capital spending environment, a potential loosening of mortgage credit, a reduced drag from tax hikes on consumption, the end of the European recession and resulting pickup in global trade bode well for the 2014 outlook. However, autumn is volatility season; a budget battle, an unfavorable mix of valuation and earnings growth and the Fed’s weakening the portfolio balance channel imply a return to normalcy.
*Photo by: Alamy