By Jac Laubscher, 10 October 2017
However, the question is whether this is the start of a new trend or whether it will turn out to be just another tentative blip in a continuing sideways movement. Can the equity market escape the doldrums in which the economy is stuck? Although the relationship between the performance of the stock market and that of the economy can at best be described as tenuous, in the long run it can surely not be ignored.
The dismal growth performance of the South African economy over the past five years has to carry much of the blame for the stock market’s weak performance, while the negative political sentiment encouraged the downward rerating of South African stocks. The extent to which South African equities underperformed their emerging market peers since “Nenegate” in December 2015 is particularly noteworthy.
The future outlook is not much better, with the potential growth rate of the South African economy having suffered a severe setback. Companies that depend on the South African economy for the bulk of their profits will be particularly hamstrung in growing their businesses.
However, one should of course acknowledge that South African companies increasingly earn more and more of their profits offshore, weakening the link between the performance of the domestic economy and local equity prices. More importantly, the fortunes of the JSE remain tied to those of international bourses and it is unlikely that South African equities can continue increasing if they are not supported by international trends, especially on Wall Street. One should therefore not lose sight of the driving forces behind the sustained increase in, for instance, the S&P 500 Index at the same time that the South African market disappointed.
Profits were temporarily boosted by cost cutting, for example, and, more importantly, earnings per share were (artificially) increased by reducing the number of shares in issue through companies buying back their own shares. Insofar as the latter was financed through increased borrowing (encouraged by low interest rates) it makes perfect sense from a corporate finance perspective, but at the end of the day it is just another sign of a lack of profitable investment opportunities that would favour top-line growth.
The weak performance of the JSE therefore happened against a supportive international background that is now threatening to come to an end. Ample liquidity provided by developed country central banks’ quantitative easing programmes and the accompanying depressed bond yields played an important role in investors turning a blind eye to risk in their reach for yield. However, central banks are now set on normalising monetary conditions.
The CBOE Volatility Index, euphemistically known as the financial markets’ ‘fear index’, recently moved into single digits, a level last seen in 2007 prior to the international financial crisis.
Equity valuations on Wall Street, which remains the world’s trendsetter, have reached uncomfortably high levels, as exemplified by Robert Schiller’s cyclically-adjusted price-earnings (or CAPE) ratio breaching the 30-level recently. The only two previous times (1929 and 2000) when this ratio broke through this level (in fact, exceeding 40 on the previous occasion) it was followed by a stock market collapse.
Investors therefore have a lot to consider from a purely financial cycle perspective. And the undeniable truth is that the upward leg of the cycle seems to be rather stretched with very little support for a further increase in share prices. Even if the Trump administration succeeds in delivering major tax reform benefiting the corporate sector, much of the potential benefits have already been discounted.
But perhaps there are more fundamental questions equity investors should be asking themselves that bear on the long term future of the asset class. Was the great bull market that started in the ’80s and came to an abrupt end at the time of the financial crisis an anomaly, or can we expect a repeat of this?
Stock market movements, both their direction and magnitude, are determined by change in the environment rather than the state of the environment. We should therefore ask ourselves what the direction and magnitude of future change is likely to be compared to where we have come from.
For the stock market to lose momentum would not require a complete reversal of the forces that propelled it since the ’80s, but just for them to weaken. And that is indeed what is happening.
The bull market in developed market equities is nearing its end and the odds are against it resuming any time soon. With South Africa having missed out on the positive sentiment towards equities as an asset class in the past three years inter alia as a result of its domestic malfunctioning, it now faces the prospect of a transition to a deteriorating global backdrop without a solution to the domestic impasse yet on the horizon.