Why Wall Street matters more than ever

Keep your eye on the S&P500 this year - it will determine global market performance.

Summary: At $US19.7 trillion, the US represents 52 per cent of the world’s market share. In 2016 investors should watch the S&P500 closely, as its performance will impact global share markets in the long term. It’s uncertain if a new rally can be sustained this year – on the one hand, US is approaching dangerously high P/E ratios, while on the other, real earnings yield is currently high. Meanwhile, Australia looks to be coping with the post-mining phase better than expected.

Key take out:  It remains to be seen how the US economy will respond to rising interest rates. Australian investors should keep an eye on whether iron ore and coal prices stabilise.

Key beneficiaries: General investors. Category: Shares.

America Rules

How America goes, so goes the world! That’s been a truism for share markets since America’s economy came to dominance after the First World War.

Here’s a clever map of the world depicting countries by the size of their stock markets. It was prepared by Michael Hartnett, Chief Investment Strategist of Bank of America Merrill Lynch.

The US, with a market cap of $US19.7 trillion, is 52 per cent of the world’s market share. Japan is runner up at $US3t, followed by the UK at $US2.t and then France and Switzerland at around $US1.3t each.

Note how small Mexico, Brazil, South Africa, Russia, India and even China are by comparison. They have large land masses and populations, but their market clout is miniscule. Australia, Taiwan, Hong Kong and South Korea punch above their weight.

The big question for 2016 is whether America’s stock market has run out of puff and is ready to crash, or whether it will mark time to allow the rest of the globe to catch up with it. So far the All-World share index is marching in step with America’s S&P500, but the performance gap that opened up after 2011 is still widening.

So the question comes back to America – can it hold up let alone stage a new share rally in 2016?

Here are recent charts from Chart of the Day that may provide an answer.

The Bear and Bull Cases

The first two say no, from here on things will get worse.  It shows America’s price/earnings ratio is at a dangerously elevated level (the red warning line) which is normally followed by a bear market. Of course it could rise further (like the great depression peak, the dot-com peak and financial crisis peak), but that would set it up for an even bigger fall later.

Historically a rise in the Federal Reserve’s cash rate from a trough has seen the US share market slump, though not for the first 12 months. Here is its typical pattern following an initial rate rise.

Also a majority of major market tops have occurred in a Presidential election year (plus or minus two quarters), hence the peaking of the S&P500 last July looks ominous.

The next two charts say yes, the best is still to come. The S&P500 share index adjusted for price inflation has now reached the same height as it did in 2000 (just before the dot-com bust), but unlike then, its real earnings yield now is high, not low.

When shares enjoy high earnings yields they normally surge, not crash. So it all depends on America’s economy continuing to strengthen, not weaken. The reason the Federal Reserve lifted the official cash rate was because its data shows America is now over the global financial crisis. Things are getting back to normal so there is no reason to believe a recession is in the making. 

It’s not just the real earnings yield which is high, so too is the real dividend yield, which is currently 1.9 per cent. This is a good omen because the stock market has done well whenever the real dividend yield exceeded 1 per cent.

Furthermore, Presidential election years, like 2016, usually experience a share index surge in their second half.

The Bottom Line

The last chart is critical to the S&P500’s outlook. It compares inflation-adjusted S&P500 earnings with America’s capacity utilisation rate. It shows industry is operating only slightly below its average capacity usage of 80 per cent, but unlike the share crashes of 2001 or 2008, utilisation has not yet plummeted.

But the chart does show utilisation as falling and dragging down earnings with it. Also note that past utilisation peaks and troughs preceded earning yield peaks and troughs by 3 to 15 months. So Chart of the Day concludes:

With the capacity utilisation rate down significantly over the past 12 months (the most significant decline since the financial crisis), the overall earnings environment is a concern.

Outside America

Fortunately price earnings ratios outside America are less overstretched. Australia’s P/E ratio is well below that of the rest of the world and just a smidgen above its average of 14.0. This is partly due to a collapsed resources sector.

Australia’s capacity utilisation rate is above its long term average of 80 per cent and holding up well; so no obvious sign here of a looming earnings crash.

In conclusion, Australia is weathering the post-mining construction and prices bust much better than expected. Western Australia and Queensland have borne the brunt of the resources crunch. The non-mining economy is expanding albeit it slowly due to a residential and commercial building boom in Sydney and Melbourne and a boost to tourism, education and manufacturing from a lower Australian dollar.

Attention remains on whether America can take rising interest rates (and a higher US dollar) in its stride or whether its economy stalls from becoming less cost competitive to other countries. In Australia, hope focuses on iron ore and coal prices stabilising which requires China having a soft landing.

Cheap Assets

While most equity and bond markets around the world look over-priced, many other asset classes look under-valued; including precious metals and gemstones, antiques and fine art, commodities and resource stocks, agricultural land as well as residential and commercial property outside global cities. Emerging market shares also look good value.

The yawning gap between developed and emerging share markets

At some point the wheel will turn and today’s ugly ducklings will transform into swans. Cyclical analysts say that won’t happen before 2021, because commodity-related busts normally last ten years as the following chart shows.

But monetarists say this time is different because the massive liquidity unleashed by central banks in response to the GFC will ultimately ignite hyperinflation and when that happens fixed interest bonds will crash, shares will drift and physical assets (including their producer nations) will provide the best safeguard against wealth destruction 

However, most of the ugly ducklings as represented by the following ETFs, still looks weak based on their price momentum. 

Key Barometer

For the moment, keep your eyes on America’s S&P500 index as it’s the key to how global share markets fare in 2016. A useful guide is whether the index’s 50 day trend line can stay above its 250 day one. This market timing tool would have kept an American investor in every rally and out of every bust in the last twenty years.

Percy Allan is Editor of MarketTiming.com.au. For a free three week trial of its newsletter and trend-trading strategies for listed ETF funds see www.markettiming.com.au.

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