Reading tea leaves is a practice that started roughly in the seventeenth century when Dutch traders started the import of the commodity into Europe from trade routes through China. Formally called tasseography (derived from the French word for cup or tasse), the practice sounds similar to divination methods of financial markets. Taken from the Encyclopedia of Occultism & Parapsychology, “the diviner now looks at the pattern of tea leaves in the cup and allows the imagination to play around with the shapes suggested….these shapes are then interpreted intuitively or by means of a fairly standard system of symbolism.” One form in financial markets is called “technical” analysis. Market prognosticators look at price and volume data for patterns that emerge, and then look to history to understand what those price patterns mean. Pictures with names like head-and-shoulders or cup-and-handle are common and, depending on the circumstance, could make the case for a trend continuing or reversing.
That is not to say that technical analysts are the only ones who parse the market dregs for an extra sense of market direction. Fundamental investors do the same; breaking down little fragments of data to guess at what it means in the bigger picture. This week, the Federal Reserve met and kept a hold on the target Fed Funds rate. This was followed on Friday by an employment report which is steady eddy – enough jobs added to the economy to sustain but not enough to push the Fed towards a hike. The equity market lapped it up. While the S&P 500 is a little off from the last all-time high reached earlier this week, it rebounded on this news to within a breath of it. Even after Chairman Powell implied that the balance of odds for a rate hike and cut are even, the futures market still puts its money on a cut by year-end.
It’s funny but when we look at the bigger picture, we take a few steps back for distance. That tends to work better than pulling out a microscope in the tea-leaf methodology.
Here is what we see in the bigger picture. The US economy is growing at a reasonable pace – not 3%+, but not teetering on the edge. The Fed has no interest in trying to kill the expansion (probably wishes it could go back in time to undo the December hike) but at this point is going to sit tight in the pickle until the evidence overwhelms one way or the other.
The strong rebound in the US equity markets in the first months of 2019 has well-outpaced the earnings growth possible and so valuations are full at roughly 17.5x this year’s expectations of earnings. Flipping the valuation metric around to be an earnings yield (earnings / price) we get to 5.7% – a bit of a premium over the yield on a 10yr US Treasury bond at 2.5% but the earnings growth needs to show up. The rest of the world is working through bigger issues than the US, but that is reflected in price. Developed international equity (MSCI EAFE) is trading at 13.9x (7.2% earnings yield) and emerging markets (MSCI Emerging Markets) are trading at 12.8x (7.8% earnings yield). Valuation is a terrible timing tool in the near-term, but it drives results over a 7-10 year period.
Amazingly, fund flows in 2019 have continued the decade-long trend out of equities. This remains one of the most unloved, persistent equity trends in memory. Usually, there is a blow-off period when cynics throw in the towel and the money chases the tape higher.
That is why we are sitting tight. Valuations are full but not extreme. There is a lot of good news priced into markets at this point so we expect the typical drawdown we see every year, but there is no reason to expect the fundamental trend to deteriorate. We think it better to keep risk at the target level but as a safeguard rotate towards quality, dividend exposure where the price multiple is at a discount. Keeping a long-term focus on valuation is our cup of tea