Stocktake: Have stock markets bottomed for 2018?

Stocks have enjoyed a decent pop in recent weeks, prompting investors to hope that a durable bottom is in. Is it? Probably, says LPL Research, which is encouraged by the technical and sentiment backdrop. Certainly, the technicals have held up in textbook fashion recently. The heavy selling in late March ended abruptly once the S&P 500 came within touching distance of its February lows and its 200-day moving average. That suggests we have seen a classic correction in an ongoing bull market, with investors hopeful that a strong earnings season will repair the damage. As for sentiment, LPL points to six data points indicating “levels of pessimism consistent with major lows”.

The number of bears in retail sentiment surveys hit their highest level in over a year, while bullishness plummeted. CNN’s Fear and Greed index hit its lowest level since the correction of August 2015. The Investors’ Intelligence survey of newsletter writers show sentiment hit levels unseen since the US presidential election, while this is confirmed by derivative positioning and equity fund outflows. Equity exposure fell to its lowest level since Brexit in June 2015. Conditions may remain volatile, but it all suggests stocks “may have bottomed for the year”, says LPL.

Silence of the bulls

This picture of muted sentiment is confirmed in the latest

Merrill Lynch

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fund manager survey, which shows that investors are decidedly cautious at the moment. But the kind of capitulation often seen at market lows has yet to be witnessed, with Merrill saying bulls have been “silenced, not routed”.

Only 13 per cent envisage a recession; just 18 per cent say stocks have peaked; respondents believe the Tina trade – There Is No Alternative to stocks – will remain alive and well until US 10-year bonds, currently 2.8 per cent, hit 3.5 per cent. There is a lot of wariness, however. Already high cash levels have spiked higher, from 4.6 to 5 per cent – a “contrarian buy signal”, says Merrill. Equity allocations are at 18-month lows while the number of investors taking out protection against market declines has hit 18-month highs. Additionally, global growth and profit expectations have also hit 18-month lows. In January, Merrill’s survey report was titled “Party like it’s 2019”. The title of the latest report – “Silence of the bulls” – shows just how much the mood has shifted.

Tech stocks – not expensive after all?

Despite bearing the brunt of the recent selloff, many investors remain iffy about technology stocks, which are widely seen as expensive after years of outperformance.

Credit Suisse

strategist

Jonathan Golub

has a different take. The problem isn’t that the selloff hasn’t gone far enough – it’s that it’s already gone too far. While some tech stocks undeniably boast eye-popping valuation multiples, the sector as a whole is only the third-most expensive of the 12 S&P 500 sectors if one looks at projected earnings estimates. In fact, technology is slightly cheaper than the overall market if one looks at free cash flow yields, says Credit Suisse. Tech stocks are not in bargain basement territory, but Golub is right to point out that this is not 1999 redux. The tech-heavy Nasdaq trades on 18 times estimated earnings for 2018, 16 times 2019 estimates and 14.6 times 2020 estimates. Strong fundamentals mean technology remains the “most compelling” of the sectors, suggesting tech stocks’ leadership role in the bull market has merely paused, not ended.

Expensive Netflix plays catch-up with Disney

Some tech stocks are expensive, of course, not least Netflix. Just over three years ago, Netflix was valued at about $20 billion. Today, the streaming giant is worth some $145 billion – almost as much as Disney – having posted stunning gains of 75 per cent in 2018 alone.

Last week saw further big gains after the company announced it had gained 7.4 million global subscribers, easily topping estimates. It's hard to look past Netflix's valuation, however. The company trades on 219 times earnings, according to FactSet data. Growth investors invariably dismiss conventional valuation metrics as passé, but enthusiasts should be careful, says NYU finance professor and renowned valuation expert Aswath Damodaran.

Investors have bought into Netflix’s business model of spending big on content and using that content to attract new subscribers, but this model “is also one that burns through cash at alarming rates, with no smooth or near-term escape hatch”.

Damodaran’s valuation model assumes that Netflix will be able to grow at double-digit rates for the next decade while also bringing its content costs under control. Nevertheless, he still values the company at $173, just over half its current valuation. Cash burn is not a trivial issue. Investing in Netflix is less a bet on subscriber growth and more on the company eventually getting costs under control, says Damodaran. Until it shows it can do so, he will “remain a subscriber, but not an investor”.