M&M update (Jan 2018)


To us M&M’s are a real pain in the butt – and we are referring to macro & market questions not the chocolate snacks leading to adorable love handles. We get asked M&M questions all the time but have never come across a coherent framework that would really allow anybody to make reliable predictions. Here are a couple of conclusions that we are quite certain of when it comes to M&M forecasts. First, they have as much predictive power as a coin toss. Second, they do not make a material difference to long-term, secular investment themes that we are focused on. Finally, most investors, i.e. Mr Market, still pay attention.

The latter fact should not even come as surprise when we remind ourselves that Mr Market is not an imaginary higher being but humans (mostly institutional investors) like you and me, who have to answer to their bosses. And many bosses like to ask questions that come up on the short-term horizon… impact of Brexit… timing of QE tapering and rate increases… Trump… NAFTA and the wall… China hard-landing. We don’t agree that time is well spent trying to quantify the short-term impact of those events, but we can relate to the dilemma faced by all the market lemmings out there.

Hence a honest disclaimer: By disregarding our M&M updates, you will not miss out on any useful insights for being a high-conviction, long-term investor. But we’ll nevertheless put in some work to provide you with our thoughts on an ongoing basis.

Let’s focus for this M&M update on the US, the world’s largest economy and equity market. Returns have been on a tear with the S&P500 ending last year ~19% up, a substantial increase that came as a surprise. Now, your initial reaction might be that this out-performance must be driven by further P/E multiple expansion. But it turns out that P/E multiples have only expanded by ~1-2% in 2017. Moreover, while P/E levels are at 10 year highs, when put in relation to T-bond yields the S&P500 does not look overvalued.

The ~19% returns in 2017 were hence largely driven by ~18% EPS growth, which contributed the lion-share (90%+) of the uptick. When we unpack headline EPS growth we find that Tech and Energy contributed ~65% of total EPS growth, which increases to ~75% when adding Healthcare. Moreover, on the back of very strong 2017 growth – the highest growth in the last 7 years – consensus growth expectation for 2018 are now 17% and 10% in 2019. This raises the question whether the growth engine will continue to fire on all cylinders and how that ties to expectations that markets are discounting.

Against that backdrop, 2018 will be another year of intense FED watching. Increasing rates, Fed-fund rates as well as long-term treasury yields, are already a reality. But will the FED continue to smoothly balance real growth, inflation and interest rates, i.e. perfectly in line with what markets are discounting? NOBODY KNOWS – everyone is just taking a piss in the wind.

The optimist view: the FED in the last 7 years or so has erred on the safe side, learned from past mistakes and reached the next level of perfect foresight – hence, we do not have to fear that the central bank will lose the plot in 2018. The pessimist view: the FED has benefited from a confluence of factors leading to increasing economic growth and falling unemployment which in 2018 are finally going to escalate inflationary pressures – the central bank will finally lose its cool and catch markets on the wrong foot.

We are generally not interested in valuations on the market level and expect that drops of 20% and more can happen at any time. But we can certainly be convinced that the risk of such drops increases when markets discount high and narrow paths of expectations. Given how finely balanced expectations appear in US equities we stand ready for more volatility and potential sharp drops. If you happen to be focused on shorter-term M&M positioning, our 2 cents would be that more upside could be found in emerging markets as well as developed markets that are less advanced in the economic cycle… why… we’ll get to that in future M&M updates.

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