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#Investments — 02.05.2017

Equity Markets To Face A Period Of Consolidation

Roger Keller

The reflation trade has allowed equity markets to gain 8% since the beginning of the year. Over coming months, stock markets will have difficulty in finding further catalysts and are likely to go through a period of consolidation. The medium-term trend is nevertheless still up, as the global economy keeps expanding.

Some Constraints in the Near Term

Equity markets are technically overbought looking at the gap between current levels and the 200-day moving average and vulnerable according to a negative divergence in the weekly relative strength indicator and negative message from the moving average convergence/divergence indicator. The same message of vulnerability is delivered by an indicator of complacency called the VIX index (an indicator of volatility) which has reached new record lows. Other indicators are sending more neutral readings, such as the sentiment of individual investors, with slightly more bulls than bears.

From a fundamental perspective, leading indicators are losing strength, economic surprises are deteriorating and earnings revisions are unlikely to be much better than seen recently, with the proportion of positive revisions reaching a height last seen in 2011. All these factors are minor elements in themselves. However, in the face of valuations that entail already high levels of expectations and given room for disappointment on policies, politics and geopolitics, equity markets are unlikely to progress further for some time.

Our preferred hypothesis for the near future is that volatility takes the form of consolidation with prices staying above the 200-day moving average as too many investors have a relatively low weighting in equities and will increasingly feel the pressure to rotate out of fixed income assets into equities. Should stock indices nevertheless go below their 200-day moving averages this would be for a short space of time, as it is usually the norm when this happens whilst the 200-day moving average is in rising trend.

Accelerating Earnings Growth Nurtures Our Positive Medium-Term View

With the world economy undergoing a period of synchronised growth characterised by broadening participation from GDP components other than consumption, global earnings growth is set to accelerate. Operating leverage, share buybacks as well as strong base effects in commodity-related sectors and in financials are expected to generate global earnings per share growth of approximately 10%; this is below consensus, which sees 12%.

What drives stock markets is the behaviour of leading indicators and of earnings revisions. Both have reached historically high levels and explain the solid rise in world equities year-to-date. Going forward, these indicators will no more benefit from strong upward momentum. Equity markets will therefore follow a more subdued uptrend over the medium term. This squares with the fact that valuations do not improve in periods when the Federal Reserve raises interest rates, which we expect.



Over the next 12 months, and beyond the phase of consolidation that we see developing over coming months, we expect moderate upside potential. Dividend yields – averaging 2.5% on a global basis - will thus bring a substantial contribution to the total return of equity investments.