Quantitative Investment Strategy - Known Unknowns – The Ghost of...

Quantitative Investment Strategy - Known Unknowns – The Ghost of 2007?
Joseph Mezrich; Yasushi Ishikawa
- Since March 2015, S&P 500 implied earnings growth has fallen from 10% to a still high 8%. How much risk is inherent in this relatively optimistic pricing of earnings growth? The question is especially important given current turbulence in the market.
- Comparisons of S&P 500 implied earnings growth with the economic policy uncertainty index (Fig. 1) and the S&P index option volatility skew (Fig. 2) suggest a benign scenario is possible, with implied growth sliding down to 7%, its long-term mean, without serious damage to equity prices.
- We thus see a likelihood that U.S. equities will continue to plod along to higher ground. But we also see a message of caution in today’s pattern of declining implied earnings growth amid an improving risk backdrop – a pattern that bears a troubling similarity to 2007, when implied growth dropped substantially below its long-term mean, damaging equity prices.
- All in, the near-term view priced in the market seems to be for minor downside and likely upside, albeit with transient spikes in volatility. But several “known unknowns” – the crisis in Greece, possible Fed rate action, and the downturn in Chinese equities – could be catalysts that make the 2007 pattern relevant.