The US market continues to flirt with higher ground.
What will stop this market?
Lower earnings? Not if the latest results are anything to go by.
This is from FactSet’s Earnings Insight report, published 5 August 2016:
‘For the first quarter of 2016, the actual, year-over-year earnings decline reported by the S&P 500 was -6.7%. For the second quarter of 2016, the blended (combines actual results for companies that have reported and estimated results for companies yet to report), year-over-year earnings decline for the S&P 500 stands at -3.5%. For the third quarter of 2016, the estimated earnings decline stands at —1.7%. For the fourth quarter of 2016, the estimated earnings growth rate is 5.7%.’
Year-over-year earnings to 30 June 2016 have declined by 3.5%. Yet, over the same period, the Dow Jones and S&P 500 indices have risen to record highs.
How can this be?
Simple maths gives us the answer.
Company Earnings and Stock Valuations
If earnings are in decline then it can only mean one thing — the multiple applied to earnings is rising.
The following chart, from multpl.com, provides us with confirmation of this (not-that-difficult-to-deduce) conclusion.
The chart tracks the S&P 500 PE (price-to-earnings multiple) applied to previous 12-month earnings…all the way back to 1870.
If we ignore the massive spike in 2009 (due to the GFC’s one-off negative impact on earnings), we see that the current reading of 25.29 (red dot) is in rarefied territory…not even 1929 breached this critical level.
The S&P 500 PE first nudged above 25 in the early to mid-1890s, before retreating.
According to the Economic History Association:
‘The Depression of 1893 was one of the worst in American history with the unemployment rate exceeding ten percent for half a decade.
‘The National Bureau of Economic Research estimates that the economic contraction began in January 1893 and continued until June 1894. The economy then grew until December 1895, but it was then hit by a second recession that lasted until June 1897.’
The next time it moved above 25 was in the late 1990s/early 2000s…the period of the tech boom — and subsequent bust.
By the time the bust was over, the NASDAQ index had lost 75% in value.
Over the very long term the S&P 500 PE ratio averages out at around the 15 mark.
The ebb and flow of investor emotions over the past 145 years has taken the ratio above and below the average.
The extremes in emotions are evident in the chart.
The despair of 1917 — in the midst of the First World War — drove the PE multiple down to a mere five times earnings. Not much is known about this period, so here’s a brief history lesson from a Columbia University report entitled, ‘U.S. Stock Market Crashes and Their Aftermath: Implications for Monetary Policy’:
‘In nominal and real terms, these were huge declines. In the twelve months ending November 1917, the Dow Jones fell 33.8 percent in nominal terms and 44.4 percent in real terms. The crash of the market in late 1917 is stunning.’
Then there’s the euphoria of the tech boom — taking the multiple paid on earnings to a hallucinogenic level of optimism. Investors were prepared to pay 45 times trailing earnings.
This period is best summed up by Sir Isaac Newton’s famous quote, ‘I can calculate the motion of heavenly bodies, but not the madness of people.’
Investors were high on the easy money. Greenspan called the mood at the time ‘irrational exuberance’…and that was in December 1996, a full three years before the boom turned to bust.
If we take a closer look at S&P PE ratio chart, you’ll see that, since 1980, when the PE ratio was in single figures, there has been a steady (albeit sawtooth) trend higher.
This coincides with the period when US interest rates have fallen from around 18% to almost zero. Investors have been prepared to pay higher and higher amounts for dividend-paying companies…even if the earnings supporting those dividends have been flat lining for the past few years.
With central bankers firmly in control of money supply, asset purchasing programs and interest rates, it is reasonable to ask: Are we in a new era of valuation, where past valuation metrics no longer apply?
However, logic tells me (or, rather, screams at me) that the argument of ‘this time is different’ simply does not add up.
Firstly, everything has a limit. Negative interest rates have a limited shelf life.
What investor in their right mind would buy an investment that promises to take money off them for the next five, 10, 30 or 50 years? It makes no sense. The only thing that makes sense is that bond traders are hoping to make windfall capital gains from central bankers pushing rates even further into the negative. They’re all hoping to pass the guaranteed loss-making bonds onto some patsies who suddenly realise they were duped into the biggest game of biggest loser there ever was.
Secondly, why are rates stuck at, or below, zero? Is it because the global economy is booming?
Rates are in the basement because the real economy (the one where real people pay for real goods and services) has a severe case of fatigue. Too much debt. Too much supply. Too little demand. Too little indexation of salaries. Too much threat to employment (Macy’s and Walmart have announced major investments in online retailing while closing more stores).
The analysts are (predictably) predicting earnings will rise in the fourth quarter of 2016. We’ll see. At the start of 2016, analysts were also predicting rising earnings…not quite how things have worked out.
For earnings to pick up you’d think sales — the stuff people buy — would also need to improve.
According to the Federal Reserve Economic Data (FRED), business sales activity in the US has not made any progress since 2013.
The accountants can improve the bottom line with some sharp pencil moves for a period of time. Costs can be cut to the bone. Management can temporarily boost earnings with share buybacks. But when all is said and done, you need to sell your product if you want to make real money…the stuff that genuine long term investors will pay a handsome multiple for.
Is management running out of earnings boosting tricks?
Bloomberg reported on 11 August 2016:
‘The number of officers and directors of companies purchasing their own stock tumbled 44 percent from a year ago to 316 in July, the lowest monthly total ever, according to data compiled by The Washington Service and Bloomberg that goes back to 1988. With 1,399 executives unloading stock, sellers outnumbered buyers at a rate that was exceeded only two other times.’
The insiders — the ones who know the real numbers — are selling.
Bloomberg offers this insight:
‘The lack of interest among executives may be a warning signal for investors who just saw analyst estimates for third-quarter profits turn negative even as equity valuations swell to levels not seen since the aftermath of the dot-com bubble.’
Maybe it’s different this time, but I don’t think so.
An assorted bag of tricks — by central bankers and executives — has been used to keep this market afloat.
This is not investing; it’s a rigged casino.
Putting money into this historically highly priced market is a mug’s game.
Sure it could go higher…and I fully expect that. But it’s like chasing the market in 1999…short term gain followed by long term pain.
Investors thinking they can get out before it all tumbles down are deluding themselves. Only the lucky few will exit safely.
Better buying awaits; however, capitalising on this opportunity requires a commodity that’s in very scarce supply…patience.
Editor, The Gowdie Letter
From the Port Phillip Publishing Library
Special Report: Central banks are losing control. Their efforts to prop up asset markets are failing. We’re now entering the endgame. What will the endgame look like? What are the short and long term investment implications? And how can you navigate this period of hyper central banking intervention…and emerge from the other side with a healthy portfolio? Vern Gowdie is one of the few minds in Australia with clear answers to these questions…[more]