Price & Earnings: The Race to the Top

Now that 93% of S&P 500 stocks have reported first quarter earnings we can look at price-earnings valuation with a fair degree of confidence. My favorite is what I call PEMax, which compares Price to Maximum Annual Earnings for current and past years. This removes distortions caused by periods when earnings fall faster than price, by focusing on earnings potential rather than necessarily the most recent earnings performance.

PE of Maximum Earnings

Valuations are still high, but PEMax has pulled back to 22.78 from 24.16 in the last quarter. Valuations remain at their highest over the last 100 years at any time other than during the Dotcom bubble. Even during the 1929 Wall Street crash (Black Friday) and Black Monday of October 1987, PEMax was below 20.

While that warns us to be cautious, as valuations are high, it does not warn of an imminent down-turn. Markets react more to earnings than to prices as the chart below illustrates.

S&P 500 Earnings per Share Growth

The last two market down-turns were both precipitated by falling earnings — the blue columns on the above chart — rather than valuations.

While it is concerning that prices have run ahead of EPS — as they did during the late 1990s — consolidation over the past quarter should allow earnings room to catch up.

Bob Doll: First quarter earnings continue to impress

Bob Doll

More positive news on earnings from Bob Doll’s weekly newsletter:

…..2. First quarter earnings results continue to impress, helped by tax cuts. With 85% of companies reporting, earnings are ahead of expectations by an average of 7.3%.1 Earnings-per-share growth is on track for 25%.1 Were it not for the effects of tax cuts, that number would be only 18%.1

3. Even if earnings are peaking, that does not necessarily mean the equity bull market is ending. According to one study, since the 1950s, a cyclical peak in earnings growth has tended to be followed by stock prices moving higher: From a peak in earnings-per-share growth, stock prices were still higher six months later 74% of the time and were higher 12 months later 68% of the time.2.

Fears of an earnings peak may be overblown, with inflation low, rate hikes at a measured pace, consumption strong and inflation contained despite low unemployment. Upside and downside risks appear balanced in this summary adapted by Nuveen from Morgan Stanley:

Reasons to be optimistic

1) First quarter earnings are very strong.
2) Equity valuations are reasonable.
3) Corporate America is flush with cash.
4) U.S. growth momentum may be plateauing, but is not slowing.
5) Trade restrictions have not been as severe as feared.
6) Global monetary policy remains accommodative.
7) North Korea risks have eased.

Reasons to be cautious

1) Margin pressures could hurt future earnings.
2) Higher rates could represent a headwind for valuations.
3) Political risks may rise as the midterm elections approach.
4) Global growth may start to slow in the coming years.
5) Trade policy remains a long-term risk.
6) Investors may be too complacent about monetary tightening.
7) President Trump’s legal issues could escalate.

But it would be foolish to ignore either upside or downside risk. Adopting a balanced strategy may be the most sensible approach.

1Source: Credit Suisse.
2Source: BMO Capital Markets

Just when you thought Hydrogen was dead and buried

Irina Slav at Oilpro.com describes how surplus energy from solar and wind farms could be stored as hydrogen as an alternative to batteries.

….in Europe, renewable power is becoming so abundant that it could be used to produce cheap hydrogen without the need for any scientific breakthroughs. Last month Euractiv cited a report from a German analytical firm, Energy Brainpool, that said surplus electricity from solar and wind farms can be used to convert water into hydrogen through hydrolysis. Hydrogen is relatively easy to store and use when needed or fed into the hydrogen fueling station network, which, truth be told, is a very sparse network.

According to Energy Brainpool, using surplus electricity for hydrogen production can become cheaper with time as the efficiency levels of solar and wind installations rise and maintenance costs decline further. In fact, at some point in the future, hydrogen could become cheaper than natural gas, which would naturally have major implications for its adoption. Again, this is only a theory because power-to-gas facilities in some countries in Europe are subject to high feed-in tariffs and grid charges that make them uneconomical in the application outlined by Energy Brainpool.

Conversion of electricity to hydrogen through electrolysis is cheap but it’s not easy to store because of its low density. Liquid hydrogen requires temperatures of -253°C. One of the more promising options is to store vast quantities in underground caverns. ICI having been doing this in the UK for many years without any difficulties [Wikipedia].

It is also expensive to convert hydrogen back into energy. Costs of fuel cells are prohibitive. Scalability for smaller applications (e.g. motor vehicles) remains a problem.

Bob Doll: First quarter corporate earnings highly impressive

Bob Doll

Bob Doll reports positive first quarter results so far in his weekly newsletter:

First quarter corporate earnings have been highly impressive. With approximately 20% of companies reporting, 81% have exceeded expectations by an average of 6.4%2. This compares to an average beat of 4.7% over the last three years, which underlies the strength of this quarter2. Much of the strength has come from reduced tax burdens: Earnings-per-share is on track to grow 23%, but would only be 16% were it not for the effects of lower taxes2.

Prices tend to follow earnings and a solid reporting season would likely see stocks posting new highs after the recent correction.

2 Data from Credit Suisse.

Red flags for Blue Sky

Robert Shand - Blue Sky Alternative Investments

More good work by Elizabeth Knight at The Age. Here she interviews Chad Slater from Morphic Asset Management on red flags at fund manager Blue Sky Alternative Investments (BLA).

“It doesn’t actually come as surprise to me that Blue Sky (BLA) has been singled out as a short. I have been contacted on a number of occasions over the last two years as to my thoughts on BLA’s business model from a short-sellers’ perspective. Many of the issues raised by Glaucus were raised in those phone calls as a concern previously.”

These include, firstly, “a business with internally valued assets”.

“Businesses with assets that are ‘marked to market’ by company paid affiliates (auditors etc) are vulnerable to manipulation as the incentives are there for management in bonus payments, to hire someone to tell them what they want to hear. Now clearly not all companies will do this, but it is a murky area. Definitely a flag.”

Flag number two, he says, is when the CEO and founder suddenly leaves and cashes out a large portion of his wealth.

Another thing Slater says to watch for is “a very young senior team that has a background in management consulting rather than industry”.

Lastly a company that has grown very rapidly from a small base is another flag, he says.

While the last point is not necessarily a red flag, the first three are clear warning signs. Especially “a very young senior team that has a background in management consulting rather than industry.” I have witnessed the dangers of that first hand. Academic brilliance is no substitute for experience.

Avoiding the hubris trap

Great example of how even the most professional management teams can fall into the hubris trap.

Michael Chaney describes to The Age how Wesfarmers burnt a billion dollars on the highly successful Bunnings hardware chain’s expansion into the UK market:

S&P 500

Bunnings Warehouse by Bidgee – Own work, CC BY-SA 3.0, Link

Chaney was the chairman that signed off and despite everything contends he had never seen a more thorough investment analysis than had been undertaken on Bunnings UK.

They had a base case set of projections and a downside case and it all looked very positive at the time according to Chaney.

But a couple of fundamental mistakes were made subsequently after acquisition of Homebase home improvement network of stores including the removal of 150 senior managers.

“One was moving out the senior management and replacing it with our Australian experts and the second was getting rid of a lot of the products and the franchises because they didn’t suit the Bunnings model,” says Chaney.

By way of example the Australian interlopers jettisoned Laura Ashley from the home decorator product line up – and British women voted with their purses.

It was the success of the Australian model and its management that blinded the higher ups inside Wesfarmers to the fact that these guys didn’t know better what the UK customers wanted. Wesfarmers got caught in the hubris trap.

Some years earlier hardware giant Lowes fell into a similar trap in the US. Number-crunchers at head office worked out that they could save a bundle by replacing senior salespeople with more junior, inexperienced staff. The knowledge base of experienced floor staff was decimated. Customer service and sales plummeted. As one manager described it: “we became find-it-yourself instead of do-it-yourself.” Fortunately Lowes were able to correct their mistake and should have learned a valuable lesson but it seems they did not.

Investors should always be on the lookout for the hubris trap. The more successful the company, the more vulnerable they are. Expanding operations away from the home country or state is often a high risk venture, where management may be blind to cultural differences, regulatory pitfalls and an array of new competitors. Expanding into new product lines or services that are outside management’s traditional core expertise may also present traps for the unwary.

Ask Woolworths (Australia) about their Masters hardware venture, Commonwealth Bank about their expansion into financial advice, NAB about their expansion into UK markets, Centro Properties (now Vicinity) and Westfield about their foray into US shopping centers,….. I could go on. It’s a long list.

Investing in a Volatile Market

The S&P 500 again respected primary support at 2550. Twiggs Volatility Index is retreating but a trough that forms above 1.0% would warn that market risk remains elevated.

S&P 500

I explained recently to my clients that the odds are at least 2 to 1 that the S&P 500 will recover and go on to make new highs later in the year.

But there is still a significant risk (one-third to one quarter) that tensions will continue to escalate and the S&P 500 breaks primary support to commence a primary down-trend.

If you are risk-averse, as my clients tend to be, it makes sense to adjust your portfolio allocation to cope with either scenario. What I call “having one foot each side of the fence” or “having a bet each way” in racing parlance.

Typical Portfolio Allocation

Gen Stocks are what I call “generational stocks” such as Apple (AAPL), Google (GOOGL), Amazon (AMZN), etc. ASX Income are stocks that yield strong dividends and franking credits.

If you have 50% of your investment portfolio in cash and short-to-medium-term interest-bearing securities (I collectively refer to this as “cash investments”) and 50% in equities, you are well-positioned to take advantage of either scenario.

If the market does fall — the less-likely scenario — you are well-positioned to convert some of your cash investments to take advantage of lower prices when the dust has settled after the crash. If the market rises, as expected, then you have enough exposure to benefit from the continued bull market. In that case, your only downside is the difference in yields between cash and equities.

Bear in mind that:

  1. This only addresses clients’ equity portfolios and does not take account of their other assets;
  2. The allocation is generic and does not take account of your personal circumstances; and
  3. The allocation is addressed at Australian investors.

Although the equity allocation is split equally between Australian and International (mainly US) stocks this does not infer that I rate them as equal market risk. Australian equities includes an allocation to Cyclicals which, in the present situation, could best be described as “counter-cyclical” as this largely consists of gold stocks which tend to rise as the market falls. My “Trump Insurance as I called it in an earlier newsletter.

J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to your sleeping point.”

~ Burton Malkiel

Warren Buffett: Bonds and portfolio risk

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.

~ Warren Buffett, letter to the shareholders of Berkshire Hathaway – February 24, 2018

Black Monday, October 1987

Cross-posted from Goldstocksforex.com:

What caused the Black Monday crash of 1987? Analysts are often unable to identify a single trigger or cause.

Sniper points to a sharp run-up in short-term interest rates in the 3 months prior to the crash.

3 Month Treasury Bill Rates

Valuations were also at extreme readings, with PEmax (price-earnings based on the highest earnings to-date) near 20, close to its Black Friday high from the crash of 1929.

S&P 500 PEmax 1919 - 1989

Often overlooked is the fact that the S&P 500 was testing resistance at its previous highs between 700 and 750 from the 1960s and 70s (chart from macrotrends).

S&P 500 1960 - 1990

A combination of these three factors may have been sufficient to tip the market into a dramatic reversal.

Are we facing a similar threat today?

Short-term rates are rising but at 40 basis points over the last 4 months, compared to 170 bp in 1987, there is not much cause for concern.

13-week T-Bill rates

PEmax, however, is now at a precipitous 26.8, second only to the Dotcom bubble of 1999/2000 and way above its October 1987 reading.

S&P 500 PEmax 1980 - 2017

While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.

S&P 500

Conclusion: This does not look like a repetition of 1987. But investors who ignore the extreme valuation warning may be surprised at how fast the market can reverse (as in 1987) from such extremes.

PEMAX second highest peak in 100 years

I published a chart of PEMAX for the last 30 years on Saturday. PEMAX eliminates the distortion caused by cyclical earnings fluctuations, using the highest earnings to-date rather than current earnings. The idea being that cyclical declines in earnings reflect a fall in capacity utilization rather than a long-term drop in earnings potential.

Since then I have obtained long-term data dating back to 1900 for the S&P 500 and its predecessors, from multpl.com.

PEMAX for November 2017 is 24.34, suggesting that stocks are over-valued.

S&P 500 PEMAX

Outside of the Dotcom bubble, at 32.88, the current value is higher than at any other time in the past century. PEMAX at 24.34 is higher than the peak of 20.19 prior to the 1929 Black Tuesday crash, and higher than the 19.8 peak before Black Monday in 1987.

This does not mean that a crash is imminent but it does warn that investors are paying top-dollar for stocks. And at some point values are going to fall to the point that sanity is restored.

Robert Shiller’s CAPE ratio

Here is Robert Shiller’s CAPE ratio for comparison. CAPE attempts to eliminate distortion from cyclical earnings fluctuations by comparing current index values to the 10-year average of inflation-adjusted earnings.

Shiller CAPE 10 Ratio

While this works reasonably well most of the time, average earnings may be distorted by the severity of losses in the prior 10 years.

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

~ Warren Buffett