Yields on 10-year US Treasuries are again testing resistance at 3.0 percent. Breakout seems inevitable.
The long-term chart shows how breakout would complete a double bottom reversal, after a 3-decade-long secular bull market in bonds/down-trend in yields.
While most major stock market down-turns are caused by falling earnings expectations rather than revised earnings multiples, I do agree with Hamish Douglass that rising yields are likely to soften stock valuations.
“Strong earnings results are coming more from revenue gains than bottom-line margins. Since 2010, 90% of positive earnings surprises have come from margins. This quarter, 75% of surprises are from better revenues. This is a healthy sign for future earnings results, and hence for stock prices.”
From Bob Doll at Nuveen Asset Management
July 23, 2018
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.
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.
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.
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
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.
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.
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.
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).
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.
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.
While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.
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.
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.
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.
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
On the weekend I discussed how earnings for the S&P 500 have grown by roughly 6.0% over the last three decades but the growth rate should rise as stock buybacks have averaged just over 3.0% a year since 2011. In an ideal world the growth rate would lift to close to 9.0% p.a. if buybacks continue at the present rate. Add a 2.0% dividend yield and we have an expected annual return close to 11.0%.
I conducted a similar exercise for the ASX using data supplied by marketindex.com.au.
The first noticeable difference is that earnings for the ASX All Ordinaries Index grew at a slower pace. Earnings since 1980 grew at an average compound annual growth rate of 4.4%, while dividends grew at a much higher rate of 6.3%.
How is that possible?
Well the dividend payout ratio increased from the low forties to the high seventies. An average of just over 60%.
With a current payout ratio of 77% (Feb 2017), there is little room to increase the payout ratio any further. I expect dividend growth to match earnings growth (4.4% p.a.) for the foreseeable future.
Buybacks are not a major feature on the ASX, where investors favor dividends because of the franking credits. The dividend yield is higher, at just over 4.0%, for the same reason.
So the expected average return on the All Ordinaries Index should be no higher than 8.4% p.a. (the sum of dividend yield and expected growth) compared to an expected return of close to 11.0% for the S&P 500. That is, if buybacks are effective in lifting the earnings growth rate.
Obviously one has to factor in expected changes in the (AUDUSD) exchange rate, but that is a substantial difference for offshore investors. Local investors are also taking into account franking credits which benefit could amount to an additional 1.4% p.a.. But that still leaves a grossed-up return just shy of 10 percent (9.8% p.a.).
I would have expected a larger risk premium for a smaller exchange with strong commodity exposure.
With 84.4% of S&P 500 index constituents having reported first-quarter earnings, 302 (73.84%) beat their earnings estimates while 77 (18.83%) missed. Forward estimates for 2017 contracted by an average of 4.6% over the last 12 months but not sufficient to raise the forward Price-Earnings Ratio above 20. That is the threshold level above which we consider the market to be over-priced.
Comparing the forward estimates for 2017 to actual earnings for 1989, we see that the market is expected to deliver a compound average growth rate of 6.0% over almost three decades.
With a dividend yield of 2.16%, that delivers a total return to investors of just over 8 percent.
Price-Earnings ratios fluctuate over time, so any improvement in the ratio should be considered temporary.
Buybacks have averaged just over 3 percent since 2011. The motivation for buybacks is that they should accelerate earnings growth but there is little evidence as yet to support this. As Reported Earnings grew at an average rate of 3.2% between December 2011 and 2016, below the long-term average.
A spike in earnings is projected for 2017 and 2018. Hopefully this continues. Else there will be a strong case for restoring dividends and reducing stock buybacks.
Dow Jones Industrials
Dow Jones Industrial Average continues to climb, heading for a target of 21000. Rising troughs on Twiggs Money Flow signal strong buying pressure.
The S&P 500 follows a similar path.
With the CBOE Volatility Index (VIX) close to historic lows around 10 percent.
However, at least one investment manager, Bob Doll, is growing more cautious:
“…we think the easy gains for equities are in the rearview mirror and we are growing less positive toward the stock market. We do not believe the current bull market has ended, but the pace and magnitude of the gains we have seen over the past year are unlikely to persist.”
Forward P/E Ratio
Bob Doll’s view is reinforced by recent developments with the S&P 500 Forward Price-Earnings Ratio. I remarked at the beginning of February that the Forward P/E had dropped below 20, signaling a time to invest.
Actual earnings results, however, have come in below earlier estimates — shown by the difference between the first of the purple (latest estimate) and orange bars (04Feb2017) on the chart below.
In the mean time the S&P 500 index has continued to climb, driving the Forward P/E up towards 20.
This is not yet cause for alarm. We are only one month away from the end of the quarter, when Forward P/E is again expected to dip as the next quarter’s earnings (Q1 2018) are taken into account.
But there are two events that would be cause for concern:
- If the index continues to grow at a faster pace than earnings; and/or
- If forward earnings estimates continue to be revised downward, revealing over-optimistic expectations.
Either of the above could cause Forward P/E to rise above 20, reflecting over-priced stocks.
Be fearful when others are greedy and greedy only when others are fearful.
~ Warren Buffett