Earnings vs. Stock Prices and Will a Trio of Warnings Fall on Deaf Ears?

by the Curmudgeon


Introduction:

In consideration for readers’ time and interests, we’ve partitioned the weekend blog post into two parts: 

1.    Earnings vs Stock Prices & Will A Trio of Warnings Fall on Deaf Ears?

2.    Easy Money Policies Encourage Financial Risk Taking; NOT Capital Investment

Part 1 (below): We first provide an update on corporate earnings growth, which two rating firms now forecast to be negative for Q3-2016.  Selected conclusions from a Leuthold Weeden Capital Management (LWCM) analysis of future returns based on stock market valuations are also presented.

A trio of financial market warnings this week was little noticed by the mainstream media.  Moody’s, BofA Merrill Lynch (BoAML), and hedge fund titan Ray Dalio of Bridgewater Associates all said that financial markets were at an inflection point and that the limits of central bank easy money policies were close to being reached. 

Part 2 (to be separately posted):  Victor’s directly related and incisive comments on why extraordinary easy money policies have NOT led to capital investment or formation of new businesses. 

Update on Earnings and Stock Prices:

Let’s revisit one of our earlier vital themes: “Do earnings matter for stock prices?” 

·       We noted in a September 9, 2016 Curmudgeon blog post that FactSet reported S&P 500 corporate earnings were down in the Q2-2016, making it the fifth consecutive quarter of negative earnings growth.  Analyst earnings estimates were also lower. 

·       In a September 28th Curmudgeon blog post FactSet forecast a 2.3% profit contraction in Q3-2016 (from the year-earlier period). 

·       That number was slightly revised as of September 30th: “For Q3 2016, the estimated earnings decline for the S&P 500 is -2.1%. If the index reports a decline in earnings for Q3, it will mark the first time the index has recorded six consecutive quarters of year-over year declines in earnings since FactSet began tracking the data in Q3 2008.”

·       This Friday, October 8th, Thomson Reuters I/B/E/S reported: “Third quarter earnings are expected to decline 0.7% from Q3 2015.  In the S&P 500, there have been 80 negative EPS pre-announcements issued by corporations for Q3 2016 compared to 35 positive EPS pre-announcements. By dividing 80 by 35 one arrives at an N/P ratio of 2.3 for the S&P 500 Index.”

With respect to earnings and stock prices, the best valuation metric is the P/E ratio.  Leuthold Weeden Capital Management did an investigation based on the Curmudgeon’s inquiry1 and reported results in a recent report (client’s only).  Here are a couple of takeaways from their findings (bold font added for emphasis):

1.  Since stocks rank in the worst valuation decile today and bond yields are near rock bottom, it’s not surprising that our forward-looking return graph stands at a paltry 1.9% against a long-term median of 7.2%. The median return strikes us as representative of the returns actually earned over the last 60 years, but today’s record low rates are discouraging for asset accumulators looking to build future wealth in a balanced portfolio strategy. (The peak expected return in 1991 was driven by the combination of a 7.6 P/E ratio and a 15.3% bond yield… like shooting fish in a barrel.)

 

2.  As for market valuations and interest rates, today’s conditions sadly lead us to expect returns well-below median in coming years. P/E ratios would need to fall and bond rates would need to rise (both to a substantial degree) before investors could anticipate earning historical long-term returns once again.

Note 1.  The Curmudgeon has owned Leuthold Core Investment Fund (LCORX)  and Leuthold Grizzly Short (GRZZX) mutual funds since their inception in 1996 and 2000, respectively.

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A Trio of Warnings by Respected Authorities:

1.  Moody’s - Liquidity Buoys Credit (related to negative profit growth):

Quoting directly from the report (client’s and subscribers only):

The extraordinarily accommodative monetary policies of the world’s major central banks help to explain why the downgrade share of US high-yield credit rating revisions plunged from 82% for the 1st quarter of 2016 to 54% for the third quarter. The latter was the lowest since Q2-2015’s 52%.

The ultra-low benchmark interest rates of stimulatory monetary policies have encouraged risk taking, which has benefited the performance of both high-yield debt and equities. From 2016’s 1st to 3rd quarter, the US composite high-yield bond spread narrowed from 776 bp to 551 bps. Recently, the high yield spread narrowed to 497 bps for its thinnest band since July 2015. The rally by high-yield debt was closely linked to recovery by share prices, where the market value of US common stock was recently up by nearly 20% from its low of February 2016.

Stable credit quality ultimately requires profits growth (see related section above on Earnings and Stock Prices?). The support from cheap money may wear thin if profits continue to shrink. The avoidance of another surge by high-yield downgrades vis-a-vis upgrades demands the widely anticipated upturn by operating profits. In the event operating profits sink for a third straight calendar year, the default outlook will worsen, spreads will swell, and recession risks will become material.

2.  BoAML - Peak Everything & Reversal of Bullish Trends:

"We are convinced that policy is decisively shifting in a direction that is less positive for 'deflation assets' and more positive for 'inflation assets,'" the BoAML team, led by Chief Investment Strategist Michael Hartnett, wrote. This year and next, investors face a reversal of "bullish" trends that have buttressed globalization and liquidity in recent years, they argue.  BoAML says it's time for investors to consider a new normal for equity and fixed-income markets.

"A reversal of these trends, together with a shift toward fiscal stimulus and higher interest rates strongly argues that the excess returns from stocks and bonds in the past eight years are also likely to reverse."   Key bullet points from their report (client’s only):

3.  Ray Dalio, Bridgewater Associates: “There is a coming big squeeze”

From a transcript of Dalio’s speech at the Federal Reserve Bank of New York's 40th Annual Central Banking Seminar on Wednesday, October 5, 2016: 

Where does that leave us now?

1) Productivity growth is slow, though properly accounting for it has never been more difficult

2) The short-term debt/business cycles as measured by GDP gaps are closer to their mid-points than to their extremes, and

3) The long-term debt cycles are approaching their very late-stages as debts can’t be raised much and central banks are approaching “pushing on a string” limitations to their effectiveness.

The biggest issue is that there is only so much one can squeeze out of a debt cycle and most countries are approaching those limits. In other words, they are simultaneously approaching both their debt limits and central banks’ “pushing on a string” limits. Central banks are approaching their “pushing on a string” limits both because interest rates are approaching their maximum lows, and because the effectiveness of QE is approaching its limits as the risk premiums and spreads are compressing.

 

 

Curmudgeon’s Conclusions:

Fixed income investors have long been under the misguided belief that they can’t lose in a zero (or negative) interest rate/ “QE forever” world.  The very well respected authorities cited in this article think that may soon change.  If central banks were the reason for so much yield chasing, it stands to reason they can also be the reason for yield fleeing as soon as short or long rates rise.  That encompasses past winners from US Treasuries, high grade corporate bonds, junk bonds, dividend stocks, REITs, etc.

The stock market reaction to this change will depend if it tips the US and other developed nations into a full-fledged recession as Victor is predicting for early 2017.   Yet if one extrapolates from the recent rise in stock prices during six consecutive quarters of negative earnings growth, a recession might be good news for stock bulls? 

 

While some may now believe in perpetual bull markets, we wonder if they have studied the physics of its cousin- the perpetual motion machine.

 

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

 

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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