Another summer swoon?
The first-quarter disappointment has resonated among economists and market participants for two reasons. First, it brings to mind the 2011 precedent, and more broadly the repeated downside surprises on growth in recent years. Second, it comes in the wake of the debate around “secular stagnation” that was kicked off by the speech by Lawrence Summers at the November 2013 IMF research conference. If the US economy cannot accelerate to a clearly above-trend pace even after the end of the private and public sector retrenchment at a time when monetary policy and financial conditions still look very supportive, then it is certainly appropriate to ask whether the forces holding the economy back are deeper and more structural in nature. (Goldman’s economist Jan Hatzius via Business Insider)
However, the widely followed ISI Group conducts regular company surveys to monitor various aspects of the economy almost in real time. In each of the past 4 years, their surveys turned south in early May, correctly anticipating the ensuing summer swoons. This year, the surveys have yet to turn down, having reached 55.3 on May 30th:
We remain Bullish and believe the US economy can accelerate from here, bank lending will increase, capital spending will pick up, and wages will grow. The 3 timely indicator we watch most closely all suggest the economy is OK-to-better. Unemployment claims 4 week average ticked down to a near-cycle low of 323k, close to a seven-year low, ISI’s company surveys increased +0.3 points to a new cycle high of 54.8, an 8 year high, and the composite PMI increased to 58.6% in May, an OK level. (ISI)
Meanwhile, the economic consensus is moving in its usual direction: Forecasters See U.S. Economy Speeding Up
The economy is snapping back, says the consensus of 50 forecasters in the report for May released by Blue Chip Economic Indicators. First-quarter growth in real gross domestic product slowed to about zero — an annual rate of 0.1% — but annual growth in the current quarter should jump to 3.4%. And having gotten back on its feet, the expansion from then on will acquire legs, according to the consensus, with 3% growth prevailing through the fourth quarter of 2015.
Even the pessimistic bottom 10 projects a snapback to 2.8% annual growth in the current quarter. From then on, it foresees quarterly growth ranging from 2.3% to 2.5% through the end of next year, still an improvement over the 2.2% average so far in this expansion.
Of course, there is always a black sheep. This time, it’s MacroMavens President Stephanie Pomboy who sees a tough economic environment ahead that will force the central bank to reverse course (Surprise! The Fed Will Have to Reverse Course). Her arguments pretty well sum up the bears’ narrative (my emphasis):
(…) People will realize that the economy really has not achieved any self-sustaining momentum and that it requires continued stimulus. I liken it to a car on a flat road that has no momentum. When you take your foot off the gas, the car just stops moving. That’s essentially what the Fed is doing.
We will have had QE1, QE2, and QE3. So how many times is the Fed going to get it wrong before people start to say, “These guys don’t know any better than the rest of us what’s going on, and they certainly don’t have the solution because they’ve done QE three times and it hasn’t helped?”
(…) if you look at a chart of nominal consumer spending, which is 70% of GDP, it has continued to decelerate, even in this period of unprecedented monetary accommodation and rampant financial-asset inflation. (…)
I see growth generally doing what it has done, which is to continue to gradually slow. (…) So I can see the U.S. economy continuing to grow at a slower pace. If GDP growth is currently 3.7%, I could see it slowing to 3% or 2%, with nominal Treasury yields coming down along with it. And over the longer term, there is no material upside risk to Treasury yields, contrary to the popular perception that rates are going to the moon.
To me, [housing is] really the key piece, because the impact that QE had on real estate is arguably the most effective part of this whole policy. (…) But all of that came to an end when Ben Bernanke just talked about the possibility of tapering last May. So a full year has gone by, and the housing market has yet to recover its footing from just the threat of tapering. Fixed-mortgage rates have come down a little bit on the back of this recent rally in U.S. Treasuries, but rates for 30-year fixed mortgages are up 70 basis points, or 0.70%, versus a year ago.
On top of that, home prices have gone up, putting affordability further and further out of reach for many people. So what we need to sustain housing from here, if anything, is lower rates, not a taper. (…)
The main problem with housing is that, now that investors have stopped buying, we find First-Time Home Buyers Locked Out:
(…) According to Census data, Americans from 25 to 34 years of age experienced the biggest decline in income—9%—of any age group from 2007 to 2012 other than people younger than 25. Many also are grappling with student debt that crimps their cash flow.
What’s more, there are fewer affordable homes available for first-timers to purchase. Nationally, the median price of an existing home has increased by 5.2% in the past year to $201,700. The median price of a newly built home registered $275,800 in April, down 1% from a year earlier. (…)
First-time buyers now account for about 16% of new-home purchases, down from a range of 25% to 28% between 2001 and 2007, according to the National Association of Home Builders. In the existing-home market, first-timers accounted for 29% of purchases in April, according to the Realtors association. That’s down from their monthly share exceeding 40%, and occasionally surpassing 50%, in 2009 and 2010 when a federal tax credit for first-time buyers was offered. (…)
The dynamics could stunt the entry-level market and broader economy for years to come. Economists believe younger Americans now are much more likely to rent for longer periods than did earlier generations—due not only to the rising home prices and high credit standards but also the high student debt levels and elevated levels of underemployment.
This is no doubt a good rear-view mirror analysis. But we must rather look forward and understand the actual causes and their on-going dynamics.
The fact is that young Americans are simply too poor to even consider forming households. One third of 18-34 year-olds are unemployed, up from 25% in 2000, and, as a result, nearly 32% still live with their parents (27% long-term average). Those working have generally low paying jobs while carrying high student debt (tripled in last 10 years). Those who might want to buy a house face rigid borrowing hurdles if they can find a house at an affordable price. Renting is an option but rental affordability is also eroding for young adults as rental rates rise while renter income fall.
Is there hope?
Well, for starters, we can safely assume that many young adults must be getting weary of living with their old folks. And, most likely, vice-versa.
In the raging debate on the cyclical vs secular reasons for the decline in the participation rate, the only certainty is that sidelined young adults will, for the most part, eventually re-join the labor market. This has already begun: while the overall participation rate remains stuck at its low level of the past 5 years, that of the 25-34 year-olds has been gradually ramping up in the past 15 months.
- The number of employed young adults jumped by 540k (+2.6% annualized) during the last 8 months, accounting for 40% of all newly employed persons during that period even though 25-34 year-olds represent 21% of the total…
- …taking the young adults unemployment rate down from 10% at the end of 2010 to 6.6% last April…
- …which could incite more young Americans to seek work actively and, likely, leave mama and papa alone:
At the other end of the age spectrum, the number of people 55 years and older in the labor force has plateaued during the past 8 months, rising only 0.5% in total, half the rate of the previous 8 months. This cohort’s supply to the labor force has grown 4.4% on average between 2004 and 2012, potentially locking younger workers out. Their unemployment rate, now 4.7%, has actually been rising since January.
The pendulum thus seems to have peaked. Thirty-eight percent of the population 55 and older is currently working, matching the late 1960’s. That ratio was 28% in 1992! If the supply of older worker has peaked, employers will turn to the youth to fill their needs.
But it could be a slow grind.
As the class of 2014 enters the job market, graduates, particularly those with a liberal-arts degree, face a stubbornly high unemployment rate for recent graduates—8.3% last year, well above that of the past several decades. Those who have found employment aren’t necessarily putting their degrees to use. In 2012, 44% college graduates aged 22 to 27 were working in jobs that didn’t require a bachelor’s degree, the highest level in nearly two decades, according to the latest data from a Federal Reserve Bank of New York study released this year.
Jobs in which a bachelor’s isn’t needed tend to pay less and offer fewer hours than a generation ago. More graduates also are taking out heftier loans; their average debt size has more than doubled to $33,000 in the past two decades. (WSJ)
Perhaps students should be more pragmatic when deciding on a college program. In 2010, 475,000 bachelor’s degrees were awarded in so-called liberal arts (including 40k in homeland security studies). By comparison, 130,000 degrees were in earned in Engineering (75k), Computer Science (40k) and Mathematics (15k).
That said, we could be seeing the low point in household formation which, at the margin, would soon begin to impact demand for housing and housing related goods and services. So, if housing is really the key piece missing for bears to morph into some form of cattle, investor sentiment could swell during the next 6-12 months. (Chart on right from Sober Look).
In the meantime, this “unloved” and “mistrusted” market as Ben Hunt puts it, keeps grinding on, confounding the skeptics who, overlooking earnings, the main and most dependable fuel for equities, keep bitching about the artificiality of an economy on Fed acronym steroids. Whatever one thinks of ZIRPs and QEs, the fact is that they exist and are having a positive economic impact with little, so far, inflationary side effects. This artificial respiration is actually keeping the patient alive, and reasonably well, for that matter. In addition, we can be assured that the doctors will stay around and do “whatever it takes”.
Earnings growth accelerating
The Q1’14 earnings season is over. Per S&P data, the beat rate was 68%, the best in a while but mainly because expectations had been reduced after the polar vortex. Operating margins were 9.75%, up from 9.52% in Q1’13. S&P 500 revenues rose 0.8% Y/Y, a touch better than Q4’13’s +0.5%.
Q1 EPS total $27.31, up 6% Y/Y. Trailing 12-month earnings are now $108.91, up 10.7% Y/Y and 6.5% over the last 6 months (+13.5% annualized).
Q2’14 estimates remain unchanged at $29.47, +11.8% Y/Y, while full year estimates were shaved 12 cents to $119.59, up 11.5%, a touch better than 2013’s 10.8% gain.
Factset provides more granularity than S&P (be aware that Factset’s definition of operating earnings differs from the more conservative S&P’s).
Overall, 74% have reported actual EPS above the mean EPS estimate and 26% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above the 1-year (71%) average and above the 4-year (73%) average.
In aggregate, companies are reporting earnings that are 5.1% above expectations. This surprise percentage is well above the 1-year (+3.1%) average, but below the 4-year (+5.8%) average. If this is the final percentage for the quarter, it will mark the highest earnings surprise percentage since Q1 2012 (5.3%).
The blended earnings growth rate for Q1 2014 of 2.1% is above the estimate of -1.3% at the end of the quarter (March 31). Nine of the ten sectors have seen an increase in earnings growth over this period due to a combination of upside earnings surprises and upward revisions to earnings estimates.
The blended revenue growth rate for Q1 2014 is 2.7%, which is above the estimated growth rate of 2.4% at the end of the quarter (March 31).
At this point in time, 105 companies in the index have issued EPS guidance for the second quarter. Of these 105 companies, 79 have issued negative EPS guidance and 26 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the first quarter is 75%. This percentage is above the 5-year average of 65%, but below the percentages recorded for Q1 2014 (81%) and Q4 2013 (88%) at the same point in time in the quarter.
For Q2 2014, Q3 2014, and Q4 2014, analysts are predicting earnings growth rates of 5.8%, 9.6%, and 10.1%. For all of 2014, the projected earnings growth rate is 7.7%.
The only dark cloud is that, of the 17 companies that preannounced in the last 2 weeks, all were negative (9 in Consumer Discretionary, 6 in IT). IT companies have made it a habit to negatively preannounce. Consumer-related companies continue to suffer from an inventory overhang after their very weak sales during the polar vortex. Factset’s blended Q2 EPS growth rate declined from 6.9% on March 31 to 5.8%, most of the decline being recorded in Materials (+17.7% to +10.9%) and Cons. Disc. (+13.5% to +10.1%).
Interestingly, margins are not forecast to mean-revert anytime soon. In fact, the mean-reversion thesis (fear) could get really hurt if Q2 margins meet current forecasts which show margins breaking up from their 2014 range:
The seeds for an enhanced and more confident earnings trend are there. If Q2 results come in near current expectations, the remaining fears on margins and profit growth could quickly disappear, potentially leading to higher P/E multiples. Even more so if the U.S. economy seems to be getting on a reasonably stronger footing.
But even with stable multiples, investors are already noticing that trailing EPS are accelerating:
- Q3’13: + 4.9%
- Q4’13: +10.8%
- Q1’14: +10.7%
- Q2e: +12.8%
- Q3e: +13.1%
- Q4e: +11.5%
After almost two years of stagnation, during which inflation slowed from 3.9% to 2.0% (pushing P/Es upward), the earnings tailwind is strengthening once again. Unless inflation markedly accelerates, equities could well have another good leg ahead.
To be sure, equities are not deeply undervalued at 17.4x trailing EPS. The dependable Rule of 20 says that fair value is 1978, a mere 3% above current levels. But the S&P 500 Index remains within the green (lower risk) area and earnings seem to be accelerating enough to more than offset the risk of higher inflation over the next 6-12 months.
There is also the possibility that equity valuation will venture into the higher (yellow) risk area, something that has not happened this cycle for the first time in 50 years. In each of the 7 upward valuation cycles since 1967, the Rule of 20 P/E (black line) rose well beyond the “20” fair level. This cycle, even with all the financial heroin provided, valuations have refused to move into overvalued territory, confirming the mistrust toward this bull.
It is thus showtime for earnings and margins, showtime for the economy and showtime for P/E multiples.
The earnings show is actually underway and getting better, drawing a larger crowd. If margins actually break out and enter the show, the crowd should keep growing, especially if the economy also gets in the act.
But the big show, the one with fireworks, is the powerful spectacle of rising earnings, rising margins and rising confidence (P/Es), a combination not sighted for over a decade but which is typical of end-of-cycle shows.
Or, we may be in for an early sixties performance in which rising earnings and stable inflation steal the show to the economy and geopolitical risks and carry equities higher on multiples stabilized around fair value.
The worst case would be hints of a sustained economic slowdown potentially generating weaker revenue growth and declining margins. This is actually the bear narrative that has refused to materialize so far in this cycle.
But don’t worry. In such a case, ladies and gentlemen, you shall be completely awed by the new and improved Yellen & Draghi show where Janet Yellen will offer an even better version of the highly successful Bernanke act and Mario Draghi will, for the first time ever, take real action rather than merely talk.
This powerful combination of lowest ever interest rates, potentially even going negative, and an almost world-wide showering of liquidity, could do the ultimate trick: boost the economy and take equity multiples well into the twenties, something last seen more than a decade ago.
In addition, we could get a surprise performer, the U.S federal government itself. In effect, now that the primary fiscal deficit is projected to almost match GDP during the next ten years, it will become almost impossible for U.S. politicians not to agree on something, a number few people thought would ever been seen again.
After more than 4 years in the bull camp, I have been a more cautious bull during the last year. Generally unappealing risk/reward ratios on valuations coupled with flattening earnings while driven by irresponsible politicians and blind central bankers made me err on the side of protecting capital and maximizing revenue. Throughout the winter, the risk of a hard patch froze me, especially with my rising worries that China was slowing more than people thought and that inflation might shortly accelerate, both fears now confirmed by hard facts.
On April 28, I wrote U.S. EQUITIES: BETTER INTERNALS, SCARY EXTERNALS as it became apparent that Q1 earnings were pretty good in spite of the harsh winter while the economy gave no signs of faltering.
The S&P 500 Index is up only 0.9% so far this year while trailing EPS are up 6.9% with generally stable inflation. Meanwhile, the Rule of 20 “Fair Index Value” jumped 7.4% since the end of December, creating an 8% gap to Fair Value, the highest gap since mid-2013 when the S&P was in the 1600 range. The recent spike in the Fair Index Value broke the flattish trend observed between mid-2012 and December 2013 when earnings growth slowed.
Getting more comfortable with equities is tempting given the current risk/reward ratio and the improving profit picture. The “externals” suggest continued restraint, however, until the Ukraine situation clears up and until we get more reassurance that inflation is not creeping up on us.
On May 12, I added in SELL IN MAY? YOU MAY BE SORRY!
(…) In fact, 26 companies have positively preannounced for Q2 so far. This is the highest absolute number of positive preannouncements since Q1’13 (24).
This is pretty significant:
- one, we know that companies are inherently wary of over-promising, knowing very well the cost of under-delivering.
- Two, Q2 estimates currently assume a breakout of corporate margins. The fact that corporations are not trying to reign in these estimates is positive. Mean-reversion remains elusive without a recession…
Such a breakout in corporate margins could be significant for market psychology, potentially lifting expectations and confidence in the apparently fairly optimistic estimates for the rest of 2014. In fact, while forward estimates normally are being ratcheted down at this time of the year, estimates are actually inching up for 2014 as a whole. (…)
I must acknowledge that profits, the most dependable underpinning for equities (vs P/Es), are pretty strong and look set to climb 10% during the next 9-12 months. Importantly, RBC Capital calculates that, ex-Financials, domestically oriented companies are recording earnings up 9.3% Y/Y in Q1 compared with +2.2% for globally oriented companies. This reduces the earnings risk linked to potential turmoil in Europe. Furthermore, RBC notes that
Financials and Energy were a drag on 1Q results. Specifically, the big-5 banks saw a 20.6% drop in earnings due to weak capital markets activity and BAC legal expenses. Within Energy, a 44% drop in crack spreads pressured margins in non-commodity sensitive names, resulting in a 14.4% decline in earnings. The setup for 2Q appears to be strong. Current forecasts point to an acceleration in Y/Y nominal GDP growth. Further, the big-5 banks and Integrateds and Refiners will benefit from a healthier operating environment.
While the inflation risk remains, it is dwarfed by the potential gain in trailing EPS in 2014. Sell in May, you may be sorry!
In summary, my train of thought goes like this:
- The earnings tailwind is back: trailing earnings are up 9.6% in the last 9 months and are expected to rise 10% during the next 9 months. Margins and profits held up very well during a tough Q1 during which earnings from Energy and Financials declined 2.8% and 3.6% Y/Y respectively. While inflation is up a little, I doubt it will rise enough to offset the growth in earnings in 2014.
- The economic background is not deteriorating and, in fact, is looking better. The U.S. manufacturing and services PMIs were very strong in May, employment is accelerating and consumers are spending.
- The central banks put is well in place and the Draghi show is about to begin, this time more doing than talking.
- The Chinese put also looks pretty solid and could well be used more openly shortly.
- The improvement in the U.S. fiscal deficit provides another, almost forgotten, put option.
- Geopolitical risks have been absorbed by investors and are unlikely to severely impact the U.S. economy.
- The bear community has thinned considerably in the past 6 months.
The risks are:
- Valuation is only fair. This is not a very cheap market. A big, sudden shock to confidence could bring the Rule of 20 P/E to 16.5 like in 2010 and 2012. If inflation is 2%, that means a fair P/E of 14.5x $110.50 (avg of Q1+Q2 trailing EPS) = 1600, a 17% debacle.
- Market technicals look positive (100-day m.a. at 1853, 200-day m.a. at 1800, both still rising) but the next four months have traditionally not been the best for equities.
- This is a mid-term election year and equities have yet to perform their usual correction, unless the 6% late January decline counts as a mid-term bust.
- The bear community has thinned considerably in the past 6 months.
At 2% inflation, the Rule of 20 says fair P/E is 18, implying 1962 on the S&P 500 Index on current trailing earnings, rising to 2015 in the summer, 2080 in the fall and 2160 next winter as trailing earnings rise, for a potential 12-15% return over the next 9 months. This is what we potentially get in the basic show, one that is, so far, supported by recent economic data.
The fireworks show implies valuations rising above the Rule of 20 fair P/E line of “20”. Over the past 50 years, it has been best to get out of equities above a Rule of 20 P/E of 22, meaning a 20x P/E if inflation is 2%. Using trailing EPS of $110.50, that brings the S&P 500 Index to 2210, up 15% from current levels. If earnings reach $115 later this year, the fireworks would take us to 2300-2400, up 20-25%.
Remember that the Rule of 20 is not a forecasting tool. Its usefulness is in helping us measure, objectively, potential reward against potential risk. As I see it now, the basic show would return 12-15% over 9 months, solely on earnings growth. The fireworks show would return 20-25%, thanks to rising P/Es. Downside to the 200-day m.a. is 6.5% while the debacle scenario is -17%. I still fail to see any signs of a recession in the U.S. so I tend to discount the debacle scenario.
I am at the age where return OF capital is more important that return ON capital. This is why I am keeping the streetlight yellow. Curbing my enthusiasm. As said, this is not a cheap market. But the earnings and economic backgrounds look good enough to increase my equity exposure, with a stronger emphasis on quality, income and liquidity.
In closing, I can’t resist quoting John Hussman, perhaps the last true bear out there, displaying exquisite frustration:
(…) Accordingly, I am changing my guidance. For those investors who trust our analysis and discipline, no change of course is encouraged. But for those who find our work to be a constant source of irritation to be regarded with open disdain, I am retracting all of it herewith – for you alone mind you – and I leave you free to buy with both hands to whatever extent you are inclined. Not that I encourage it really – that would be bad Karma – but someone is going to have to hold equities at these prices. It would best be those who are fully aware of our concerns and prefer to reject them. So the more you dislike my work, and particularly if you are nasty about it, I have no objection to you accumulating – perhaps on margin – as much stock from other investors as possible.
I like John Hussman. One of the last well articulated bear, I enjoy reading him, important as it is to always be aware of counter arguments, especially when the bull/bear ratio is so lopsided. I know that Hussman will eventually be right, likely only just before the next recession, however. Hopefully, I will see it coming. More likely, however, my discipline on valuation will have pushed me out of equities well before.