With the S&P 500 Index at 2100, the Rule of 20 P/E is now 19.5, a big bounce from 17.6 at the September low. The upside to “fair value” (2157) is but 2.7% while the downside back to 17.4 (1845) is 12%. To offset this clear negative imbalance in the risk/reward equation, one needs to see high probabilities that
- earnings will shortly accelerate meaningfully.
- inflation will decelerate from its recent 1.9% core reading and/or
- conditions will be such that equity valuations will overshoot to at least 21.9 on the Rule of 20 (2350) which would balance risk with potential reward..
The recent May high on the S&P 500 Index was at 20.8 on the Rule of 20, the highest valuation so far during this bull market. In all previous bull markets since 1960, the overshoot on the Rule of 20 P/E has been 22 or higher.
Encouraging earnings and decent guidance, so far, are feeding the market with positive energy as we enter the seasonally stronger November-May period for equities. Add Draghi’s “whatever it takes – scene II”, China’s clear stimulation bias and the Fed’s indecision (a positive?) and you get the kind of bounce we got in October.
To tell the truth, investors are just as confused as the Fed is. Yet, absent any clear positive economic trends, they continue to bet that policy makers will keep paving the road to capital gains.
But the key is clearly out of financial decision makers’ hands. It is rather into consumers’ pockets, be they American, European or Chinese. The world economy needs people to spend during the important holiday season in order to sustain growth and clear the worldwide inventory overhang going into 2016.
Last September 21, I argued that the recent world growth slowdown was due to the time lag between the time commodity prices collapse and the time commodity users begin to take full advantage of their improved purchasing power:
The reality is that the widespread collapse in commodity prices coupled with the strong USD is crippling most developing countries without a simultaneous offsetting stimulation of demand in developed countries. (…)
In real life, commodity producers are quick to retrench as soon as they see lower prices in futures markets. Anticipating the inevitable drop in their revenues, they adapt their consumption patterns well before their revenues actually decline.
On the other hand, commodity consumers do not adjust their consumption so rapidly. For starters, it often takes a while before lower commodity prices find their way to the final products. Secondly, people will often wait and see if the lower prices have some permanency before actually taking full advantage of their newly found purchasing power.
We are currently going through the severe demand slowdown in producing regions, awaiting the full effect on demand from commodity consumers.
The hope is that this dislocation between demand from producing (mainly developing) countries and demand from consuming (mainly developed) countries does not last much longer and that consumers in richer developed countries start using their enhanced purchasing power to boost consumption.
There is increasing evidence that consumers in commodity consuming countries have begun spending their windfall, even though nominal stats may be hiding the volume reality.
As I have previously documented, there is currently a meaningful gap between goods and services inflation in the U.S.. In effect, while the deflator for Personal Consumption Expenditures is up only 0.3% YoY, it masks the reality that Goods are deflating 2.8% YoY while Services prices are up 1.9% YoY. This is like saying that the January weather averages 60 degrees in the U.S. because it is 30 degrees in Minneapolis and 90 degrees in Miami.
Total retail sales were up 2.4% YoY in September, a meaningful deceleration from the 3-5% range of 2013-14. The problem stems from energy-related items which are clearly deflating but also from the stronger dollar which has made imported goods cheaper in the U.S.. This is holding down nominal sales but helping boost un-reported volume of sales.
Here’s the CPI reading last September:
The reality is that U.S. consumers are spending at a strong and sustained pace, owing to rising employment, rising wages and declining oil prices.
Real GDP is up 2.0% YoY in Q3 but real consumer expenditures are up 3.2% on a 5.7% jump in real durables and 2.9% rises in both non-durables and services.
Gallup’s October survey supports the thesis of accelerating consumption trends in the U.S.. The 3.3% increase in nominal dollars spent in October may not fully reflect volume growth given the deflation in goods:
No wonder consumer-centric companies have not negatively pre-announced more than usually in recent weeks. Nominal sales may be low but volume is growing nicely. As of November 2, the 47 discretionary-consumer companies that have reported Q3 results showed EPS growth of 18.4% (surprising by 5.9%!) on revenue growth of 4.1%. The 23 staples-consumer companies that have reported showed EPS down 0.7% (surprising by 4.3%) on a 0.9% decline in revenues.
Strong consumer spending during the holiday season is critical as the higher volume of sales would help clear excess inventories throughout the system to start 2016 on a solid footing. This would directly reverberate on producing industries. Interestingly, Markit’s Manufacturing PMI report for October turned up after 5 months of deceleration with the final reading up from the earlier flash number. Markit reports that the latest PMI
pointed to the sharpest improvement in overall business conditions since April. Moreover, the latest data signalled a turnaround in growth momentum from the 22-month low recorded in August.
Manufacturing production increased at a robust and accelerated pace in October, with the rate of expansion the fastest for seven months. This reflected a reasonably strong upturn in new business volumes during the latest survey period.
New export sales continued to rise at only a modest pace in October, with survey respondents noting that the strong U.S. dollar remained a headwind to growth. Nonetheless, the latest rise in new work from abroad was the third in the past four months, and the fastest since September 2014.
Real retail sales are also buoyant and accelerating in Europe…
…in Japan where monthly sales have been rising at a 7.7% annualized rate in the last 5 months after declining at a 6.6% annualized rate in the previous 6 months (chart from FT)…
…and in China where YoY sales growth rates troughed last April:
So, while everybody is focused on the recent slowdown in world economic growth, North American, European, Japanese and Chinese consumers are spending merrily, setting the stage for accelerating production trends in coming months. This stealth acceleration seems solid given the health of consumer finances in developed countries and in China and continuing low energy and other commodity prices. Wages are also rising at a good pace owing to improved employment ratios. In time, credit will ease further making it easier for the less affluent to borrow, especially with regards to first house buyers.
Looking somewhat further out, the recent strong victory of the Canadian Liberal Party on a clear borrow-to-spend platform after a decade of fiscal austerity from the Conservative Party could be a harbinger for looser fiscal policies in OECD countries during 2016. This would take pressure off central banks seeking to normalize monetary policies.
Admittedly, this is not a cheap market at 17.6x trailing EPS and a 19.5 Rule of 20 P/E. The S&P 500 Index is only 2.7% below “fair value” (2157) as per the Rule of 20:
- Can earnings accelerate meaningfully from here? Yes, if retail sales stay healthy, if the dollar stops appreciating and if commodities, mainly oil, stabilize or turn upwards.
- Can inflation decelerate from its recent 1.9% core reading? Possible, but likely not by much given recent trends in core prices.
- Can equity markets overshoot during the next 6 months? Yes, given positive seasonality, low economic and earnings expectations and continued ample liquidity conditions. Add the year-end performance or face-saving chase given that most pension funds and hedgies are underweight equities and under-performing.
The Q3 earnings season is turning out pretty good overall. Trailing 12 months EPS as per Thomson Reuters’ tally are now seen at $119.17, up 0.8% from one month ago as Q3 EPS are now estimated at $29.94, down 0.3% YoY compared to –4.2% expected on Oct. 1st. RBC Capital digs deeper to find that the earnings of the 359 S&P 500 companies that have reported so far (80% of the market cap) are down 0.7% thanks to a +4.7% surprise factor. It calculates that
EPS growth is on pace for –0.3%, assuming the current beat rate for the remainder of the season. This would be 6.7% excluding Energy.
This +6.7% ex-Energy growth rate is remarkable given the slow economy, low inflation, the strong dollar and rising labor costs and reflects corporate America’s resilience in the face of revenue growth of +1.5% ex-Energy. The cost cutting efforts should provide leverage if and when top line growth accelerates which could be during Q4 as explained above.
Energy has been a big drag on S&P 500 companies earnings throughout 2015 with YoY drops averaging 60%, effectively knocking some 5% off the S&P 500 overall growth rate. This drag is expected to peak in Q4 at –67% before improving to –29% and –18% in Q1 and Q2 of 2016. Meanwhile, Energy company multiples have expanded, inflating overall P/Es in the process as this RBC Capital shows:
Speaking of “energy”
With stocks beginning to bump up against all time high levels — 2126.64 on July 17 is the all-time market high – JPMorgan looks at who has energy left in the gas tank that might push stocks to new highs. The answer, in short, is momentum.
If the stock market can somehow, someway, gain further traction, it could trigger derivatives short covering and longer term momentum-based trend followers who might have dry powder left to start 2016 with a bang.
The net speculative positions that are short U.S. equity futures “is still pretty negative and stands only modestly above its October 6th low. So while many algorithmic fund managers might have reversed positioning, there are still many who remain short. The question is can they get squeezed if momentum carries price trends further? Just like the old exchange saying that trading volume begets increased trading volume, this is a situation where JPMorgan somewhat cautiously is saying a move higher in prices will beget additional buying and further moves higher for stocks. “While the position reversal by CTAs points to capitulation by bearish equity investors, the overhang of short positions in US equity futures suggests that there is room for further short covering,” the report said. (Valuewalk)
Overshooting could happen if world economic conditions improve and inflation remains muted. Better retail sales would be a big surprise to investors and the FOMC and even though U.S. interest rates would begin to normalize, the positive outlook would likely be well received. The recession doomsayers would certainly hibernate for a while.
Recent PMI reports are encouraging as they point to better growth in developed countries and stabilization and, in some cases, turnarounds, in developing countries:
U.S. MANUFACTURING PMI BOUNCES BACK UP Manufacturing production increased at a robust and accelerated pace in October, with the rate of expansion the fastest for seven months. This reflected a reasonably strong upturn in new business volumes during the latest survey period.
EUROZONE MANUFACTURING PMI STEADY AT 52.3 Output growth ticked higher during the latest survey month, underpinned by a slightly sharper increase in new orders. Intakes of new export business* also rose at a moderately faster pace, the quickest since June.
JAPAN MANUFACTURING PMI, NEW ORDERS SHOW STRENGTH Growth in production picked up to an eight month high, supported by a marked increase in total new orders. Meanwhile, growth in new export orders resumed after decreasing slightly in the prior month.
- CHINA MANUFACTURING PMI UP 1.1 TO 48.3 ON RISING EXPORT ORDERS Total new business declined only modestly, helped in part by a renewed increased in new export orders.
- South Korea’s new orders from abroad declined fractionally during the month, with the rate of decrease the joint-slowest in the current eight month sequence of contraction.
- In Taiwan, the rate of contraction eased further from August’s 35-month record to the slowest since May. While new work orders fell in October, the rate of reduction was the weakest seen in five months.
- In Malaysia, new export orders at Malaysian goods producers rose for the second month running in October. Furthermore, the rate of expansion was the most marked since July 2014.
The recent pick up in export orders at developing countries reflects improving inventory levels in developed markets. If commodity prices stabilize or even rise a little, domestic demand at developing countries would also contribute to better world growth rates.
In effect, the JP Morgan Global Manufacturing PMI rose ended a long slide in October when it rose from 50.7 to 51.4, the largest monthly rise for almost 2 years to reach its highest level since March.
The bull/bear ratio has the best record as a contrary indicator. Even though the number of true bears is not as high as I would like, the large cohort of baby bears (correction camp) pleases the contrarian in me and makes me take the current bull/bear ratio seriously.
The upward trend in equity volumes during 2015 and more so lately is also encouraging (three charts above from Ed Yardeni):
Lastly, the important 200-day moving average has turned back up:
This is not a strong call. One, we are late in the economic and valuation cycles. Two, the Fed will most likely begin rate normalization in December, creating a headwind few investors are used to. Three, valuations are not cheap making equities vulnerable to any shock.
This is a momentum play, banking on accelerating consumer expenditures in developed countries triggering rising production across the world, a stabilization or even turn in commodity prices and rising revenues and earnings expectations entering 2016.
If you stay on this train, stay close to the exit and be alert.