Earlier we noted one of the observations noted by Goldman's David Kostin as part of his weekly market summary, namely that "the flat YTD equity market is impressive considering the news flow: Persistently disappointing domestic economic data (partly weather-related), an EM currency crisis, uncertainty in China growth and its shadow banking system, and the Russian invasion and sponsorship of the Crimea succession plebiscite on Sunday, to name just a few events since the start of 2014"... and yet the S&P is just shy of new all time highs. Actually, it is not impressive at all when one considers that centrally-planned markets do not respond to any news (especially if the news is negative - there's "snow in the winter" for that), but really all newsflow is either bullish or ignored. Which, incidentally, means the concept of a market, which discounts events and the future, no longer exists. Indeed, it hasn't existed since 2009 when we first noted that the Stalingrad & Propaganda 500 only reflects what the Fed wants it to reflect - an experiment that will end in far more than tears. So what else did Kostin have to say? Here it is, in a nutshell:
March 9th marked the 5th anniversary of the current bull market. S&P 500 has gained 1200 points or 178% since 2009. Three drivers of the rally: A profit rebound (59% of rally), a P/E multiple expansion (25%), and a change in expected EPS growth (16%). Looking ahead at these three drivers, we expect an 8% rise in the level of earnings this year, and a similar growth rate in 2015 given our economic forecast and assuming stable margins. S&P 500 trades around fair value at 15.6x forward EPS but the median stock trades at 16.7x, an extremely high valuation in historical terms. Our year-end 2014 target of 1900 represents a modest 3% upside from current levels.
And outside of the nutshell:
S&P 500 celebrated the five year anniversary of the current bull market by slipping almost 2% this week. At 1845, the index is now flat YTD. Below we identify the key drivers of the 178% or 1200 point market rally since the S&P 500 bottomed at 677 on March 9, 2009. We also consider how the three drivers might change in the future. Our year-end 2014 target remains 1900.
A rebound in corporate profits coupled with P/E multiple expansion explains nearly 85% of the rally. Change in expected earnings growth rate contributed a comparatively modest amount (see Exhibit 1). In terms of sectors, Financials and Information Technology contributed about 40% of the rally followed by Consumer Discretionary, Health Care, and Industrials. Together these five sectors accounted for more than 75% of the bull market.
Earnings recovery accounts for the majority of the market rally. S&P 500 trailing EPS jumped by 69% to $110 from a low of $65 at the market bottom. The gain in earnings translates into roughly 700 index points. Financials was essential to the recovery in S&P 500 earnings. Financials' EPS rebounded from being the only sector losing money to once again being the largest contributor to S&P 500 EPS. Consumer Discretionary and Information Technology also contributed significantly to the rise in EPS. AAPL had the largest individual contribution, representing 8% of S&P 500 profit growth.
Multiple expansion explains 25% of the bull market. The forward P/E climbed by 44% from 11.0x in March 2009 to 15.9x today. During the same period, the Health Care EPS rose 15% but its P/E multiple doubled from 9.3x to 17.8x. Industrials had a similar pattern: its P/E surged from 8.3x to 17.0x. The change in expected EPS growth rate accounts for less than 20% or roughly 200 index points of the market rally since 2009. Five years ago the expected forward EPS growth rate equaled -5%. Today it stands at +8%. Energy sector’s expected EPS growth swung from -51% to the current +11%.
In order for S&P 500 to climb higher, (a) the level of profits, (b) the expected forward earnings growth rate, and/or (c) the P/E multiple must change. Given the high starting point of all three metrics, it is hard to identify any one of these that will climb significantly during the coming year. In terms of the future level of profits, we forecast S&P 500 EPS will rise by 8% to $116 in 2014 followed by an increase of 8% to $125 in 2015. Bottom-up consensus estimates are just slightly higher at $118 and $131, respectively. However, the polar vortex and associated weak economic data has translated into negative sales and earnings revisions for nearly every sector during the past one and three month time frames.
We expect many firms will issue negative earnings guidance ahead of 1Q 2014 reporting season that takes place from mid-April to mid-May. Profit margins for the broad market and most sectors stand at record high levels. Managements have been struggling to maintain current margins, a point that was made abundantly clear on the recent quarterly conference calls (see S&P 500 Beige Book, February 11, 2014).
A potential driver of higher profits would be faster economic growth. The US economy is experiencing its fifth year of expansion but growth has been extremely weak, averaging just 2.2% annually since 2009. Goldman Sachs Economics expects growth will accelerate to 2.7% led in part by a strong recovery in business spending. Our S&P 500 earnings estimate reflects our GDP forecast but the sensitivity of earnings to GDP is mild. We estimate every 100 bp shift in GDP growth translates into $5 in EPS. In contrast, a 50 bp shift in margins has the same $5 per share impact on EPS.
Acceleration in EPS growth rate at the index or sector level is unlikely, in our view. The level of profits has recovered sharply from the depressed level of five years ago but the rate of change going forward will be modest.
The third possible driver of a higher stock market is expanded valuation. However, equities are expensive on almost every valuation metric we use. S&P 500 currently trades at 15.6x forward expected earnings, a multiple we would characterize as the high side of a range of fair value. However, the median S&P 500 stock trades at 16.7x forward earnings, a multiple that is extremely high by historical standards. The median stock has traded at a higher multiple than today only 9% of the time since 1976 (Exhibits 3 and 4).
The flat YTD equity market is impressive considering the news flow: Persistently disappointing domestic economic data (partly weather-related), an EM currency crisis, uncertainty in China growth and its shadow banking system, and the Russian invasion and sponsorship of the Crimea succession plebiscite on Sunday, to name just a few events since the start of 2014.
Money flow into stocks is one argument why S&P 500 multiple could rise from current levels. Although equity mutual fund flows remain positive, 70% of the YTD inflow has been to non-US stocks. The largest demand for shares stems from corporate buybacks. We recommend our 50-stock sectorneutral Buyback basket comprised of firms with the highest buyback yields. At 14.1x, the basket trades two P/E points less than S&P 500. The buyback basket yield of 10% is 4x the market.
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The Zagat-style summary, the market is "extremely overvalued", but it will rise on an "increase in the level of profits" and "we expect an 8% rise in the level of earnings this year", even though "we expect many firms will issue negative earnings guidance ahead of 1Q 2014 reporting season that takes place from mid-April to mid-May."