Via ConvergEx's Nichaolas Colas,
If U.S. equities feel brittle, they should. Even though the S&P 500 is up 2.6% on the year, all that gain has come since early April – Q1 was a washout for large caps with the headwind of a stronger dollar. Valuation of 18x current year earnings means domestic stocks are priced for perfection in a distinctly imperfect world: negative revenue growth for multinational companies, increasingly negative earnings comparisons, and a domestic economy stuck in (at best) first gear.
Yes, central bank liquidity from Japan and Europe may well push global equity markets higher. But what we really need is a pullback – that classic 10% correction that flushes out weak hands, reestablishes the discipline of “Risk” in the “Risk-Return” equation, and shows capital markets how to do more than just follow central bank liquidity. So watch June’s price action in U.S. stocks very carefully, because this process needs to start now. The bull market that began in March 2009 is now an ancient bovine indeed.
After all, better 10% now than 20% or more later in the year. The first is inconvenient. The second is unwelcomed.
One of the greatest – if largely forgotten - stories from ancient Greece is a text called the “Anabasis”. Written by soldier and writer Xenophon around 400 BC, it tells of 10,000 Greek mercenaries stuck deep inside the Persian Empire and very far from home. Their sponsor, Cyrus the Younger, had managed to get himself killed and with no local sponsorship the 10,000 have to retreat all the way from what is now Baghdad to the Black Sea, some thousand-plus miles to the north. On the way they have to fight not only Persians but local tribesmen, find food and shelter, and all the while hold military order. Against all the odds, they make it to a Greek colony on the Black Sea and then home. While a retreat is rarely a victory, the Anabasis did give another Greek named Phillip of Macedon the idea that a motivated and small group of soldiers could actually defeat the mighty Persians. His son – Alexander the Great – put that vision into action. And then some…
Fast forward to 1970s New York City, and the (now) cult classic film “The Warriors”. A small gang petty thugs has to make its way from the northernmost bit of the Bronx to Coney Island in south Brooklyn after being wrongly accused of killing a powerful gang leader named Cyrus. On the way, they encounter other gangs, police, and all the mayhem for which 1970s New York was rightly known. They do eventually make it back to the shores of Coney Island, just as the 10,000 made it to the coast of the Black Sea. Yes, “The Warriors” is a direct take-off of the “Anabasis”, right down to the shout out for the long dead Persian king Cyrus.
The message is therefore the same in both narratives: a successful retreat in the face of overwhelming odds can be rightly considered a victory. Consider that as you look at the 5 year chart for U.S. stocks. The S&P 500 is 94% higher over that period, with small caps (+101%) and mid-caps (+101%) up slightly more. But any retreats along the way? Hardly. The last pull back of any note was in mid-2011, when the S&P 500 declined by 17% and bottomed in early September. It’s been over 1,300 days since then.
So how deep are we in “Enemy territory”, and would a retreat be wise at these levels? Consider the following:
Just as an army – even a retreating one – travels on its stomach, equity investments need earnings to survive a long march. More particularly, they need the promise of future earnings growth. And that ingredient is missing at the moment. First quarter earnings for the S&P 500 this year were $26 on an operating basis ($22 with “one-time” charges included) versus $27 last year ($25 as reported). For the second quarter, estimates from S&P show a $28.57 estimate ($26.67 as reported) versus $29.60/$27.47. It isn’t until Q3 2015 that we begin to see projected improvements of $29.97 versus $29.60 last year for operating earnings, and $28.08 versus $27.47 as reported.
Also important to consider: analysts have a predictable tendency to estimate high and bring their numbers down over time. Those Q3 numbers could, therefore, be too optimistic. Regardless, just the data for Q1 and Q2 shows that U.S. large cap companies are solidly in the grip of an “Earnings Recession”.
Bad things happen to good companies, so is that bottom line bump in the road already in stock prices? It doesn’t seem so. S&P is showing a 2015 earnings estimate for the 500 index of $116/share, putting the current year earnings multiple at 18.2. Interest rates are low, to be sure, at 2.2% on the 10-Year Treasury so a P/E ratio that’s college-aged shouldn’t be a shock.
Still, an +18x multiple is typically a valuation measure consistent with only 2 expected outcomes. The first is earnings expansion typical of a classic “Growth stock”. If a company or sector can grow 20% a year, many investors will pay 20x earnings to go along for the ride. Since no one expects 18% earnings growth from the companies of the S&P 500, we need to look to classic “Value investor” math. In this paradigm, markets see through the valley of a cyclical dip in earnings power to the next upswing. Unfortunately, most value investors want to see earnings multiples of 12-15x to feel properly compensated for the risk that things don’t work out as expected. That implies that the S&P 500 would need to earn $141-176/share in 2016 or 2017 at the latest. S&P’s current estimate is for $133/share for the 500 stock index in 2016.
Doing simple math entitles you to tutor your 8 year old, not manage a portfolio, so let’s look beyond valuation. Over the last 5 years investors have learned one (and a half) things. The first is that you want to own equities where central banks are buying long dated bonds. That worked well in the U.S. during the Federal Reserve’s quantitative easing (QE) program, and it has been equally profitable in Japan and Europe. The half-a-thing markets have learned is to hedge the currency out of this equation.
But what happens when one central bank – in this case the Federal Reserve – decides to normalize their policy? Granted, the exit from QE has been easy since the European Central Bank and the Bank of Japan collectively took up the slack with their own programs. The S&P 500 is up 9.8% over the last year and the last new high was all of 6 trading days ago. But just consider the volatility we’ve seen in currency and fixed income markets over the past month. Yes, equities have been nonplussed by all the drama, but can that be a permanent feature of what is supposed to be a riskier asset class?
The “Anabasis” is probably good reading not only for U.S. equity investors, but for the Federal Reserve as well. We have no doubt that they would strongly prefer to “Retreat” from their zero interest rate policy, after all, and get to a short term cost of funds that is historically more normal. We’ll know more about how they consider that decision later this week, when we see the May Employment Situation Report. Any number close/over versus consensus (currently around 225,000) would be a bugle call for retreat among equity investors since it would mean the Fed is one step closer to raising rates. A result below 100,000 might actually be good news for stocks, since it would reduce the chance of a 2015 rate hike. You would, at the same time, have to write off hopes for earnings growth in 2015 and that would limit any gains based on current valuations.
Either way, investors should remember that sometimes a small retreat on your own terms is better than a long march to the sea.
