Irrational Exuberance Is Back... And Even The Fed Is Worried

Authored by John Authers, originally posted at The FT,

Markets are extravagantly confident that brokers are too bearish, and that their profit forecasts for US companies are too low. The multiple of 18 times next year’s projected earnings at which the S&P 500 currently trades, according to Bloomberg data, allows little other interpretation. It is at its highest since 2002, outstripping any level it reached during the credit bubble, or when the Federal Reserve was pumping up asset prices with QE bond purchases.

There are other signs that optimism on earnings is taking hold. For a while, the S&P has been dominated by high dividend-yielding stocks. This is a sensible strategy when you do not have faith in corporate profitability or growth. In the past few weeks, however, the S&P 500 Dividend Aristocrats index has started to lag behind the market. Classic income-producing sectors, such as utilities and real estate investment trusts, have also ceded leadership.

And companies that take a lead in buying back their own stock are also underperforming after years of outstripping the market. For some years, corporates have been the marginal buyer of US stocks, and so the news that buybacks are falling might have been taken as a sign that the good times were over. Instead, a poor earnings season for buybacks, implying a shortage of corporate cash with which to pay them, has coincided with a breakout rally to new highs — hard to justify unless the good times for earnings are back.

One other reason why implicit optimism on earnings runs high: such optimism is necessary to justify what is otherwise a bet against history. S&P earnings have now declined for four consecutive quarters — historically, earnings declines this protracted are always accompanied by equity bear markets. During this slump in earnings, which the numbers cited most widely by brokerages tend to understate, the US stock market has twice registered corrections of more than 10 per cent, but has avoided a bear market.

Much, therefore is running on earnings. And indeed, an earnings recovery is widely cited as the prime reason to buy into US stocks at a time when they look too pricey. The argument, repeated in numerous brokers’ notes and cheerful conversations in recent weeks, goes as follows. First, it is the direction of change that matters to markets, and on this basis it looks like US earnings have reached an inflection point. Earnings were down in the second quarter compared with a year earlier. But the extent to which they are declining reduced; the second-order derivative has changed.

Added to this, energy companies have driven the awful numbers for the S&P as a whole, and this can be explained almost entirely by the huge fall in the oil price that started in the second half of 2014. For the second quarter, earnings for the S&P as a whole were down 2.5 per cent, on revenues that slipped by 0.5 per cent. Exclude energy, and the numbers were positive — earnings rose 1.8 per cent, backed by a rise of 2.5 per cent in sales, according to Thomson Reuters.

In the final quarter of this year, the adjustment in the oil price will at last drop out of year-on-year calculations, and energy earnings are projected to rise. For the fourth quarter, earnings are expected to rise healthily. On this argument, a one-off huge adjustment to the energy sector has distorted perception of the entire market. The oil fall also helped to drive a stronger dollar, which weakened the dollar-denominated foreign earnings of multinationals. With the dollar weakening of late, currency should help companies in the second half of the year.

So, the bullish argument has it, the inflection point in US earnings has been reached, a bear market has been averted, emerging markets are taking up some of the strain again and brokers have been slow to catch up with reality.

Against this, estimates for the current third quarter are actually still falling, and including energy, the brokers still call for a slight fall of 0.4 per cent. Earnings in the second quarter were better than expected, but they always are; they beat expectations by less than has been usual in recent years. If this is an inflection, the turn it signals is not at an acute angle.

Company managements tended to be downbeat when guiding questioners during their earnings conference calls. Margins, which have been historically high, tended to fall. There are nerves about the effect of US electoral uncertainty on consumers, and on the fallout from Brexit, about which much remains uncertain.

Further, it is very unusual for top-down strategists to be more bullish than bottom-up analysts.

Analysts have huge inbuilt incentives to be over-bullish, and they are not remotely bearish at present. Thomson Reuters finds that they have written solid double-digit percentage gains throughout next year.

Add to this that US retail sales data suggest a sluggish economy, meaning that there is little reason to expect a big rise in revenues; that margins will be hard to expand; and that core inflation and earnings data suggest at least a whiff of inflation and a risk of higher rates from the Fed.

Put all these together, and the highest prospective earnings multiples since the dotcom boom look like irrational exuberance.