From Nick Colas of Convergex
With the S&P 500 closing just a few days ago above 2400, it is time to once again ask the question: are US stocks still cheap enough to own? The answer based on fundamentals is “Yes”. Earnings growth was strong in Q1 (+13.6%) and Q2’s expectations are low enough to beat (just 5.8%). Interest rates are still low at 2.34% on the US 10 year, partly buttressed by expected Fed rate policy through the balance of 2017. No, at 17.5x forward earnings, equities are certainly not cheap. But you own stocks for the hope of upside revisions to earnings and a temperate environment for rates. Those factors exist right here, right now. What worries us? First, volatility remains low. That’s a sure sign that everyone sees the rosy scenario we’ve just outlined. Second, long run historical measures of valuation show we shouldn’t expect much from US stocks in terms of future returns. The Shiller PE (trailing 10 year) was at 27.2 on January 1, 2007; it is 29.5 now. Compounded 10 year price returns for the S&P 500 since 2007 are just 4.8%. Bottom line: everyone believes the same thing (equities will work), and the crowd will be right (albeit with subdued returns) until it is very, very wrong.
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Since the S&P 500 held 2400 into the close on Monday, I got to wondering what “2400” would turn up on a Google search. Nothing about the S&P’s record close appeared, but I did find out you can get a pretty nice one bedroom in the Gramercy Park neighborhood of NYC for $2,400. And that a perfect score on the SAT is 2400. Or that New York City Tax Commission is in Room 2400 of that huge municipal building downtown.
The closest thing to a “Sign” about the merits of 2400 is that it is military time for midnight (along with 0000), and therefore the classic definition of the “Witching Hour” – when all manner of ghosts and demons come out to play. But just how “Real” is witching hour? Do people see more ghosts at midnight than other times of the day?
Google Trends has the answer: no, people search for “Ghost” on Google most between 2-3am. Moreover, Google users (i.e. everyone) are more likely to search for supernatural information on the weekends and least of all between 7-10am. And lest you think it is an unusual search, consider that queries for “Ghost” outnumber “Insomnia” by roughly 4:1. (Although they do peak slightly after, at about 3-4am).
So, have US stocks hit their “Witching hour” at 2400, or do we have a few more hours before we go online to search for things that go bump in the night?
To answer that question we need to look at equity valuations, a discipline that admittedly feels about as rigorous as the occult sciences. Some numbers serve as warnings, others as welcoming agents, and still others mean nothing. Until they do…
A few points to kick things off:
- FactSet currently shows bottom-up (determined by equity analysts following individual companies) earnings for the S&P 500 at pennies under $133/share. That makes the price/earnings multiple 18.0x for the S&P 500.
- FactSet also shows that earnings expectations have risen by 2.2% for 2017 since the end of April. This is primarily due to Q1 earnings pushing numbers higher. A month ago analysts expected a 9.0% growth rate for first quarter earnings as compared to last year; that number is now 13.6%.
- The bounce in Q1 results has allowed analysts to cut back on their Q2 expectations, which are now looking like 5.8% expected growth versus 8.6% a month ago. This is one of the less-discussed pieces of how analysts game their earnings expectations, and does not indicate a big pothole coming for earnings.
- For the year as a whole, analysts expect earnings growth of 5.2%, with revenue growth of 9.9%. If that sounds like a disconnect, it should. Marginal revenues always come through at faster levels of earnings growth since fixed costs are already covered by base revenues. Translation: actual earnings growth will be better than analysts are printing, and the market knows that.
- You can see the whole FactSet report here, and as we’ve mentioned before it is very useful: https://insight.factset.com/hubfs/Resources/Research%20Desk/Earnings%20Insight/EarningsInsight_051217.pdf
So, while valuation numbers might be flashing yellow, earnings growth seems ready to speed through the intersection and push markets further down the road.
The second thing to consider is interest rates, which are the foundation for equity market valuations. Remember day 1 of finance class: cost of capital is the risk free rate plus a premium for risk-adjusted expected returns. A few points on interest rates:
- The yield on 10 Year Treasuries is a very equity-friendly 2.34%. That is lower than the start of the year’s 2.45% level, so even if we hadn’t seen Q1 earnings come through as strongly as they did equities would still be higher today. That’s just math… Lower rates and constant earnings expectations push stocks higher.
- The market feels they understand Fed policy to a “T”. Fed funds futures place a 74% chance of a rate increase at the June meeting, and 45% chance of another move by the end of the year.
- An important point: equity holders WANT a Federal Reserve that is attentive to inflationary pressures and continues to tighten. That will keep long rates low and equities relatively high. No one wants the classic “policy mistake”, where the Fed goes too fast. But the M.O. of the current Federal Reserve is to go slow. And that’s perfectly fine with equity investors.
- To see the CME Group’s newly updated Fed Watch tool, click here: http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
So where are the ghosts and goblins in this outlook? Under the bed, in the closet, and behind the curtains, of course. They always hide until you are just about asleep and only then make themselves plain.
And that’s where we are right now in terms of market cycles. Volatility, both expected and actual, is extremely low. The case I have laid out here is extremely well understood and serves as the cornerstone for any positive construct on US equities.
True to the comparisons with the occult, what ails US equities can be summed up with a variety of “Signs” and “Omens”. A few examples:
- The “Oracle of Omaha” Warren Buffet likes to look at total US market cap to GDP, as does the secretive billionaire hedge fund manager Paul Tudor Jones. At current levels it sits at 120%, much closer to its highs (136%) than its lows (34%).
- See here for more, and a chart: http://www.cnbc.com/2017/04/21/hedge-fund-legend-paul-tudor-jones-says-this-chart-is-terrifying-and-should-freak-out-the-fed.html
- The Shiller PE is a controversial tool for analyzing long term trends in valuation. It takes a 10-year look-back at earnings and averages them, rather than the one year look forward most investors use as their central tool. It ignores changes in accounting standards and interest rates.
- The current Shiller PE multiple is 29.5x, versus an average back to 1880 of 16.8x. The all time high readings were 30x ahead of the 1929 crash and 44x just before the dot com bubble burst (December 1999).
- While the Shiller PE clearly shows stocks are expensive, it has little forecasting power over a three year forward look. See here for a clever analysis on that point: http://www.businessinsider.com/shiller-pe-versus-subsequent-3-year-real-equity-returns-2015-6
Where the Shiller PE does have some forecasting ability is in long term (10 year) forward returns, and that makes good sense. After all, buying when stocks are cheap should yield better long term outcomes. Here’s a case study:
- We started 2017 with a Shiller PE of 28.1; the last time we kicked off a calendar year that high was 2007 (27.2). A history of the Shiller PE here: http://www.multpl.com/shiller-pe/table
- The ten year returns for the S&P 500 ending today compounds to 4.75% on a price basis and 6.9% for total returns.
- Average CAGR total returns for the S&P 500 since 1967 are 10.09%, well ahead of those recent 10 year returns.
Some people use the Shiller PE as sort of a ghost story, meant to scare. And you can certainly read it that way – bad things often happen when it gets this high. And they may do so again.
But when you layer on the current low volatility environment another scenario pops up, one with an equity market that very quietly returns 5-8% with very little price fluctuations. Yes, in the past that scenario would pull investors into the fray and make for an artificially overvalued market, and then a fall. But the current crop of investors has been around for 3 notable bubble bursts: dot com, housing, and Financial Crisis. Will they really get sucked in again?
Or have they had enough scares to know better?