Contrary to what you may have read elsewhere, with virtually all S&P 500 companies having reported Q2 results, earnings growth is tracking at a negative 75 bps according to Morgan Stanley, a lackluster growth rate which further supports the bank's call for an earnings recession which it defines as two or more quarters of flat or negative growth, in 2019.
Negative earnings growth within the index is also broad: 6 of 11 sectors are seeing negative growth this quarter, with Materials, Industrials, and Tech faring the worst. Health Care and Financials are experiencing the strongest growth but it is only in the single digits, and with the yield curve inverting it is only a matter of time before US banks slide into earnings recession as well. Meanwhile, the ever bearish Morgan Stanley is gearing up for similar results in the back half of the year "as companies reckon with tariffs, labor cost pressure, eroding margins, and excess inventory."
Meanwhile, sales growth has also been sluggish this quarter if positive, with S&P growth up 3.9% year over year. This is a far cry from the robust sales growth we saw throughout 2017 and 2018. That said, revenue growth is in negative territory in 4 sectors. The sectors seeing the strongest revenue growth are Communication Services and Health Care, however the rising margin compression suggests that labor and wage costs are now aggressively eating away at the bottom line.
So with earnings now negative for two consecutive quarters - at least as calculated by Morgan Stanley, other banks "surprisingly" still show a modest increase - it is probably not surprising that as has been the story of the year, multiples continued to drive the market, which is up 15% YTD, rather than estimate changes. As we reported at the time, in July, the S&P 500 rose 1.3%, entirely driven by P/E expansion on dovish central banks. But, as Bank of America calculates, following the recently-announced 10% tariffs on additional Chinese goods and looming recession risks, the P/E fell over 5% so far in August, to 16.1x.
Yet even with the drop, the market's multiples on earnings look elevated relative to history, although there is one metric by which stocks look particularly attractive in the new low-rate environment: 60% of S&P 500 stocks' dividend yields eclipse the 10-year treasury yield.
Subjective, and generally irrelevant dividend comparisons aside as bonds and stocks are worlds apart when it comes to their risk profile, to allow readers to decide for themselves whether stocks are massively overvalued and overbought, or perhaps cheap compared to the world's biggest bond bubble, here is a breakdown of the S&P 500 across a wide variety of valuation measures proposed by Bank of America, 20 in total. What the analysis shows is that of 20 metrics, the S&P is overvalued based on 18 by as much as 92% (on a historical market cap to GDP basis) and up to 114% if looking at the S&P in WTI terms, and is cheap only according Price to Free Cash Flow (23.8x vs 28.0x) which however is a function of ultra low interest rates, and also based on a ratio of Trailing (-2% cheap) but not Forward PEG multiples.
The above analysis is only relevant if the US economy fails to slide into a recession, which is certainly not guaranteed. As a reminder, Rabobank last week calculated recession odds at an all time high 81%...
... while BofA's own economists now forecast a 1-in-3 chance of an economic recession in 2020, which is usually accompanied (or preceded) by an EPS recession. Historically, the median peak-to-trough EPS decline during EPS recessions was 21%, which points to a trough S&P EPS of $129.78, if we start to see earnings decline from here.
This means that the market is currently trading at 22x this implied trough EPS, the most expensive valuation since the Tech Bubble. We are confident that everyone remember what happened next.