U.S. GDP contracted by 1% on an annual basis in the first quarter of 2014. Despite that pullback, the S&P 500 hit an all-time high this past week. This disconnect has me concerned that investors are becoming too complacent. Here are nine problems I see with the market.
1. Corporate earnings can grow for a few quarters and even multiple years through cost savings but, ultimately, corporate revenue in aggregate must rise for earnings to expand. My concern is that the cost savings have already been wrung out of the companies that comprise the S&P 500, and future earnings growth through margin expansion will be hard to realize.
2. At the end of the day, stocks appreciate over time because EPS (earnings per share) increases over time. EPS increases for two reasons. First and most importantly, corporate earnings increase. Second, EPS can increase by reducing the shares outstanding through corporate stock buy-backs. As an investor, I would prefer to see EPS increasing through earnings growth as opposed to stock buy-backs. Organic earnings growth is far more sustainable over time. Much of the share buy-back activity has been spurred by rock bottom interest rates that have enabled corporate CFOs to issue debt and buy back stock. This capital structure arbitrage will be lessened as interest rates rise. As a result, one of the two drivers of EPS growth will be lower going forward.
3. I know that ten years from now the market will be substantially higher than its current level because a decade from now corporate earnings will be much larger than they are currently. The P/E multiple placed on those aggregate earnings bounces around but remains relatively constant over time. The lion’s share of stock market gains in 2013 came from P/E expansion. Earnings did not grow by over 30% last year, rather the P/E multiple expanded by around 22% and earnings grew around 8%. There is a limit to how much more the P/E multiple can expand. As a result future gains in the market will be harder to come by.
4. Most importantly, there is absolutely no way corporate earnings can continue to grow in aggregate if GDP continues to decline. Corporate earnings in the first quarter of 2014 were relatively weak. On a year over year basis, aggregate corporate earnings for the S&P 500 grew around 2% in the first quarter of 2014. Analysts, as they almost always do, are expecting earnings growth to accelerate in the remaining half of 2014.The market is already pricing in this acceleration and, if we do not see double digit earnings growth for the S&P 500 on a year over year basis by the fourth quarter of 2014, the market will begin to come under pressure. Essentially, the market has already priced in a relatively robust earnings recovery which will be hard to realize unless GDP picks up dramatically.
5. Currently, the 12-month projected earnings for the S&P 500 are at an all-time high. Thus, it is not surprising to see the S&P 500 also at an all-time high. However, the main reason the market is hitting new highs has absolutely nothing to do with revenue or earnings growth. The market is going up because interest rates are going down. The yield on the 10-year treasury is currently much lower than what market participants expected as of the beginning of the year. The Ten-Year Treasury yield started 2014 around 3.0%. The median estimate from economists at the end of last year was for the yield to rise to 3.4% by the end of 2014. As of May 30th, the yield was 2.47%. Lower interest rates mean higher P/E multiples for two reasons. Low interest rate make stocks more attractive relative to bonds, and low interest rates mean higher present value of future cash flows from owning a stock. The problem is, of course, rates cannot go much lower. In fact, I expect rates to move higher. This will hurt bonds far more than stocks, but will not be great for stocks.
6. The Federal Reserve remains extremely accommodative. The low interest rate environment is not exclusively due to the Fed’s bond buying, but the quantitative easing certainly is helping. Eventually, the Fed must stop buying bonds. When the Fed does stop buying bonds they will likely need to sell some of the bonds they have on their balance sheet or allow the bonds to mature. In either case, the Fed is likely going to lose money on the bond holdings. The Fed is not alone in this regard. Most likely, anyone buying a 20-30 year bond is going to lose money on the bond over the next few years as interest rates rise. Again, we have a stimulus to the market that will eventually have to be removed, and the market is behaving like the stimulus will continue.
7. Right now corporate profit margins are at all-time highs. The reason is that wage inflation is at all-time lows and technology continues to displace labor as a means of production. Essentially, profit margins are high because workers are not, in aggregate, getting the same share of the economic pie that they have historically. Eventually, wage inflation must increase. If it does not, we are going to start to see a greater degree of political instability world-wide. As wages begin to rise, profit margins and corporate earnings will begin to come under pressure. Yes, it is definitely true that the new global labor market is causing wages to be under pressure by forcing U.S. workers to compete with a huge supply of workers from previously communist countries. But, I do not buy the argument that this time is different. We always have had inflation. Inflation will eventually materialize again and, when it does, the inflation will include wage inflation, which will put downward pressure on profit margins and, thus, put downward pressure on corporate earnings.
8. As I explained last week, expected volatility is way too low. It is going to spike as it has historically and, when volatility spikes, the market usually sells off. The week before last, I indicated that the aggregate market value of the stocks that are publicly traded in the U.S.A. now exceeds the country’s GDP. This metric is signaling that equities, in aggregate, have become too big relative to the economy. Additionally, speculation is starting to increase - penny stocks are making a comeback, blank-check companies are beginning to IPO, and online stock newsletters are popping up like daisies. All of this points towards the later part of a bull-market.
9. Inflation is simply not present. If the bond market, which tends to be a little more even keeled than the stock market, saw even a whiff of inflation, the 10-year treasury yield would not be around 2.5%. We still have in this country a massive budget debt, and there are only three ways this can be addressed. Either we have to increase taxes, decrease government spending, or have inflation reduce the debt. Most likely, we will not increase taxes dramatically, or decrease spending - instead inflation will materialize (effectively inflation is a tax on cash holdings; if you hold cash, it buys fewer goods and services in the future). Thus, if inflation occurs, the U.S. debt is paid back with less valuable future dollars. When this inflation materializes it should hurt the bond market more than the stock market - but inflation is not a benefit to the stock market. The stock market would much rather see a low-inflation environment with moderate earnings growth, which is what we are in now, than a high earnings growth high inflation environment.
Despite these issues the market is hitting all-time highs. So what is an investor to do?
The answer is the same in a bull or a bear market. You try and keep the asset allocation in line with your individual risk-level, and try to continue to hold equities at the highest level you can bear. I think the best analogy is baseball. We are in the second half of the bull-market. I am not clear if it is the sixth inning or the ninth inning. All I know is that the bull market is more than halfway over.
We still have not seen the euphoria phase when caution is thrown to the wind and investors see equities as being risk-free. That stage is still coming, and we all know what stage comes after. Despite our knowledge that future market corrections and crashes are in the cards, you cannot make money timing markets. It simply does not work. Additionally, any valuation model - historical valuations, the FED model, a dividend discount mode, shows that the market is very clearly not over-priced or excessively expensive. Also, the market is below its inflation-adjusted highs reached in 2000. My gut feeling is again the bull market has farther to run.
Thus, my advice is that an investor should continue to hold equities but, psychologically, prepare themselves for a sell-off. When that sell-off materializes, it is extremely important that you maintain your current equity exposure. We know how the game ends. It ends with the stock market moving higher over multiple years. In fact, the market will likely double over the next decade.
During the upward trend over the next decade the market must experience some corrections and even a crash or two. As I have said many times, we are overdue for some selling. Do not be surprised when it materializes, and do not panic. Continue to hold stocks for the long-run.
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