After over a year without a more than 3% correction in the S&P 500, surely it is a matter of time before something wobbles and equity markets react. To be fair, the market has had plenty of reasons for moving into a more corrective period in recent months. Geopolitical issues appear to be much graver than in recent years, the US administration has so far failed to pass any substantive policy measures and the Fed has continued to tighten policy. To date, nothing has mattered to equity investors, with the S&P seemingly on the verge of a melt up (according to some commentators).
It seems to us that the main reason to justify buying equities is that, with interest rates so low, there is simply no alternative. When the likes of Warren Buffett assert that equities are cheap relative to bonds, surely enough said. Another reason to be positive on equities is because earnings are growing fast again, and forecasts predict growth continuing in double digits. There is some truth in these assertions, and also a lot of hope, in our opinion.
On the corporate earnings front, there are various ways that earnings can be measured. Companies naturally like to paint their performance in the best light, and so produce what are known as “pro forma” results which excludes some costs which are deemed as one off and can include some extraordinary gains/income as if they were ordinary. On the basis of what companies want us to believe, using data from S&P, trailing 12 month earnings have grown by 18% year on year. At $115.92 through the second quarter, that leaves the market on a price to earnings ratio of about 22x.
So growth looks strong and although the market looks a bit richly valued, it is not bubble like. Furthermore, as can be seen, on both a quarterly and trailing 12 months basis, earnings are an all-time high, having recovered from the energy driven slowdown in 2015/16.
Chart 1 – S&P 500 pro forma earnings
When we look at earnings as measured under generally accepted accounted principles, the profile is not that dissimilar, in that earnings are growing strongly again. However, on this basis, earnings are not at an all-time high and have not grown at all since Q3 2014. Using GAAP earnings, the market trades on a price to earnings ratio of about 25x, not so attractive.
S&P 500 GAAP Earnings
Another way to consider earnings is using the data derived from the national accounts. The quarterly GDP numbers include corporate earnings and we show this measure in chart 3 below. Although the picture is not dramatically different in terms of general profile, we would point out that there really hasn’t been that much growth since 2012.
Chart 3 – After tax profits as per national accounts
So, the earnings picture is definitely improving, and yet when stepping back, the improvement is modest since 2014 when using company data, or even 2012 if using national accounts data. The real story for the bulls though is that the market performance has exceeded that justified by earnings in the last 5 years of so, as can be seen in chart 4.
Chart 4 – S&P 500 and trailing 12 month GAAP earnings
What we have illustrated above on the earnings front is well known in the market. However, we think that the real unknown for some, and what Wall Street doesn’t really want to talk about, is that financial engineering has massively distorted the earnings numbers.
It is estimated that companies have bought back $3.8 trillion of their own shares since 2009. This financial engineering does not change the Dollars and Cents that a company earns, but by reducing the share count, does increase the earnings per share growth. It is estimated that this financial engineering accounts for 70% of the growth in earnings since 2012, and that earnings over the same period would have grown by about 7% rather than 24%, if we strip out the effect from financial engineering.
Given all of this financial engineering, how much trust should investors give to any earnings based market valuation technique? Wall Street may want to present the market in the most favourable light they can, and even then, the vast majority of pundits will admit that the market is expensive on these measures. So, they will then try and say that compared to low interest rates, the market is reasonable value, and if all else fails, they will say that there is simply no alternative to equities in a zero rate world.
We would also like to point out that looking at earnings alone is only part of the picture. For the last 5+ years, companies have been borrowing money to buy back their shares, with chart 5 below (courtesy of SocGen) showing how total corporate financing has exceeded cash flow.
Chart 5 – Corporates outspend cash flow
Another way of illustrating the disconnect over the last 5 years is seen in chart 6 (again courtesy of SocGen) which illustrates Corporate net debt and earnings before interest, tax and depreciation. Yes, there are some companies with massive cash piles, but actually, these are the tiny minority. The fact is that there are many companies now that have stretched balance sheets, where earnings growth is not strong (again, there is a select few that are enjoying a greater share of the corporate earnings pie), and for whom the next recession could be (will be?) devastating.
Chart 6 – Corporate Net Debt and EBITDA levels
And this is why the little wobble in credit markets in the last couple of weeks could be so interesting. A deterioration in the credit markets is a great leading indicator of poor equity market performance (see chart 7 below). Not only that, but with credit spreads driven to such tight levels as investors search/reach for yield, there is frankly little upside if financial markets remain benign, but significant downside if a recession were to occur in the next year or so.
There is a glaring anomaly in the chart below, in that the widening in spreads in 2015 and early 2016 did not lead to an equity bear market. It did cause a 13% correction, but given the deterioration in the credit market, should we not have expected a larger downturn in equities?
Chart 7 – S&P 500 and High Yield spread over Treasury yield
We think there are a couple of issues with the 2015 period. First, the deterioration in credit markets was concentrated in the energy sector which was reeling from the collapse in the oil price. Removing the energy sector would make the widening in spreads less dramatic. But more importantly, we have to remember that the central banks felt the need to intervene heavily in early 2016 to yet again back stop the system.
So where does that leave us today? Well, if you squint hard enough at the chart above, you can see a slight uptick in high yield spreads in the last couple of weeks. This is occurring at a time when the Federal Reserve is raising interest rates and embarking on balance sheet reduction (n.b. despite saying they would reduce the balance sheet by $10 billion per month in Q4, the balance sheet is actually slightly larger today than it was at the end of September – the Fed may have some catching up to do here, which could marginally impact markets). Not only that, but as shown above, the corporate sector is more leveraged than ever before, both in nominal terms and as a % of GDP, and the picture is worse if we strip out those companies with significant cash balances.
We have also shown above how companies are having to borrow money to buy back shares, and the whole situation is becoming very circular. Easy Fed policies have encouraged massive corporate borrowing to buy back shares, which has boosted the equity market. Low rates would no doubt allow this to continue, but the Fed is raising rates now. Higher interest rates will reduce cash flow for many companies and may make financial engineering less attractive, but this would also reduce share buybacks which could then remove a strong underpinning of the equity market.
We could be entirely wrong here, but our position is that, excluding the small group of tech companies that have massive piles of cash, the average company has a much weaker balance sheet than before the last crisis, and is therefore vulnerable to tighter Fed policies, and ultimately a recession. Not only would a recession be devastating for corporate cash flows and earnings, share buybacks will be dramatically reduced as companies hunker down, both financially and by cutting other expenses, such as jobs. Job losses would also be devastating to consumers (we’re talking here about the majority – let’s call them the 90%, and not the upper 10% who have benefitted the most during the post GFC recovery). Simply put, the US corporate and consumer sectors are massively interest rate sensitive now.
Chart 8 – Consumer credit as a % of GDP
In a worst case scenario, the Fed tightens policy too much, and we head into a repeat of 2008. In the best case scenario, global central banks ace it, and exit the extreme policies they have been pursuing since the GFC, without upsetting the financial markets whilst both the private and public sectors deleverage. Now, if the markets were reasonable value, then perhaps the potential risks of holding equities through this very delicate policy normalisation process would be a good bet, but we simply don’t buy into the narrative that earnings is an appropriate way to value the market at this juncture. At the very least, sensible investors will be cross checking valuation against some non-earnings based measures.
With so much financial engineering, the earnings picture has just become too distorted, and takes no account of the increase in corporate debt since GFC. So, we prefer measures such as price to sales, which as can be seen in chart 9 is within just a few per cent of the all-time high in 2000.
Chart 9 – S&P 500 price to sales
The fact is, the US equity market has rarely, if ever, been more expensive than it is today, and the vast majority of companies are more indebted than before the last financial crisis, and therefore sensitive to rising interest rates just at the time when the Fed continues to tighten policy. The market can go higher, but this may just encourage the Fed to continue tightening in the belief that overall financial conditions remain benign. But when the turn comes, it could come very swiftly, and investors should be on the lookout for warning signs.
We said last week that we felt the canary in the coalmine would well be emerging market bonds, but the same applies to the corporate bond market as well. If this deteriorates further in the weeks ahead, it will become increasingly harder for the equity market to ignore. Furthermore, the higher the Fed raises rates, the more vulnerable the corporate sector becomes, and the potential for negative feedback loops to occur for both the financial markets and the real economy.
Ultimately, we strongly believe that now is not the time for investors to be over committing to equity markets. Soundly based models are indicating that returns over the next 10 to 12 years will be near zero in nominal terms; over the next 7 years, negative in real terms. It is also rational to expect periods of volatility in the years ahead; most likely including a bear market. We also think that it is reasonable to believe that central banks will make some sort of policy error as they try and normalise (history illustrates they always do). As always, timing the market remains incredibly elusive, but we do believe that investors should be looking at the credit and emerging market bond markets as these historically have been great leading indicators.
Stewart Richardson
RMG Wealth Management
