Stocks are behaving as I expected. On Jan 18 I highlighted “valuation levitation,” writing “the market senses that, with rates so low and dividends set to keep growing, investors could decide that stocks deserve a materially higher valuation despite slow economic growth, recession in Europe, Barack Obama in the White House, etc.” On March 6 I noted, “We may well exceed the current year-end targets of bullish strategists, of around 1600.” Since then four or five strategists have raised their targets. When the bears finally capitulate and raise targets, it may be time to take some profits.
Inexpensive versus 2004-2006, When Rates Were Much Higher
I keep hearing pundits gravely declaim that we are in a “stock market bubble” engineered by the Fed. They are dead wrong. Stock prices are up a lot, but so are profits. Since the end of Q1 2009, stock prices are up 94% but profits are up 88%. Valuations are very reasonable and still lower, by 1 or 2 PE points, than their 2004-2006 average:
- The S&P 500 PE on trailing pro forma EPS is 14.9x versus a 2004-06 average of 16.9x.
- The S&P 500 PE on forward pro forma EPS is 14.0x versus a 2004-06 average of 15.1x.
The average 10-year Treasury bond yield, 2004-2006, was 4.5%, or over twice current levels. So investors are not valuing stocks as though yields will stay at 2%, which means that when yields rise there is no reason for stock prices to fall.
Plus ca change, plus c’est la meme “jobless recovery”
The misperception that we’re in a stock market bubble is understandable because: A) Bernanke has cut short rates to zero and is aggressively buying bonds, B) Stocks are doing well while the U.S. economy has 7.7 % unemployment. This situation seems weird but is actually normal. Back in 2009 we correctly predicted that we were likely to have yet another weak “jobless recovery” made worse by Obama’s regulatory onslaught, but stock prices would rise nonetheless, with everyone wondering why profits and stocks were rising when the economy was weak. So it has come to pass.
We are in a replay of the “jobless recoveries” that followed the 1991 and 2001 recessions, when unemployment was distressingly high for extended periods, the Fed drove short rates to surprisingly low levels, but profits recovered and stock prices soared. Economists should do more research on why, starting with the 1991 recession, employment has been so slow to recover. One factor is globalization; during recessions companies cut costs by shifting operations overseas, so when demand recovers it is met with production in China and Mexico, not Ohio and Illinois.
Profit Scorecard—Bottom-up versus Top-down
You need a scorecard to follow Wall Street’s take on profits. The Street has two estimates of S&P 500 EPS — the “bottom-up” estimate reflecting analysts’ estimates for 500 individual firms, and the “top-down” estimate of strategists, which is based on macro variables. It is widely assumed on the Street that analysts are too bullish and, as the year progresses, will cut their estimates toward the strategists’ top-down figure. Because it is generally assumed the bottom-up number is too high, it is not bearish if it gradually declines. Currently the U.S. economy is doing better than expected, and the bottom-up estimate is trending lower from $115 six months ago to below $112. Meanwhile strategists are raising their numbers modestly, to $108-110, implying profit growth this year of around 5%. If we hit that figure and profits look set to grow again in 2014, it will be positive for stocks.
Positive Message from the Early Reporters
A few years ago we started to analyze results of companies that report earnings in the third month of the quarter; these “early reporters” provide clues as to how good or bad the upcoming earnings season will be. Now several Wall Street firms monitor early reporters. (Thanks for the imitation; I’m flattered.) What the early reporters reveal now is that Q1 earnings reported in April will be fine but not super-strong. Fifteen major firms reporting over the last couple of weeks divide into three groups:
- Five (Costco, Nike, Discover Financial, Adobe, and Dollar General) had genuinely strong results. My takeaway: the U.S. consumer is in decent shape despite the tax hikes.
- Three (Oracle, FedEx, and Jabil Circuit) were quite poor. However, two reflect problematic business models, not weak demand. Oracle is losing share to cloud-based software providers and FedEx is hurt by customers opting for slower but cheaper shipment methods.
- Six were basically in line with forecasts—Factset, Williams-Sonoma, Lennar, Tiffany, Darden, and KB Home.
These results and decent U.S. macro data suggest that first quarter profits, and guidance for the second quarter, will be reasonably good. But with the dollar strengthening and Europe’s recession hurting multinationals, results will be only good, not great.
Not Straight Up; Beware Euro-pain
I have no opinion on near-term stock prices. Consult your local astrologer. But after a big move up investors have big profits to protect, so a 5% dip could occur at any time. As I have warned in the past, the most likely trigger is Europe, where we see an ever wider and more dangerous chasm – between jobless voters in Portugal, Spain, Italy, Greece and now Cyprus (can France be far behind?) and a bumbling, disjointed, fragmented elite in Brussels and Berlin that is focused on austerity and political integration, not economic growth.
Copyright 2013 Thomas Doerflinger. All Rights Reserved.
