“In the short run, the market is a voting machine. In the long run it’s a weighing machine.” – Warren Buffett
Rule #1: Don’t fight the Fed.
Rule #2: Never forget Rule #1.
It appears that the Federal Reserve has succeeded. Low absolute interest rates around the world have created a stampede into risk assets, including US equities. Despite widespread fears over possible impending economic recession and a host of additional global concerns, the 7+ year-long bull market in US stocks (remarkable the 2nd longest on record) continues to advance. In the face of another quarter in which profits for the S&P 500 Index are poised to fall once again (extending a streak of declines set to match the longest earnings retreat on record) (1), stocks recently powered ahead to record high levels. The risk-on TINA (2) market appears to make more and more sense to investors…at least for now.
What is pushing stocks higher? Over the long run, only three factors ultimately determine stock prices: profits (earnings or cash flows), interest rates and sentiment. The Fed has done their part with interest rates (note that 10-year US Treasury benchmark yield recently hit an all-time low), adding tremendous support to stocks [Figure 1]. Market participants have chipped in helping overall sentiment, pushing bullishness to very positive levels. What about corporate profits?
The US earnings recession accompanying the current move higher in stocks has been a long one by any standard. S&P 500 companies have posted negative profit growth for 6 straight quarters, a stretch that has been exceeded only once since 1936 (the 7-quarter slump of 2007 – 2009) But while the lack of profit growth explains why the Index has displayed higher levels of volatility, the less-heralded shallowness of the earnings decline is critical to understanding the market’s overall resilience.
Measured by depth, net profits are down only 18% from their recent 2014 peak, a retreat that is less than half the size of the last three declines and well short of declines during the worst recessionary periods. Additionally, the current decline pales in comparison to the 18% average profit decline in recessions since 1936 (4). That goes a long way to explaining why we can readily recognize the recession in corporate profits but not a corresponding retreat in the overall economy.
Having said that, both future revenue and earnings growth estimates continue to be revised lower [Figure 2]. As a result, valuations have expanded dramatically as the anticipated re-acceleration of profit growth is pushed further into the future. Call it “profit confidence” but investor faith that earnings will rebound has pushed price-to-earnings multiples to over 25 times reported profit using standard GAAP accounting. Consequently, the S&P 500 Index now trades at a higher multiple than it has 90% of the time in the past 80 years (the average ratio over that time period is ~17 times) [Figure 3].
So far, the Federal Reserve has been investors’ best friend (see Rules #1 and #2, above) but at these valuation levels, the market anticipates a significant re-acceleration of profit growth and that will be required to justify aggressive investor expectations. In addition, despite what (so far) appears to be an isolated “one and done” increase in the Fed Funds rate plus tremendous success in calming the markets’ nervousness over expectations of future hikes, the Fed continues to lurk on the sidelines.
Is this concern discounted in today’s stock prices? Does it really matter? Of course, we don’t know for sure but if history is any guide, we can tilt the odds of future out-performance in our favor by keeping history in mind: only one recession in the last 100 years+ has not been accompanied by some form of tightening of the Fed Funds rate. (5)
In the interim, uncertainty surrounding higher rates, the upcoming election and post-Brexit fallout appear to be overwhelmed by the anticipated positive effects of improved employment, low levels of inflation, near-record low interest rates, a weaker US dollar, slowly rising commodity prices and stabilizing corporate profits. All-in-all, economic growth appears to be steady and stable. Factoring in recent economic data releases as well as current profit trends, earnings estimates should begin to move higher, helping justify current valuations.
In essence, stocks are now essentially muddling through, waiting for an inflection to occur in earnings. But given current valuations and the rising risk of a resumption of the Federal Reserve rate hike cycle, caution is warranted. More specifically, we believe heightened focus on client capital preservation is a top priority and are striving to achieve this objective by: 1, lowering overall risk levels in portfolios through a reduction in exposure to above average equity volatility, 2, paring asymmetric (unattractive) risk/reward profiles in fixed income holdings and 3, allocating un-invested capital to cash (when possible).
Our fundamental research-driven, long-term opportunistic investment process is grounded in a strategically disciplined and patient approach. Timing and price are ALWAYS important, even more so during periods of quasi-irrational behavior. Of course, we will make mistakes (as all investors do) but we recognize that controlling the risk associated with those mistakes is absolute critical to long-term out-performance. When the markets present a limited number of new attractive investments, we are not afraid to sit on our assets.
- S&P Dow Jones, Bloomberg
- *There Is No Alternative*
- Evercore ISI
- MKM PartnersResearch