Last week was not good for S&P company earnings. S&P’s estimate for Q4’14 EPS dropped 3.6%. Of the 69 companies that reported last week, 21 (30.4%) missed their estimate compared with only 17% of the 321 companies that had already reported. Big misses were in Consumer Discretionary and Staples, Financials, Telecoms and Utilities. As a result, S&P’s beat rate dropped to 69.7% at the end of last week from 72% the previous week and 74% in Q3’14.
Importantly, trailing 12-month EPS are now $113.04, down $1.00 (0.9%) from one week ago. Given estimated EPS for Q1 and Q2’15 ($26.88 and $29.20, down 1.6% and 0.5% YoY respectively), trailing EPS will decline another 0.5% to $112.46 after Q2’15.
More worrisome are the negative trends in some key sectors. A more complete analysis will be needed once the earnings season is passed but, with 390 companies in, we can see that Consumer Staples EPS are -11.7% YoY, Financials -8.7% and Industrials +6.3% slowing from +8.4% and +13.9% in Q3 and Q2’14 respectively. These are not healthy trends in 3 sectors that account for 44% of the non-commodity sensitive companies in the S&P 500 Index. Excluding Health Care and Technology companies which can often dance at their own beat, nearly two-thirds of the fabric of the U.S. equity market is showing weakness lately. The same worrying sector trends are visible in the S&P 1500 Index, indicating that the nascent problems extend beyond the larger companies.
Equity valuation is stretched to the point where we need unbridled optimism to reach much higher levels. The S&P 500 Index P/E on trailing EPS is truly in “sell high” territory unless you expect a repeat of something resembling the internet mania (click on charts to enlarge).
But this time is different, isn’t it? Interest rates are so low that higher multiples are justified in this world backstopped by the major central banks. Well, that did not quite happen in the late 1940’s when 10Y Treasuries last flirted with 2.0%, did it?
In truth, inflation jumped from 2% in early 1946 to nearly 20% in April 1947 before getting negative between May 1949 and June 1950. Here’s how the dependable Rule of 20, which takes inflation into account, behaved during these highly volatile years:
If you had bought equities in 1946 when high P/Es “could have been justified by low interest rates”, you would have suffered a 21% setback to May 1949…By contrast, in 1946, the Rule of 20 was screaming “sell”. Three years later, it was screaming “buy”, just before equities took off for a 300% ten-year bull market.
The Rule of 20 P/E is bumping against the “20 fair value” level. It has done the same several times since late in 2009, in fact 4 times since December 2013, uncharacteristically refusing to traverse into the higher risk area like it traditionally has done in the past before the ultimate market peaks.
Unlike the actual P/E, the Rule of 20 P/E is not at its past normal cyclical high of 22-23, leaving upside potential to the more daring investors. Actually, since trailing EPS are not expected to rise until Q4’15, investors need rising multiples to push prices higher during the next 12 months. Can the ongoing deflationary bout, potentially morphing into outright deflation, provide enough impetus to earnings multiple? After all, if inflation declines from the current 1.5% to zero as many expect, fair P/E under the Rule of 20 P/E rises from its current 18.5 to 20.0, justifying 2282 on the S&P 500 Index, 9% above its current level.
Using round numbers, 2300 seems to be the best we can hope for during the next 12 months given flat earnings. This would take the actual P/E to 20x. The last time this occurred other than in a mania was in 1992 when EPS were rising rapidly. It also occurred in 1961 as investors joined in the Kennedy euphoria. The young, charismatic President quickly loosened monetary policy and boosted the economy after several difficult Eisenhower years. The euphoria lasted until December 1961 when the P/E reached 22.4x (23.1 on the Rule of 20). The 24% slide in the following 6 months brought investors back to reality and P/Es back to 15.6x (17 on the Rule of 20).
Investor anxiety currently lacks no feeds. Will Draghi succeed with the eurozone economy? Will Merkel succeed with Greece and Russia? Will China stop its growth slide? These are all well known risks but their respective, almost binary, outcome is not.
One significant unknown is the combined impact of lower energy prices and the rapid rise in the U.S. dollar. The positive effects of lower energy prices are well understood and anticipated. What investors may be failing to appreciate is the effect of the meaningful decline in import prices other than energy stemming from the sudden and sharp rise in the U.S. dollar as world investors boost their dollar exposure and other countries actively devalue their currency.
The end result is a rapid drop in prices seriously threatening profit margins given the acceleration in wages and the forthcoming rise in interest rates.
The dollar’s 20% appreciation since July 2014 is already having a big impact on U.S. import prices which have declined at a 4.9% annualized rate between September 2014 and January 2015 excluding petroleum prices. In January alone, import-ex-petroleum prices dropped 0.7% or 8.7% annualized. This chart from BloombergBriefs illustrates the tight relationship between the dollar and import prices, suggesting that the latter will continue to decline rapidly in 2015.
The following charts dig a bit further, showing selected U.S. import prices from certain countries:
We all know that declining import prices benefit U.S. consumers. What most people have so far failed to grasp is that competitive forces dictate that domestic producers also cut their prices to remain competitive with imports. The ensuing deflation hits revenues (revenues = sales volume X price changes) for all corporations other than service providers. With wage costs rising 2-3% and a low unemployment rate, corporations have limited means for trimming costs, bringing the margin squeeze that bears have been predicting for over 5 years.
These trends may well explain the puzzling weakness in U.S. retail sales in December and January. Sales volumes have been pretty good but sales deflation restrained total revenue growth well below what the energy windfall suggested.
Doug Short illustrates this with retail sales ex-autos slowing to +1.7% YoY in January, a big slide from +2.1% in December and +3.8% in November.
Where did the oil windfall go? The sharp rise in restaurant sales is well known but it cannot be the end of the story. Americans are actually buying more, but retailers are not feeling it because of the recent sharp goods deflation.
The effects of sales deflation is well known to retailers such as Best Buy which has been struggling for years to grow volume and cut costs to offset ever declining selling prices in electronics. As the table shows, Best Buy et al. are not done swimming upstream as their principal wares have been deflating at accelerating rates lately.
Sales deflation is now hitting everywhere. New car prices are just beginning to feel the devaluation heat but that will likely accelerate in coming months.
Only services will be spared, not facing much foreign competition. Services account for some 60% of the U.S. CPI and their steady inflation is masking what is happening to the goods segment. Given recent sector inflation data, core goods which constitute the bulk of core retail sales, are experiencing annualized deflation of close to 1% in recent months and are now down 0.8% YoY.
The most recent trends in producer prices reveal that retail deflation is only beginning. Core PPI for final demand goods, which was rising at a 1.9% annual rate during the first 9 months of 2014, was unchanged in Q4 and declined 0.2% in January. In the middle of the production pipeline, PPI for core intermediate processed goods declined at a 4.5% annual rate in Q4, accelerating sharply to -16.8% in January, after rising at a 2.0% annual rate during the first 9 months of 2014. The PPI for unprocessed core goods cratered at a 19.3% annual rate in Q4, dropping another 0.7% MoM in January.
Another way of tracking price trends building up in the manufacturing pipeline is to watch the PPI by stages of production flow. The BLS tracks prices during production stages from 1 to 4. The last 3 months clearly show the deflation trends building up at the manufacturing level with January being the first month on negative prices for the final stage of production.
This sales deflation is creating a margin squeeze for goods producers and retailers. Their costs are largely influenced by the overall CPI, mainly wages which have been rising at a 2.0-2.5% clip lately. When sales inflation is much different than cost inflation, margins are impacted. During the last several years, sales inflation exceeded cost inflation but this is quickly reversing.
This is happening when U.S. exports, accounting for 14% of GDP, are stalling due to the higher dollar. U.S. export prices ex-petroleum are down 3.7% YoY in January. The PPI for Goods for exports Ex-food and energy has dropped at a 6.1% annualized rate in the 3 months to January 2015. Exporters are also getting pinched by deflation.
In all, unless sales volumes rise strongly, the long awaited downturn in corporate America’s margins may be finally occurring, right when most people have given up forecasting it.
As the Factset chart illustrates, analysts are simply extrapolating margins beyond the short-term oil downdraft in Q1’15.
The surprise could be double: revenue growth will miss the 4.2% expectation for the average sector excluding Utilities, Materials and Energy in 2015 as the inflation component is morphing into a deflation component; secondly, margins estimates will also prove excessive as costs cannot be ratcheted down enough. This combination will weigh heavily on corporate profits and the 9.2% average growth rate currently expected for S&P 500 sectors other than Utilities, Materials and Energy will prove much too optimistic. This is particularly true for sectors like Consumer Discretionary and Staples, Technology and Industrials. Service-oriented sectors such as Financials, Health Care, Construction and Housing will likely escape the squeeze.
In all, 2015 is shaping up like a year of nasty surprises for equity investors who have never experienced deflation. This is happening when valuations are historically high and as the FOMC debates when to begin the inevitable interest rate normalization process. There is no more central bank backstop available and a Republican-controlled Congress will limit any fiscal stimulus.
At best, this will be a market of stocks where service providers will outperform goods producers and retailers. At worst, this will be a difficult stock market as investors reassess the overall lofty valuations accorded to corporate America. The lonesome cowboy sure has a strong currency, but it may not be good for profits.
And God forbids a Chinese yuan devaluation…
I have been positive on U.S. equities since March 2009. I have occasionally warned of strained valuations and excess optimism but I never felt that equities were near anything other than a temporary correction. When earnings were showing signs of flattening, or when valuations appeared lofty, lower inflation and/or central bank interventions were there to save the day. My equity exposure has remained above neutral for the last 6 years.
In August 2014, I gave U.S. equities 3 stars out of 5, my lowest rating since March 2009 (THREE-STARRED EQUITIES):
Using 25% probability of a 15% correction and a 75% probability of reaching 2150 before March 2015, the weighted outlook is +4% (5-6% total return) on the S&P 500 Index.
In my January 21, 2015 Swan Lake post, I argued that energy deflation was good for the economy given that past periods of declining oil prices haven’t dragged core prices down.
Under the Rule of 20, with core inflation at 1.5%, fair P/E is 18.5x or 2142 for the S&P 500 Index. (…) Given that earnings ex-energy continue to rise at a decent 5-10% rate and that energy stocks are near their lows (Facts & Trends: “Buy Low” Time For Oil), it seems a good bet to stay at the table and see how things evolve in coming months. (…) In all, this equity market does not seem ready to deliver its swan song.
The black swan is now with us in the guise of significant and widespread currency devaluations, negatively impacting U.S. exports, but also collapsing U.S. import prices and forcing domestic goods producers and retailers to cut prices to remain competitive.
The Rule of 20 says that fair value is 2100 with core inflation at 1.5%. It would theoretically rise to 2300 with zero inflation but it seems unreasonable to assume zero inflation and stable or rising earnings in the same equation in the current environment.
Downside? Five percent to the 200-day m.a. of 1986, 12% to the October lows (1840), but potentially more if earnings tumble. Given the very limited reasonable upside, I am moving to a below neutral equity position.