Equities trade on earnings.
But what earnings?
Not as trivial a question as it seems. In 2016, Capital IQ’s GAAP EPS were 12.3% lower than Cap IQ’s operating EPS, themselves being some 12% lower than Facset’s, Thomson Reuters’ and Morningstar/CPMS’s numbers. Differences narrow during 2017 but Cap IQ’s GAAP EPS remain 10% lower than other measures.
In effect, an investor using Capital IQ’s EPS currently sees the S&P 500 Index as more expensive than one using other aggregators’ numbers, even more so if using GAAP EPS.
Purists will advocate only using earnings based on Generally Accepted Accounting Principles (GAAP), available since the mid-1980s per a SEC rule, on the basis that such earnings cannot be manipulated and are thus the true earnings of a corporation in a given year. There are several problems with this but the main one is that, in reality, equities don’t trade on GAAP earnings.
- Since 1988, the correlation between the S&P 500 Index and GAAP EPS is 78%. With Capital IQ’s “operating” EPS, the correlation is 89%. Since 2003, the correlations are 71% and 90% respectively.
- During recessions, GAAP earnings become even more meaningless because of widespread write-downs since companies are required to carry assets at the lesser of cost or value based on current circumstances. In 2008, the humongous Q4 write-downs brought total GAAP earnings down to –$23.25 on the S&P 500 Index, bringing full year earnings to $14.88, down 78% from $66.18 in 2007. In 2000-2001, the drop was 51% while in 1990-91, the decline was 25%.
- Another example is the effect of the significant decline in Energy companies’ earnings following the recent collapse in oil and other energy prices. GAAP results for the Energy sub-index totalled –$36.15 in 2015 and 2016. Not only energy equities never traded negatively, these huge losses severely impacted total S&P 500 GAAP earnings which declined 18.4% from peak to trough even though most other sectors were enjoying rising earnings.
While it is true that some companies periodically abuse the system and trick “operating” earnings, the various aggregators are able to correct excess creativity and provide investors with aggregate earnings that comply with the notions of operating profits and realistic operating earnings power.
Personally, I follow 4 serious independent aggregators: Capital IQ, Thomson Reuters, Factset and Morningstar/CPMS. These groups comb each and every quarterly statements and compile aggregate operating results that are consistent with the past and across industries. As the chart below shows, data from Thomson Reuters, Factset and Morningstar/CPMS are pretty similar.
Capital IQ is a little more conservative on certain items such as pension expenses and asset write-downs and can be different at certain periods even though, over time, its operating earnings have generally been very similar to others. I have also plotted total economy-wide earnings from the national accounts (NIPA).
Here’s the same chart with data indexed at 1994=100 illustrating the validity of S&P 500 “operating” earnings as a good reflection of total economy-wide profits. Over a period of 20 years to 2014, operating earnings from TR and Capital IQ were identical (98.4% correlation) and within 2.7% of NIPA profits (95.8% correlation). The recent drop in energy prices widened the gaps but they are closing as 2017 progresses.
Investors looking at valuation models should thus be aware that models currently using Capital IQ data tend to overvalue equity markets by 10.6% using operating EPS for 2016, 7.8% using trailing EPS but only 3.0% on the full year 2017 as the gaps close during the second half, based on current projections. Obviously, if one uses GAAP earnings the overvaluation is 10% larger and gives you scary charts like this one showing absolute P/E ratios back to 1880 (courtesy of multpl.com):
However, the biggest problem arises when one uses the CAPE model, also known as the Shiller P/E. This admittedly very scary next chart is currently prominently displayed by everybody with a negative bias on U.S. equities:
What people should know about CAPE:
- CAPE only uses “as reported” earnings. However, companies have only been required to provide GAAP earnings since the mid-1980s. In prior years, there was only one set of data which is also referred to as “as reported” but which has really nothing to do with the current reported “as reported” GAAP earnings. In effect, there are two different types of data in the CAPE historical data set: “as reported” EPS prior to the 1980s and “as reported” EPS under GAAP thereafter.
- Therefore, historical “as reported” earnings are not as “clean” as purists may think. Accounting and accounting standards have evolved considerably over a century. As an analyst in the 1970s, I had to thoroughly comb financial statements and the few related notes to uncover “unusual” accounting treatments and calculate true earnings and returns. The tendency then was generally to enhance earnings through liberal use of accounting rules (and other tricks for some even more liberal companies). If widespread, as one would imagine and as my experience demonstrated, this resulted in historical PE multiples actually being deflated by creatively enhanced profits. Since the 1980s, “as reported” earnings are generally reduced by GAAP measures, resulting in generally inflated P/E multiples. So, even though CAPE uses “as reported” earnings over its entire history, the data is not as clean, pure and consistent as implied.
- Contrary to what many purists assert, the difference between GAAP and operating earnings is not huge and is not worsening. In fact, there is a lot more consistency since 2003 and other than in recessionary periods, the spread between operating and GAAP earnings is within a rather narrow and consistent range.
- Index earnings are derived by adding together, dollar for dollar, the results of each Index company without regard to their respective market weight. During Q4’08, some 80 companies representing 6.4% of the S&P 500 Index, reported losses totalling $240 billion or $27 on the Index. AIG alone subtracted $5.13 to the Index earnings even though its weight in the Index was only 0.02%. Wharton professor Jeremy Siegel estimated that on a weighted basis, S&P 500 Index profits would have been nearly 80% higher.
- The CAPE at 30 is misleading being calculated on the average GAAP earnings of the last 10 years which include the truly miserable 2008-09 write-downs by AIG et al.. Many of these companies are no longer in existence but their humongous losses continue to drag down Shiller’s 10-year average. More recently, the collapse in energy prices caused Shiller’s trailing 12-month EPS to decline 18.4% during the 2014-2016 interval, a period during which operating EPS per Thomson Reuters and others actually declined only 3.7% on average.
- As a result, Shiller EPS remain 10.8% below their peak level while all three other aggregators have EPS 2.3% above their peak on average.
- While this 13% spread in earnings trends is significant, the other important fact is that the trend in Shiller’s 10-year average is restrained because of the two unusual earnings declines in 2008-09 and 2015-16. CAPE may be a scary 30, but it is measured against “cyclically depressed” earnings, meaning that the YoY growth in the 10-year average earnings is currently a low 57%, in the 8th year of the recovery.
- Interestingly, as we start to shed the humongous losses of 10 years ago, Shiller’s 10-year average earnings will rise 20% through 2019 even if quarterly earnings remain unchanged throughout the next 30 months, and another 10% over the following 7 years, again keeping quarterly profits unchanged during the next decade.
Equities also trade on yearnings.
While equities are not outrageously valued, they are nonetheless on the pricey end of the range.
As we approach September and October, the two most dangerous months of the year, amid the DC circus, little hope for anything meaningful from the Trump government to help this rather slow economy and an uncertain Fed, corporate America’s amazing capacity to keep growing earnings is very welcome.
As is the recent declines in inflation rates: headline, core, median, sticky or not, name it, they all peaked YoY in February are are all down in sync since.
Equities thus have two critical backwind providers: rising earnings and slower inflation rates. This when valuation measures are on the high end of the range and when many other signs of market tops surface, creating more confusions, keeping everybody either cautiously bullish or nervously bearish, or vice-versa…
Hence the need to rely on objective and rational benchmarks like the proven, stable and dependable Rule of 20.
The Rule of 20 says that fair value for the S&P 500 Index is [(20 minus inflation) x trailing operating EPS]. Simple and straightforward with no forecast. And it works. The correlation between the Rule of 20 “fair value” (yellow line) and the actual level of the S&P 500 Index (blue) is 91% since 2003, 93% since 1988, 97% since 1957 and 98% since 1927.
The black line oscillating around “20” is simply a measure of the gap between the calculated “fair value” and the actual level of the Index transposed into a Rule of 20 P/E, with “20” being “fair value”. Below and above the 20 line, equities are increasingly good value or poor value respectively.
It is not a forecasting tool, rather an objective measure of the current over-undervaluation of equities versus the calculated “fair value” (mean) level. As is obvious from the chart, valuation always, eventually reverts to its historically stable mean of 20. The spread between actual and the mean is an objective measure of the current risk/reward potential, allowing investors to rationally allocate their capital according to their own particular risk aversion profile.
The current reading is that “fair value” is 2301 [(20-1.7) x 125.74], 7.0% below the current level of the S&P 500 Index (2475). Another way to look at it is to add the current P/E on trailing EPS (19.7), add inflation (1.7) to get the Rule of 20 P/E (21.4) which is 7% higher than 20.
So far this cycle, the trend in valuation is very much along its historical pattern of going from undervaluation to overvaluation. We know the cycle will eventually reverse but nobody knows when and how. All we know is that equities are 7% above their fair value, not outrageous but on the wrong side of the range, where equities can remain for long periods of time as can be seen on the upper long-term chart chart.
However, we also know that “fair value” is on the rise thanks to rising EPS and declining inflation rates. This generally keeps equity markets buoyant even when valuation is not favorable. Absent signs of a coming recession (Fed tightening to fight economic excesses), the backwinds supplied by rising earnings and slow and/or declining inflation can sustain periods of overvaluation. Since March 2017, the Rule of 20 Fair Value has risen 9.5% on a 6.5% gain in trailing EPS and a decline in inflation from 2.2% to 1.7%. The S&P rose 4.4% during the period. As a result, the Rule of 20 P/E declined from 22.3 to 21.4, reducing the calculated downside to “fair value” from 11.3% last March to 7.0%.
- By most conventional measures, equities are overvalued, ranging from a moderate overvaluation (Rule of 20 @ 7.0%) to “obscene” overvaluation (e.g. CAPE @ 30).
- Late cycle features are numerous and rising in numbers as the cycle gets older and older.
- However, there are no signs of recession in the foreseeable future and no real reasons for the Fed to engineer one given the rather sluggish economy, moderate wage growth and subdued inflation trends.
- So this rather old cycle nonetheless remains pretty healthy economically and financially. This is confusing people used to “call the cycles” as time is no longer on their side. Mean reversion is not automatic when no strong Fed medicine is required.
- Meanwhile, corporate America keeps delivering good revenue growth, steady to rising margins and surprising profits. Equity bears continue to get confounded as mean reversion has yet to materialize on profit margins. This unusual elongated economic cycle makes the profit cycle much more resilient compared with past “normal” 4-year waves.
- So far, there is just enough confusion out there to prevent the bulls from completely taking over and bring valuations to really dangerous levels per the more dependable Rule of 20 gauge. There is little doubt that if no good correction happens, greed and capitulation will naturally take valuations to really extreme levels, no matter the economic and financial conditions.
- In the meantime, it is crucial to keep a close eye on the following indicators:
- Corporate margins must hold since many current valuation measures are highly dependent on current high margins. So far in 2017, margins keep rising. Historically, most periods of declining margins were during recessions.
- Inflation trends: the Fed, and most observers, are confused by this extended low inflation era. But equity markets feed on it knowing very well that it keeps the Fed friendly.
- However, deflation scare could come back.
- Politics!!! Greed and fear feed on optimism and pessimism. Right now, we are all stunned by what’s happening in Washington and frustrated by what’s not happening in Washington. But we must remember that this bizarre but nonetheless business-friendly government could change radically 15 months from now.
- Market technicals: given the huge money flows into ETFs, a change in trends can easily and rapidly feed on itself and bring about a significant correction even in the absence of deteriorating fundamentals. There is leverage out there and Joe Public is increasingly involved. Once ETF dynamics get into reverse, Joe and other Algos of this world may not understand what’s happening and panic/machine selling could ensue and be rather nasty.
It is important to understand that the Rule of 20 measures the downside risk to its current calculated “fair value” level (Rule of 20 P/E of 20). Fair value is not necessarily ground floor; equities can, and often do, overshoot for a certain period of time for reasons mentioned above. Fair value is also not static being dependent on earnings and inflation, two dynamic variables.
I moved to 2 stars in March 2016 at 2031 on the S&P 500 Index when the Rule of 20 Fair Value was 2081 and declining under weaker EPS and rising inflation. Fair value declined to 2017 by July, but then inflation peaked and EPS troughed. Fair value has risen 13.6% since, in line with the S&P 500. In effect, the overvaluation is currently the same as one year ago but EPS are rising rapidly and inflation is lower and seemingly quiet.
The S&P 500 trailing 12-month EPS are up 10% in the last 12 months and seem set to reach $132 for the full year. On that basis, assuming inflation remains around 1.7%, fair value will reach 2415 by early 2018.
In all, time is on investors’ side because of the friendly Fed (slow growth, slow wages, slow inflation) and because of the dynamism of corporate America. CEOs and CFOs are clearly focused on costs and margins and keep delivering the goods. There is little sense in telescoping potential problems when there is little evidence that the economic cycle is about to end.
Markets have also been unusually calm amid a rather uncertain world political environment, chaos in DC and a potentially confused Fed. Comfort or complacency, or both?
In truth, I feel like an equilibrist standing still on a tightrope. I know I might fall but I am only 7 feet above ground and there is little wind to really bother me. I fell good. But I worry about the quality of this old rope. If it breaks, I fall on the floor which, although only 7 feet below, could prove weak and who knows where I could end up.
Given my age and personal aversion to risk, I maintain a 2-star rating, keeping equity exposure somewhat below neutral and focused on income and financially solid companies.