Edge and Odds

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It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

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***EQUITIES VALUATION

The Rule of 20 Strategy Goes All Cash Again

July 16, 2020

The Rule of 20 Strategy moved to a 100% cash position as trailing S&P 500 EPS dropped abruptly as Q2 results started coming in pushing the Rule of 20 P/E to 24.2 at yesterday’s opening.

We have reached “extreme risk” levels on equity valuation (black line) while the R20 Fair Value [(20 – inflation) X trailing EPS] (yellow line) is in a clear downtrend as EPS are falling faster than inflation.

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The current environment is one of extreme valuation risk accompanied by deteriorating fundamentals. Either investors are totally oblivious to very negative basic equity parameters or they believe the current environment is unusual and/or temporary and valuations do not reflect intrinsic values and better upcoming earnings.

My sense is that both beliefs are in play: expectations of a “V” shape recovery and the desire not to miss this other “don’t fight the Fed opportunity” by inexperienced and momentum-driven people. When the economic expectations will prove wrong, the ensuing decline in valuations will be exacerbated by the crowd’s quick return to earth. Equity markets have this habit of declining much faster than they climb.

This chart shows periods when the Rule of 20 Strategy was all cash since 1957 (black line = R20 P/E). This truly is a “buy low/sell high” strategy.

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Since 1957, after the R20 Strategy dictated a 100% cash position, the S&P 500 Index offered negative returns to the next valuation cycle low 7 out of 9 times, shielding investors from severe losses averaging 23%.

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The Strategy was all cash during the dot.com bubble keeping investors out of this highly speculative, “irrational exuberance” period.

The only period when the Strategy really failed was between March 1991 and December 1994. However, the S&P 500 was unchanged until November 1991 while earnings declined 12%. EPS then surged 63% during the following 3 years while inflation declined 150 basis points, providing a sharp boost to the Rule of 20 Fair Value which skyrocketed 83% during the period. Overvalued equities were supported by the strong backwind provided by a sharply rising R20 Fair Value. Not quite the case now.

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NORMALIZING THE ABNORMAL

This is not a normal, Fed-induced, recession and the economy and financial markets are being strongly supported by governments and central banks around the world. There is thus a case for normalizing earnings. However, there are no rules for that nor are there any precedents to help us assess what “normal” profits will be post pandemic.

  • First, we do not know how it will evolve and when it will end (timing issue).
  • Second, we do not know what the economy will be like and how corporate America will look like when it eventually ends (revenue/margins issue).
  • Third, we do not know how the gigantic economic and financial support will be paid for (growth/taxation issue).

One way out is to calculate what earnings need to be for equities to trade at Fair Value which, in the Rule of 20, is arrived at by multiplying trailing EPS by (20 minus inflation).

If we assume inflation is 1.0% (1.2% in June), fair P/E would be 19.0. At 3220, we would need $169.50 in EPS to be at Fair Value. Current forward 12-month estimates are $143 but full year 2021 earnings are forecast to reach $163, essentially back to their 2018-2019 level.

On that basis, one could argue that equities are close to being fairly valued based on normalized earnings and that a large cash exposure is not warranted. Counter arguments are:

  • Any estimate currently is only based on hope that the world will return to normal early in 2021.
  • Most companies are unable to provide guidance given the uncertainty.
  • In a normal world, with normal growth, normal corporate guidance, forward estimates almost always prove too high, by some 10-15% in general.
  • The post pandemic world will be nothing close to normal (see THE DAY AFTER…).
  • The coming U.S. elections could materially change the financial outlook, particularly with respect to taxation.

In addition to the earnings risk, the assumption that equities will settle at Fair Value is not supported by history. The Rule of 20 P/E always over-correct one way or the other so it is safer to assume that the valuation downside risk is for the R20 P/E to cycle back to between 17 and 19 which, at 1% inflation, means a P/E of 16.0-18.0. Applied to the $169 low-probability estimate, we get a range of 2700-3050 for a 6-16% downside risk on not-very-solid earnings estimates.

WHAT ABOUT TINA?

Another argument in favor of high equity valuations is the abnormally low level of interest rates. The argument is that low interest (discount) rates boost the value of future cash flows while simultaneously keeping people invested in equities since There Is No Alternative. Counter arguments are:

  • The discount rate is also a function of the probabilities of achieving estimated cash flows. Any mid-to-long term forecasts at this time is subject to abnormally wide error factors which should tend to keep discount rates higher than normal.
  • If interest rates are abnormally low, it must have a little to do with the fact that growth is also abnormally low. If interest rates stay lower for longer, as the argument goes, they will probably reflect a slower for longer economic growth environment. Expectations for slower economic growth should normally translate into lower earnings growth and lower earnings multiples.
  • There have been periods of abnormally low interest rates before. These have not translated into higher equity valuation, at least per the Rule of 20 which very rarely exceeds 24.0.
WHAT ABOUT TECHNOLOGY STOCKS?

The increasing importance (weight) of technology and other acronym stocks in equity indices such as the S&P 500 Index suggests to some investors/strategists that equity markets are justified trading at higher multiples. Yes, but

  • These companies are growing fast because their superior technology enables them to grow faster than incumbents. The corollary is that these incumbents are growing at a rate slower than their historical growth rate which normally results in a lower multiple for these stocks that are still populating equity indices. If Amazon grows so fast gaining market share, its losing competitors are effectively slowing down and their stocks should attract lower valuations as a result.
  • One could argue that as incumbents disappear (and many will during the pandemic), growth will accelerate for the survivors. If the world returns to normal, that may be so for a short period but once all the weak companies are gone, overall growth has not changed and competition has effectively intensified among the remaining stronger players.
  • Maybe tech and acronym stocks are also overvalued as suggested by this chart from Ed Yardeni. Note that Ed uses forward earnings here:

  • Lastly, there have also been periods in the past when some sectors gained importance in equity indices as a result of their growth and rising domination. Yet, the range in the Rule of 20 P/E has been remarkably constant between 16 and 24 over time.

The Rule of 20 Strategy is not investment advice. It only serves to help us objectively assess valuation risk vs reward. It makes no forecast, only using trailing earnings and current inflation rates, applied on the historical norm that the Rule of 20 P/E normally fluctuates between 16 and 24 with 20 being the norm for Fair Value.

In this hopefully abnormal world, even normalizing earnings and multiples carries abnormal risks.

Mug Once on “Cheers!”:

Sam: “Beer, Norm?”
Norm: “Have I gotten that predictable? Good.

DANGER ZONE

February’s JOLT report revealed that job openings in the USA exceeded the number of unemployed job seekers by more than one million for an 11th consecutive month. This chart shows the sharp acceleration in openings throughout 2018 to levels well above actual hires.

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Here’s the YoY chart, far from suggesting that employers see any need to pullback. Openings are up 15% from last year, three times more than hirings.

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But the law of supply and demand has not been repelled just yet and compensation costs are clearly accelerating. This chart plots QoQ trends…

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…and this one charts yearly changes, the blue bars being the yearly averages and the red bars the end of year changes. We have crossed the 3.0% level and growth in wages and salaries is now comfortably exceeding inflation.

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This is good news for workers but a growing challenge for companies. S&P 500 companies were still growing revenues per share 5.0% in Q4’18 but that was sharply slower than the 8.8% average growth rate of the first 3 quarters of the year. Meanwhile, economy-wide business sales growth has precipitously dropped from the 8.0% range last summer to 2.1% in December along with retail sales and oil prices.

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S&P aggregate revenue growth, which excludes fluctuating share count, was 3.6% in Q4, an abrupt slowdown from 10% last summer.

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More charts warning of a possible revenue recession:

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This next chart plots nominal and real business sales growth, the latter now flirting with zero:

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Trends in corporate pretax margins closely correlate with business sales per dollar of wages (the last data point on margins, the red line, is Q3’18). Given what we know of recent business sales, inflation and wages, trends are no friends so far this year…

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Capacity utilization correlates nicely with trends in business sales…

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…and with profit margins:

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Analysts are currently assuming revenue growth averaging 5.2% during the next 4 quarters, in line with Q4’18, pretty surprising given that all of the above suggest continued headwinds concurrent with rising pressures on margins from labor costs.

The last time growth in business sales and S&P 500 revenues went negative was in 2015 when oil prices cratered from $105 to $30. While Energy companies revenues slumped 36% during 2015, non-Energy revenues grew only 1.0% on average. Current forecasts for non-Energy revenues for the next 4 quarters are +5.9% on average. This is down from the 7.1% average for 2018 but up from the 4.4% growth recorded in Q4’18 even though most economic indicators have been weakening so far in 2019.

Corporate pre-announcements have worsened in recent weeks as Refinitiv illustrates:

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There is also a sharp drop in U.S. business activity expectations as measured by Markit. At +29% in February, the net balance of companies expecting an increase in output is down from +38% in October and the lowest for two years.

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Markit says that “the drop in optimism has been attributed to uncertainty surrounding future legislation and trade wars, a tight labour market which is pushing wage costs up, increased competition from domestic and foreign firms, and the ongoing impact of tariffs which has led to increases in raw material prices.” Interestingly, and worryingly, Markit found that much of the increased pessimism is at service providers where “the net balance of service sector firms expecting a rise in business activity has dipped from +40% last October to +29% in February.”

This translates in “expectations of greater workforce numbers at their lowest since June 2017 and just below the series trend.” Also, “the overall net balance of companies that foresee a rise in investment (+8%) is the lowest for two years. In fact, it is also the second-weakest of all the countries monitored by outlook surveys (behind only the UK).”

These expectations are supported by Moody’s analysis of Core Business Sales (“business sales excluding sales of identifiable energy products”).

In a manner that warns of slower growth for 2019’s business outlays, the year-over-year increase of core business sales abruptly slowed from 5.3% of January-September 2018 to 3.5% of 2018’s final quarter. (…) The correlation between the annual percent changes of private-sector payrolls’ moving three-month average and core business sales’ moving 12-month average is a highly significant 0.86. Hiring activity cannot proceed independently of business sales indefinitely.

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These are not synonymous with a vibrant economy. Another example of weakening demand conditions is poor pricing power as revealed by Markit’s surveys: “the net balance of firms expecting to raise their selling prices fell from +23% to +12% in February, with both the manufacturing and service sectors projecting weaker rates of charge inflation.”

All in all, the net balance of companies predicting greater profitability (+26%) is the weakest for two years, with “reduced confidence around future profits largely emanating from weaker sentiment at service sector firms.”

FYI, the Service sector accounts for 77% of the U.S. economy, 86% of total employment and 80% of new jobs created in the past year.

Given all of the above, one would expect corporate executives to be in a cost-cutting mode to protect profit margins. Yet, data from Challenger, Gray & Christmas show that announced layoffs due to cost-cutting totalled 9,572 in January-February of this year, down from 12,204 last year. This suggests that the labor market is so tight that employers prefer to hang on their workers rather then find themselves even more understaffed or underskilled when the economy strengthens again.

Meanwhile, investors should be prepared for slow revenue growth and reduced operating margins, perhaps much more so than currently expected by the sell side.

Analysts are currently expecting Q1’19 earnings to decline 1.5% (-0.6% ex-Energy) but see a quick resumption to growth in Q2. Evidence at this time suggests that the recovery may not be as early and a string of negative earnings growth seems more and more probable. If so, trailing EPS will likely decline during 2019 from their current level of $162.86. The last time this happened, in 2015, equity markets trended down with high volatility. Current valuations are near “Fait Value” per the Rule of 20, much like in early 2015, but the risk is that Fair Value will edge lower in coming quarters. It declined 4.7% from March 2015 to February 2016, a period during which the S&P 500 Index retreated 8.2%.

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(…) the number of companies that are about to report falling first-quarter profits keeps going up. More than 200 firms in the S&P 500 are now expected to earn less than they did a year ago, data compiled by Bloomberg show. That’s a lot more than were in the same boat three years ago, a stretch generally viewed as the worst profit recession of the bull market. (…)

While the [expected earnings] decline isn’t as bad as the one at the worst point of the 2015-2016 contraction, its breadth is new. Back then, the whole drop had a single explanation: falling oil prices. Excluding energy producers, S&P 500 profit would have increased.

Now only three industries are forecast to show positive growth: industrial, health-care and utilities. Technology, the biggest group in the S&P 500, may report a 9 percent decline, while energy and materials companies each suffer a 15 percent drop. (…)

As much as bulls hope that the first-quarter deterioration will be transitory, history shows that profit declines tend to cluster. Since 1937, only 10 percent of the quarterly slides have lasted exactly three months, data compiled by S&P Dow Jones Indices and Bloomberg showed. In the 18 instances where profits fell by three quarters or more, all but four were accompanied by bear markets. (…) (Bloomberg)

Good time to review the portfolio, manage beta and prune investments in highly leveraged companies. Corporate insiders seem to be doing just that as Crescat Capital has found:

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U.S. treasuries have been marking time so far in 2019, while economic indicators have weakened. Slower growth and slower inflation could help repeat 2015 in that market as well.

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The rosy scenario is a trade deal with China that would quickly boost world demand. I do not doubt a deal, because both sides need and want it; I doubt a quick economic snap back however.

Contact: edgeandodds [at] gmail.com