Even some of the very best can find facts that fit their views.
Monday, to convince his readers that the current booming earnings may not necessarily prevent equities from falling, currently bearish David Rosenberg wrote
I keep telling anyone who wants to listen that on the eve of the October 1987 meltdown, year on year earnings growth was 50%.
My perplexed gray hair immediately sent me a startled message: “Really? We don’t seem to recall that. Do you?”.
Here are the facts:
Trailing S&P 500 Index earnings ranged between $14.52 and $14.85 throughout 1986, rose to $15.86 by September 1987 and kept accelerating to $17.50 by December on their way to their $25.22 cycle peak of June 1989.
Earnings thus were barely rising for most of 1987. By the end of the Q2 earnings season in August, they were up 3.9% YoY. The growth rate reached 20.9% by December and did actually hit 50% but only in June 1988. My bet is that Rosie misread a chart or a table.
Q1 2018 earnings are now expected to jump 24.6%. YoY growth rates exceeding 20% are rather rare events, especially well into the economic cycle and absent high inflation.
Since the 1950’s, the 20% growth rate threshold was reached 11 times, three of which were during the high inflation seventies (FIFO accounting inventory profits helped) which, unsurprisingly, were the only occurrences followed by poor equity returns given the low earnings quality and rising inflation. Equities struggled a little in early 2004 when inflation suddenly accelerated but managed to gain 5% to February 2005.
The other 7 times when earnings momentum reached +20%, equities rose 10% and 20% (rounded averages) during the following 6 and 12 months. All but one of these periods saw stable or declining inflation.
The only time when equities rose strongly after earnings had risen 20% and inflation was accelerating was …in 1988. Even though inflation went from +3.9% to +5.4% between May 1988 and May 1989, the S&P 500 rose 22.5% as earnings won the race against inflation with YoY growth averaging 38.2% during this 12 month period.
Not to conclude that equities cannot decline given the strong earnings, however. In May 1988, the actual P/E was 12.7 vs its current 18.0 (well above its long-term median of 13.7). The Rule of 20 P/E (which takes inflation into account) was 16.6 vs its current 20.1 (right on its median).
So! What to do?
On the one hand, sentiment, technicals and earnings tracking say go…on the other hand, rising inflation and interest rates, high volatility, so-so valuations, sell in May and go away say no…
- This highly volatile market is not comfortable. People are obviously nervous about interest rates, inflation and profit margins amid an apparent cost push cycle.
- But valuation has improved to a neutral Rule of 20 P/E while earnings are truly booming thanks to a lot more than tax reform. Overall, margins are still rising even excluding tax reform.
- Technicals are not negative per the EMA and the 200d m.a. (holding and still rising) and per Lowry’s analysis (favorable supply/demand and breadth).
- We got sentiment back on the plus side but it is very volatile.
Sentiment and technical factors play on the short term volatility of equities. Fundamentals dictate the medium to longer term trends: inflation and interest rates are currently troublesome so late in the cycle (oil, wages, commodities and a tightening Fed). But profits are very, very strong and are not showing peaking signals just yet. Based on current evidence, profits will be winning the race against inflation and interest rates for at least another 3-6 months and we have yet to get negative signals from credible recession indicators.
The S&P 500 Index has declined 7% from its January 26 peak of 2866 (it actually corrected 11.8% from top to bottoms reached Feb. 9 (2529) and Apr. 4 (2547)). Since then, trailing earnings have increased 13% from $128 to $145 (tax-reform adjusted) and seem set to reach $152 by mid-summer after Q2. This is a very powerful backwind from the most fundamental variable for equities: profits.
The headwinds are rising inflation and interest rates, impacting earnings multiples. Inflation is up from 1.8% to 2.1%, a 16.7% advance while interest rates are up 30% (3m bills) and 25% (10Y Ts) since yearend.
And we have a fragile consumer with little savings, slow real wage growth, rising fuel prices and a tightening Fed.
And we have a highly indebted corporate America facing rising interest rates through 2019, hoping the fragile consumer keeps consuming and costs remain manageable.
But we also have tax reform which provides a bounty of cash to profitable companies and strong fiscal incentives to boost capex, do M&A and/or buy back equities (share repurchases for the quarter were up about 34% vs Q4’17, and up 43% YoY, based on the 25% of S&P 500 companies filing quarterly reports so far, according to data from S&P Dow Jones Indices).
In all, this does not look like a cycle end just yet. Maybe the best scenario would be a slowing economy leading to contained inflation and a more cautious Fed. Corporate America has shown it can grow profits in a slow-mo economy.
Cautiously positive. But also read TOPSY CURVY: SMALL IS NOT THAT BEAUTIFUL