***EQUITIES VALUATION

I generally prefer to value equity markets on actual trailing earnings, preferring facts to fiction. But we have to face the increasing possibility of trade wars given the unyielding rhetoric suggesting that Trump really means it, that he’s going to get it and that wars are always difficult to end after they really begin.

This is truly unreal when U.S. unemployment is at a 50-year low. And, given the amount of debt and the lack of dry powder across the globe, really nobody can afford a world recession which will more than likely come with a trade war.

Financial markets have so far dismissed the possibility that things will truly unravel.

Bur unless something positive happens pretty soon (without somebody losing face?), the discounting machine will start churning. This could well begin during the Q2 corporate conference calls as executives will need to inform shareholders of the potential impact that the numerous disruptions and cost increases could or will have on their business and financial results.

Then, economists, analysts and rating agencies will repeat “oh! my god” over and over again as they reassess the outlooks of each of these indebted consumers, companies and governments in a recessionary world with rising costs and widespread layoffs.

 

Some may keep sleeping well reading that Bank of America’s strategists estimate that a 10% increase in import costs from trade tariffs would reduce S&P 500’s per-share earnings by 3-4%. What’s the big deal?

But Barclays sees an 11% drop from an across the board 10% tariff.

I always discount such estimates that simply assume a static world. Trade wars would have worldwide repercussions on goods flows, business logistics and corporate and consumer confidence. Spending would freeze for a while as real people, corporate or not, would want to know when and how this mess would end. Remember, there are no savings (buffers) in this indebted world.

I really do not know how things will evolve from now on, but I know I have to start assuming the worst and discount the current beautiful earnings. For the first time since 2009, we have to think that a recession and a bear market could be in our near future.

Trailing earnings are currently $140.11, a number that would be close to $146.50 if we pro forma the tax reform for the whole past 12 months. Trailing earnings will increase to $146.70 ($151 pro forma) if current Q2 estimates are met.

So far, of the 137 corporate pre-announcements, 53 are positive and 72 negative, slightly worse than at the same time during Q1’18 and Q2’17:

But guidance did not worsen during June as the 12 additional negatives were almost offset by the 10 additional positives. So far, so good! But is this the calm before the storm?

The dependable Rule of 20 is now 21.0 on trailing pro forma EPS and 20.4 using pro forma EPS after Q2.

In normal times, this would be fair value with valuation upside (to 23) about equal to valuation downside (to 17). Strongly growing earnings would tilt confidence positively even with rising inflation bending the Rule of 20 Fair Value downward (yellow line above), something Q2 results will soon correct.

But this Trump era is nowhere close to normal times, even more so as we approach the trade war crunch time with little, if any, talks being held as far as we know. We must thus incorporate all this uncertainty in the valuation and discount the upside from earnings, inflation and valuation.

Unless trade war risks truly abate, equities are unlikely to get any valuation boost. If trade wars erupt, markets will immediately assume lower earnings and higher inflation. Valuation upside would thus be capped while the downside to 17 on the Rule of 20 P/E would gain credibility (S&P 500 down 19% to 2230), tilting the risk/reward ratio from valuation from roughly balanced to clearly negative. Add lower earnings and you likely get a true, potentially historic, bear market.

How lucky do you feel?

Allow me to offer some very relevant charts from Ed Yardeni. Keep in mind that recent forward earnings are boosted by the tax reform, the effect of which on the YoY rate of change ends after 2018:

All these charts bear watching.

With this, please allow me to go fishing this week.

Barron’s interviewed John Apruzzese, chief investment officer of Evercore Wealth Management in its May 7 edition (Who Says This Market Is Overpriced?):

Inflation is absolutely crucial for long-term investors. It’s the most important macro factor. Oddly, the market is stuck on the P/E ratio. When people talk about Treasuries, they don’t say that if a bond yields 2%, it is selling for 50 times the coupon. It’s upside-down. The conventional way of saying inflation is important is the Rule of 20, which is that the P/E plus inflation should equal 20. Why is that? It makes much more sense to think about the earnings yield than to use a reciprocal. Once you do that, it falls into place. You can take the earnings yield and subtract inflation and that’s the real earnings yield. (…)

That’s significant because people are looking at the CAPE [cylically adjusted P/E] ratio, which looks really expensive using the average of the past 10 years. Of course it does, because it includes 2008 and 2009. As soon as that rolls forward, the P/E falls. On the other hand, people might say the P/E isn’t that expensive relative to low bond yields. Inflation is related to bond yields, but bond yields are artificially low. For example, the 10-year Treasury should nominally yield GDP [gross domestic product] and be at 4%. But it doesn’t because it has been manipulated by the central bank. When bond yields return to normal, people will have lost the justification for the current P/E.

Today, on the real earnings yield, the market is almost exactly at its long-term average. (…)

“John has always focused on the core issues in investing,” says Ed Yardeni, chief of Yardeni Associates, another market bull.

Yardeni says that Apruzzese’s study of the real earnings yield “neatly incorporates inflation into a stock-valuation model. It’s a simple model that is easy to construct and comprehend, and it has a good track record.”

Apruzzese explains why he is using the real earnings yield (REY) model [E/P – Inflation] and not the simpler Rule of 20:

At low inflation levels, each percentage point by which the CPI growth rate increases will reduce fair value for stocks by just five percent or so under the Rule of 20.

Say inflation has been running at two percent, much as it has been lately. An increase to four percent would take fair value on stocks from 18 times earnings to 16, but it’s difficult to imagine such a muted reaction to that great a jump in inflation. By contrast, fair value would drop by the same proportion, from nine to eight, if inflation rose from 11% to 12%, even though the markets probably would judge such a move as far less significant than a doubling of inflation in a low-inflation environment.

(…) a more conceptually and mathematically rigorous adjustment that takes full account of inflation would start with the earnings yield instead of the P/E ratio and subtract the inflation rate. (…)

REY provides a full adjustment for inflation, without the distortion that results from subtracting the same change in inflation from different starting rates and therefore different fair values. REY will rise or fall by one percentage point with each decline or increase, respectively, in the inflation rate, no matter what the starting levels of inflation or the nominal earnings yield may be, providing a more accurate assessment of potential returns. (…)

Mathematically sensible (although debatable) but less useful in the real world. Judge by yourself:

The Rule of 20 is much more stable around its 20.0 average with a very useful symmetry around the average allowing for more dependable calculations of risk vs reward which is the ultimate objective.

FYI, here’s Apruzzese’s November 2017 paper A Reality Check for Stock Valuations.

Also FYI, LPL Research produced this chart in its April 30, 2018 Market Commentary. Notice how average P/E ratios plus inflation always total roughly 20.