This bull market will be known as the most unpopular in history. The bigger and older it gets, the least appealing it is, much like most of us… 

BAD BREADTH BULL

My friend Michel points me to a Nov. 27 FT article (Fangs and Nifty Nine power US equities) warning about the bad breadth that this equity market has had throughout 2015:

(…) Some talk about the Fang stocks — Facebook, Amazon, Netflix and Google — while Ned Davis Research refers to the Nifty Nine, which adds Priceline, Ebay, Starbucks, Microsoft and Salesforce. (Note that Apple appears on neither list.) If made into indices, research by the FT statistics group shows that either of these groupings would have gained about 60 per cent for this year, while the S&P 500 is up about 1 per cent.

Meanwhile, the equal-weighted version of the S&P, where each stock is given a weighting of 0.2 per cent, has fallen slightly for the year, even as the main cap-weighted index has risen. So, unusually, the average stock has failed to beat the index. Most US stocks are down for the year, even if the Fangs’ exploits have kept the main benchmark in the black. (…)

Goldman Sachs calculates that five stocks (AMZN, GOOG, MSFT, FB and GE) totalling 9% of the index cap have accounted for 100% of the S&P 500 return YtD. Without these stocks, the Index is down 2.2% this year.

But that does not mean that all the other 495 stocks were actually down. Remember that Energy is -15.4% YtD, Materials -6.4% and Industrials -1.9%, reflecting the widespread and sustained collapse in commodity prices and the strength of the USD. These 3 sectors contribute 27% of the S&P 500 Index number of issues.

In reality, four sectors are up and six are down this year, including Financials which are down 0.9% even though banks are +1.6%..

The other reality is that in spite of the drop in commodity and dollar sensitive stocks, 232 issues are up YtD and the top 50 are up 7.9%. This is in spite of massive flows out of U.S. equities throughout the year. The total outflow from U.S. equity funds totals $143 billion YtD, greater than the 2008 outflow when the world was falling apart!

So much for the bad breadth.

As a matter of fact, “market breadth, measured by performance and valuations, is well above historical trends” says RBC Capital with these two charts (as of end of October) as evidence:

But if you still smell bad breadth around you, Goldman offers a second breadth. The GS team has identified 11 periods with “exceptionally narrow breadth” and guess what, only 4 periods were followed with negative returns 6 months after and three 12 month after. It seems like this bull is not at its last gasp.

That said, smelly whiffs are indeed reaching us from time to time from several corners.

Michael Lewitt, author of The Credit Strategist, has a highly sensitive nose, able as he is to smell the “market internals”:

Investors continue to bid the prices of a select group of mega-stocks to unsustainable levels while most of the market experiences a stealth bear market. Market internals are terrible.

Try reading his listing of all the external smelly sources with a single breadth:

Commodity prices are plunging, the dollar is powering higher, the yield curve is flattening, ObamaCare is collapsing, global trade is plummeting and terrorism is spreading across the globe. The high yield credit markets are sending distress signals and 10-year swap spreads are negative. Energy companies are going out of business faster than you can say “frack” and trillions of dollars of European bonds are again trading at negative interest rates. The world is drowning in more than $200 trillion of debt that can never be repaid while European and Japanese central bankers promise to print more money and the Federal Reserve is being dragged kicking-and-screaming into raising interest rates by a paltry 25 basis points. Accurate pricing signals in the markets are distorted by overregulation, monetary policy overreach and group think. Hedge funds are hemorrhaging and investors, desperate to generate any kind of nominal return on their capital, continue to ignore the concept of risk-adjusted returns. Some market strategists believe this is a positive environment for risk assets; I am not among them.

Believe it or not, Lewitt omits this topsy-turvy situation:

Forget Going Public, U.S. Companies Want to Get Bought U.S. companies are dropping initial public offerings and selling themselves at the highest rate in three years, underscoring the gap between volatile financial markets and a booming merger business.

(…) All told, the dollar volume of U.S. IPOs this year has dropped 63% from the total in 2014 to $36 billion. At the same time, more than $2.3 trillion worth of merger and acquisition deals have been announced this year, a record pace that is up 46% from the total volume of 2014. (…)

At least 18 companies have stopped pursuing filed U.S. IPOs this year because they were being acquired, according to a Wall Street Journal analysis of Dealogic figures. That amounts to about 10% of companies that filed for IPOs and either went public or sold themselves this year.

That’s the highest share since 2012 and nearly double the rate in 2014, when the most offerings since the dot-com boom were completed, the analysis shows.

The figures could be higher since 2012 due to companies’ confidential IPO filings. That year, the Jumpstart Our Business Startups Act went into effect, allowing companies with under $1 billion in revenue to initially file confidentially for an IPO. (…)

Only seven times in the past 20 years have IPO and M&A dollar volumes diverged in this fashion, Dealogic figures show, with one category declining from a year earlier and the other rising. (…)

Of the last 20 listings through Nov. 20, more than half priced below their projected range, Dealogic figures showed. And the number of health-care and technology IPOs, often the deals with the biggest potential gains, has dropped 43% through Nov. 20 versus the same period last year, Dealogic figures show. (…)

Meanwhile, shares of U.S. public companies announcing acquisitions in deals over $1 billion have risen an average 2% the day after the announcement, according to Dealogic. That reverses an average 1% drop over the past 20 years.

To be sure, M&A gains appear to be slowing. For example, the 2% jump this year is down from a 3% jump in 2014 and a 4% jump in 2013. (…)

If there is bubble, it is in the M&A area. Evercore ISI calculates that over the past 22 months, there have been 1,483 deals over $1B totalling $8.4 trillion. I did the math for you: this is 67 deals per month, more than 3 deals per working day. Wanna be a short seller for a living? Better have long nails!

Back in early 2009, the world was much more fetid. In fact, it was downright repugnant. How in the world could that have been the birth of this great bull market? A generational low on valuation coupled with the onset of a huge earnings growth phase. Valuation and earnings. Where are we now on these two basic, overwhelmingly important variables?

To repeat myself:

Let’s assume the following environment for the next 12 months:

• World GDP will grow some 3.0%, China +6.5% and the USA +2.5%.
• Inflation will be close to zero.
• Oil prices will decline 40%.
• The USD will appreciate 20%.
• U.S. manufacturing will be in recession dragged by weak exports and depressed oil markets.

S&P 500 EPS in that environment?

Few would have said flat. Yet, they are flat YoY in Q315 with precisely that environment!

The earnings season is over and frankly, these earnings are remarkable:

• Cons. Discretionary: +15.1%
• Telecom:                   +14.7%
• Health Care:              +12.7%
• Financials:                 +  7.9%
• Technology:               +  5.9%
• Industrials:                 +  0.3%
• Cons. Staples:           –  0.8%
• Utilities:                      –   2.1%
• Materials:                   – 15.5%
• Energy:                       – 57.1%

With 2 important sectors down big time, total EPS are essentially unchanged (-0.8%).

With exports down and the USD up 20%, industrial earnings are flat!

Now, assume the USD and Brent are unchanged from their current levels and everything else is trend lined. S&P 500 EPS 12 months out?

Some clues:

• Ex-Energy, EPS are up 6.5% YoY. And ex-Materials, probably +7.2%. What can Industrials, Materials and Energy contribute without the USD and Oil headwinds?
• Factset digs deeper:

For companies (ex-Energy) that generate more than 50% of sales inside the U.S., the blended earnings growth rate is 10.1%. For companies (ex-Energy) that generate less than 50% of sales inside the U.S., the blended earnings decline is -2.1%.

The blended sales growth rate for the S&P 500 (ex-Energy) for Q3 2015 is 1.4%. For companies (ex-Energy) that generate more than 50% of sales inside the U.S., the blended sales growth rate is 4.7%. For companies (ex-Energy) that generate less than 50% of sales inside the U.S., the blended sales decline is -4.9%.

So,

• U.S. centric companies are increasing earnings 10.1% with revenue growth of 4.7% in a zero inflation environment and a 2.5% GDP growth rate.
• Other non-Energy companies have been able to keep earnings from falling more than 2.1% on a 4.9% sales decline given weak foreign economies, a 20% appreciation of the USD and declining exports.
• Any which way you look, margins keep rising! Cost discipline remains strong.

Next 12 months possibilities:

• U.S. economy improves enough for Fed to raise rates.
• Draghi keeps pushing.
• Abe keeps shooting.
• China keeps stimulating.
• Brent flat at worst.
• Copper et al flat at worst.

Current 2016 consensus: +8.3%

Doable.

In all, the earnings picture, even the all-inclusive picture, is not deteriorating much in this putrid environment. The fact is that developed world economies have become services economies, heavily skewed towards the consumer who strongly benefits from weak commodity prices. The divergence has been accelerating in recent years as these two charts illustrate (from Ed Yardeni and St-Louis Fed):

A manufacturing recession is no longer a big problem for the U.S. economy nor for the market:

So, for example, in the US, payroll employment in goods-producing industries accounts for only 14% of total payroll employment, down from 44% during 1943. During Q3, services accounted for $9.9 trillion (saar) of real GDP, while goods accounted for $5.3 trillion of real GDP. Since services-producing businesses tend to be less cyclical than goods-producing ones, this transformation should moderate the business cycle. (Ed Yardeni)

Energy, Materials and Industrials (EMI), which represent 21% of the S&P 500 Index, have had dismal EPS performances during this bull market without preventing total EPS from rising significantly, highlighting the strength of the other sectors:

Another way to illustrate this: average quarterly EPS for Energy, Materials and Industrials vs average EPS for all other sectors:

In addition to the huge outperformance over the entire bull market, notice how the “EMI” earnings flat lined after their initial cyclical recovery while the “Others”’ earnings kept rising and even surpassed cyclicals’ earnings. Based on current estimates for 2016, average “EMI” EPS could reach $5.60 in Q4’16 while “Others” are forecast to hit $7.86, up 19% from their current level. If such growth materialises, it will surely leave many bears breathless.

In effect, between Q1’11 and Q4’16, the EMI earnings will be down 18% while “all others” will have jumped 65%. This is the new normal in developed countries and investors are gradually recognizing it after the China euphoria. The weight of EMI stocks in the S&P 500 Index has been dropping constantly over the years, from 45% in 1979 to 29.5% in 1989 to 26.7% in 2009 to 21.5% currently. The damage these stocks do to the overall index in cyclical downturns is getting less and less significant.

Valuation is a perilous exercise, especially for investors who use forward earnings relying on economic forecasts which are either trend lined or otherwise resting on generally optimistic assumptions. It can also be hazardous to those who do not take the time to dig beneath the surface as was the case in 2009 (see my March 3, 2009 analysis S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years).

The absolute P/E on trailing EPS is 17.5, seemingly attractive when compared with the last 22 years (18.5 including two bubble periods) but it is clearly above its longer-term average of 13.7 since 1927 and 13.8 since 1983. It is not, however, in bubble territory. In an environment with little recessionary threat and minimal inflation and interest rates, a P/E of 17.5 TTM EPS can provide positive returns.

Market averages can be influenced by odd situations. Currently, the Energy sub-index is selling at 29x earnings, a huge premium to the overall market. This is because Energy profits are cyclically depressed. In such highly volatile industries, high P/Es are generally not indicative of excessive valuations, quite the opposite, in fact, as this CPMS/Morningstar chart shows:

Energy is 8% of the S&P 500 Index (14% in 2009). Its current high P/E contributes 2.3 points to the market P/E, about 1 P/E point more than it would on normalized earnings. One might therefore say that the market’s “true” P/E  is not 17.5 but rather 16.5.

The more dependable Rule of 20 P/E is 19.4, very close to the “20” fair level and, even though it is at the low end of its 2-year range, it is clearly not in buy-low territory. At such levels, it is best to be about “average invested” and beta cautious. The upside rests on equity markets rising well into overvalued territory (“rising risk” area: 21-23 on the Rule of 20 P/E) like they have done in every cycle since the 1950s. At 22, the S&P would be at 2400, up 15% from current levels.

The downside seems limited to the 1800 area, 17x on the Rule of 20 P/E, right where the S&P 500 recently bottomed. It had troughed at 18x in October 2014. This is a 10% downside from current levels.

Given the status of the domestic U.S. economy (i.e. a strong consumer), current inflation and earnings trends, the 15% upside potential against a 10% downside risk justifies a slightly above neutral stance on U.S. equities.

Meanwhile, it is important to monitor some of the key “market internals” such as the 200-day moving average, currently back on a rising trend.

And here’s another interesting moving average:

After all, it seems that some people don’t mind bad breadth…from a bull. In the end, a bull’s bad breadth remains preferable to a bear hug.