THE SITTING BULL

From its January 26 high of 2866 to Friday’s close of 2580, the S&P 500 has corrected exactly 10.0%. Just a normal correction within a bull market or the beginning of the end? Let’s look at the evidence systematically and objectively.

EARNINGS

Earnings are the lifeblood of equities, “the indispensable factor or influence that gives something its strength and vitality”. Earnings are strong, tanks to

• a good economy that provides healthy revenue growth,
• continued corporate focus on cost control that provides rising operating margins and to
• tax reform which provides an automatic boost to 2018 net profits, contributing about one third of the expected 19.6% EPS growth for S&P 500 companies.

The evidence on the economy remains good near the end of the first quarter. There are no serious signs of recession for 2018 (per even the most cautious economists and strategists and per the Leading Economic Indicators) and the recent PMI surveys all point to rising new orders in both manufacturing and services sectors in North America, Europe and Asia.

The main risk lies with the U.S. consumer who has seemingly pre-spent the 2018 tax savings and finds himself with virtually no savings to absorb any setback, right when the Fed is rising interest rates, the price of oil is up 70% from its June 2017 low and overall inflation is threatening to squeeze real incomes.

There has never been a recession without the LEI turning negative. That said, Steve Blumenthal reminds us that “there have been 13 Fed interest raising cycles in the last 70 years and 10 of them landed us in recession. The other three were mild economic slowdowns, but we weren’t then in this much debt.”

Rising interest rates generally have their most significant and immediate impact on the housing and automobile sectors. They have both lost momentum in early 2016, right after the first FOMC rate hike.

Nonetheless, total business sales remain healthy against 2% inflation while inventories have been kept under control.

S&P 500 companies grew revenues 7.3% YoY in Q4’17, a sharp acceleration from +4.5% in the previous 4 quarters (with all 11 sectors accelerating). These trends are currently expected to continue in 2018. However, the consumer (28% of direct S&P 500 revenues) could decide to restore its savings and Tech revenues (12%) could slow much more than forecast during a trade war with China.

The leadership from Financials and Technology companies is particularly strong during 2018. These 2 sectors account for 40% of the S&P 500 Index, 42% of total earnings and 46% of the expected growth in S&P 500 earnings in 2018.

The risk to 2018 earnings is limited thanks to tax reform but margins could get squeezed by slower revenue growth, accelerating wages and other costs (e.g. transportation) which generally lurk up so late in the cycle.

In all, the environment remains earnings positive with little, if any, current evidence pointing to a meaningful slowdown in S&P 500 earnings growth. The first quarter is coming to an end and corporate guidance remains upbeat, giving credibility to the expected huge 18.4% gain in EPS with the first releases starting in about 2 weeks.

VALUATIONS

It is generally best to measure equities based on the hard facts of trailing earnings. Tax reform is changing this for 2018 and it makes good sense to adjust trailing EPS by the expected tax savings provided by the new tax law. Working with the widely accepted 7% accretion, trailing EPS are currently $142.30 on which analysts are presently adding 11% more earnings on a 6.6% revenue growth forecast for the year. Interestingly, and perhaps worryingly, this expected scorecard of +6.6% revenue growth leading to +11.0% EPS growth ex-tax reform is a copy/paste of 2017 results.

At 2580, the S&P 500 Index is selling at 18.1x adjusted trailing earnings. Some pundits will see this as quite reasonable against the 18.5 average and median of the last 25 years. But this ratio is significantly boosted by the 1998-2002 period when P/Es averaged 26.1.

The more stable Rule of 20 P/E (actual P/E + inflation) has corrected back to its “20” long-term median using adjusted trailing earnings of $142.30 which means that equities are currently fairly valued on a risk/reward basis: the 15% upside potential from valuation to 23.0 is equal to the downside from valuation to 17.0, give or take one or two valuation points on either side at the extremes.

There are 2 components to the Rule of 20 multiple: earnings and inflation.

When inflation rises, the fair P/E decreases proportionately and vice versa. The jury is still out on inflation in 2018 but recent evidence is pointing to upward pressures from extended resource utilization 9 years into the cycle. As 2018 progresses, the race will be between growth in profits and growth in consumer prices. If profits meet the current full year bottom-up forecasts of $158.00, the S&P 500 index sells at 16.3x forward EPS. For the Rule of 20 P/E to be at the 20.0 fair value, inflation could rise to 3.7%, double its current reading! If inflation is 2.5% by year-end, fair P/E would be 17.5 which would mean 2765 on the S&P 500 Index assuming $158 in EPS.

So we have the Rule of 20 P/E sitting on its long-term “20” fair value level, right when the S&P 500 Index is, once again, sitting on its 200-day moving average which is still rising smartly.

Valuation-wise, probabilities of upside are now balanced with downside risk with a pretty strong earnings backwind which could get further validated when the Q2’18 earnings season begins in mid-April.

That said, further upward moves in inflation and interest rates would complicate the outlook given the weak consumer and poor balance sheets.

It is true that bull markets don’t die of old age. Yet, this bull seems more and more worried about its deteriorating environment. Thanks to strong earnings and tax reform, it may have enough vitality to keep going, but its repeated sitting sessions are a warning of accumulating fatigue and increasing anxiety. Portfolios should be constructed with lower beta companies sporting above average balance sheets and free cash flows.