Our most significant investment premise is that investors are overpaying for earnings growth to a degree we see as highly problematic over time once it becomes clear that current valuations price in expectations that are quite unrealistic. This thesis is more meaningful for us than our view that as a general rule equities are wildly expensive.
Keeping in mind that earnings growth over the last few years has been underwhelming to say the least, it still would likely come as quite a shock if net income comparisons were to broadly turn even slightly negative. With that said, the current drivers of global growth, especially the mind-blowing debt-induced frenzy in China, will eventually bump up against limits by virtue of basic math and known policy changes, putting pressure on corporate profitability.
Three scenarios have worked against our core premise. First, the median equity valuation has increased further into extremely overvalued territory and now resides at well over twice normal levels. They are now above 2000 and 2007 bubble peaks by 40%-50%. Also, value stocks have lagged growth stocks by over 15% this year. Thirdly, tech stocks have been quite strong all year and we simply haven’t found much value in the sector. Within the tech sector, a few market darlings are driving returns.
We do think value investing will still work over time even as some prominent practitioners of the craft have expressed doubts as indexing and automated-investing have become even more popular. We have seen this same angst late in prior bull markets and know that value won in the end.
As mentioned earlier, tech stocks are dominating returns this year. In October, they accounted for about 75% of the S&P 500’s gain. Year-to-date, tech stocks have accounted for about half of that index’s return.
The environment of today should not be confused with what used to be considered normal mostly because of extreme central bank involvement across the globe for nine years. In spite of these supposedly stimulative benefits, GDP growth has run about half of prior cycles and earnings growth has been challenged for years.
If you want to surprise someone touting the wonders of this year’s earnings results, you might mention that the trailing twelve-month GAAP earnings for the S&P 500 through the third quarter of 2017 are running at about $107 versus the last peak of $106 in late 2014. That’s not a lot of growth over three years! Earnings for that index have been bumping between about $80 and roughly $100 for years. It’s astounding to think how much more investors are paying for that $1 of earnings since 2014!
Even the “fudged” operating earnings numbers that ignore negative items for the S&P 500 are coming in about 5% below the expectations crafted before Mr. Trump was elected. Holy narrative-crushing facts, Batman! In spite of this, investors have thrown caution to the wind by chasing a shrinking group of stocks while cash on the sidelines and volatility reside at historically low levels.
Reality can set in rapidly. GE’s stock has now been cut in half as it resets expectations under new management. We don’t expect it to be the only company to do this. That this could happen to such a widely followed company exposed to many of the industries that have driven growth in this cycle is instructive for those who may think risk is dead.
Leveraged stock buybacks and earnings “management” can only go so far. Only a few months ago, many well-informed GE investors and analysts were expecting annual earnings to soon hit $2 and now the new CEO just guided to close to $1 and cut the dividend in a big way.
Importantly, as we have highlighted as a major risk in past posts, the corporate bond market has recently become much less friendly. That bears watching and confirms the darker picture painted by the flattening Treasury curve and declining breadth in equity markets. Also, it does seem as though investors are at least paying attention to credit measures in stock land, particularly since new tax cut proposals are not debt friendly.
Optimism over tax cuts has been a driving force in markets this year. If Congress is willing to risk hoodwinking voters with overly rosy promises of more take-home pay in order to give tax cuts to corporations, we may see some actual legislation in coming months. However, we expect that anything passed will be pared back versus current proposals and will not be in any way a game-changer for growth or earnings.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.