Our Perspective on Q3 2015

October 20, 2015by Hoy Grimm0

Stock Valuations Near the End of the Economic Cycle

How do we know when the market is expensive?

We compare a company’s stock price to the profits (EPS – earnings per share) and assets of the company that create value for shareholders. Using these fundamental comparisons – Price to sales, price to book value, price to earnings and debt to sales, we can compare the current valuation of a company to previous points in history.

How expensive are stocks right now?

Based on the current S&P 500 estimates for 2015 of $110.60 the S%P 500 index is valued at 18 times current earnings. This valuations contains an estimate for the last three months of 2015 of $30.21 in earnings per share. If this prove sot be optimistic, then the Index is trading at greater than 18 times earnings.

How did the market get expensive?

When stock prices rise in expectation that earnings will rise, but they don’t…

 

[blockquote author=”John Butters, Senior Earnings Analyst, Factset“]

“For Q3 2015, the blended earnings decline is -5.5%. If the index reports a decline in earnings for Q3, it will mark the first back-to-back quarters of earnings declines since 2009.”

[/blockquote]

 

Earnings are declining and it has become a trend not a bearish forecast. They will continue to decline until demand materializes from somewhere. If earnings decline and demand doesn’t arrive, stock prices will fall under intense scrutiny.

Will earnings get better?

To answer this question, let’s look at what corporate accountants do to increase earnings per share.

  1. Work to increase the company’s revenue and sales which should help EPS.
    1. Bring new products to market that are in demand
    2. Raise prices that customers pay

 

  1. Make an acquisition to increase sales, revenue and profits

 

  1. Reduce expenses
    1. Reducing production costs by modernizing equipment or building more efficient production facilities
    2. Reduce employee headcount (layoffs), wages, and benefits
    3. Refinance company debt to lower borrowing costs.
    4. Cut dividend payments to shareholders

 

  1. Reduce the number of shares outstanding so that earnings are calculated over a smaller share count.

 Revenue growth is stalling out so profit margins are coming into focus. 

“In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. – Warren Buffet

 

S&P 500 Profit Margins are nearing 10% (Silverblatt)

It is likely that profit margins will revert back to historical levels. This will reduce earnings and put more pressure on the cost side of business. As a result, companies are reducing wages and benefits.

Once accountants exhaust the profit nudge from reducing employee wages and benefits, they reduce hiring to essential personnel only:

“The U.S. economy created 142,000 jobs in September, a number that missed expectations and could cool expectations that the Federal Reserve will start raising interest rates soon.
Unemployment held at 5.1 percent, according to the Labor Department. A separate member that includes those who are working part-time for economic reasons or have not looked for employment fell to 10.0 percent.
Economists had been expecting the report to show 203,000 new jobs, from the downwardly revised 136,000 in August (from the originally reported 173,000).”

If a slower rate of hiring doesn’t help increase profitability, the accountants issue lay-offs to existing workers.

Companies have exhausted their ability to artificially manufacture EPS gains. They are now left with the reality that they are reliant on consumer spending to grow. Increasing revenue requires that a company can create demand for their products and services. Demand requires 4 conditions to materialize before a sale happens:

  1. Products that are needed by customers
  2. Discretionary income available to purchase
  3. Access to credit to finance purchases that exceed income
  4. The willingness to part with income or to take on debt to fund a purchase

Lately, even high wage earners have seen their incomes stagnate:

 

 
Stagnating wages inevitably lead to reduced spending.
The feedback cycle kicks in:


Source:  Survey of Consumer Expectations,  2013-15 Federal Reserve Bank of New York (FRBNY).

 

What happens when investors realize that the market is expensive and want to get out?

Overbought conditions that change quickly create a lopsided effect as investors head to the exits in unison. The exit can get very crowded in a hurry. This massive Chinese traffic jam is a visual example:

 

Here is a description of the physics behind these situations:

When this happens — when all the cars are traveling at close to the same average speed because of the vehicle density on the roadway — they become highly dependent on one another. A physicist might compare the relationship to the correlated motion of electrons in metals, which gives rise to weird phenomena like superconductivity.

Highly correlated traffic means that a tiny perturbation — a butterfly flapping its wings, or a single driver braking unexpectedly — will send little ripples of corresponding slowdowns through the entire chain of cars behind him/her. That’s one reason why slowdowns and traffic jams occur most commonly at merge points, especially exit and entrance ramps, or when lanes are closed due to road construction. 

Sound familiar? The exit can get crowded with investors selling to cash but also speculators who used borrowed money to leverage their gains as the market increased. These margin investors have increasingly added to the borrowing balances since 2009:

While the total amount of margin borrowing is eye-catching, sudden reversals of margin usage are more important. These reversals signal a shift in momentum that can lead to the crowded-exit phenomenon that leads to panic selling and excessive price declines.  

 

Summary

None of the circumstances we described here are new or secret. In fact we have been warning clients about these conditions for more than a year. Why should investors take heed now? With the summer decline in foreign stock and bond markets, investors have other options to consider besides selling domestic stocks and sitting in cash. Chris Brightman (aptly named, by the way) published an excellent article that outlines the valuation discrepancies between emerging markets and domestic markets.

You should read it and digest his analysis.

Investors have no excuse to ignore domestic economic weakness and domestic stock valuations. They have cheaper investment options to rotate into and reduce risk.

 

 

Hoy Grimm

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