My last post was quite awhile ago – January 14, 2014 to be exact. Why the hiatus? I’ve had nothing novel to write about. My rationale for commentaries is to produce quality insights (if I can) rather that to push out as much prose as possible.
Back then, I took credit for predicting the fall in energy prices. If I don’t congratulate myself, who else will do it? I also said the following worried me some:
Two problems I can identify. Should the P/E on current earnings remain constant? Part of the current valuation is biased by future earnings expectations. Based on estimates I’ve seen the forecast for 2015 remains about $120. Expectations are adjusting downward quickly, which in my experience influence valuations negatively. It is also inevitable (human nature) that revisions will overshoot due to our propensity to overweight recent events. Put an 18X multiple on earnings of $99 takes us back to closer to an 1800 target on the S&P 500 – at least a 10% correction.
Although it didn’t get down to 1800, it got pretty close as you can see from the graph.
Once that was out of the way, I saw nothing to keep the market from moving toward my earlier target, on an estimated $120 of ‘peak’ earnings divided by a ‘normalized’ risk adjusted 5% discount rate = 2400. And here we are today at 2185. Do I see another (roughly) 10% upside from here? It will depend (as others who write about these things are saying) on earnings and expectations. According to most research sources the estimated earnings for the next 12 months is pretty much the same as it once was for the current year. For example, the earnings corresponding an 18.57 PE would be about $118. But since the trailing PE is nearly 25X earnings, we remain far short of that potential still.
Some concerns that came from the July FED policy meeting minutes (just published) also worry me:
However, during the discussion, several participants commented on a few developments, including potential overvaluation in the market for CRE, the elevated level of equity values relative to expected earnings, and the incentives for investors to reach for yield in an environment of continued low interest rates.
Overvaluation in commercial real estate and high equity valuations are not as bad as the last item – not only are investors blindly reaching for yield (disregarding risk), many are also perfectly content to lock in current low yields for long time periods. When things look too good to be true, they usually are in my lengthy experience. The question isn’t what can go wrong, but rather what else can go right?
A strategist I respect (and have quoted frequently) has this to say today:
We estimate sequential earnings growth of 11.8% in Q2 on a quarter/quarter seasonally adjusted annualized basis. We expect Q3 will show positive year/year growth of about 2%, but this positive momentum will not be apparent until the earnings season begins in mid-October. (from the Wednesday, August 17, 2016 Investment Strategy by John Aitkens, of TD Securities )
In other words, there could be good news on the earnings front, but it won’t be evident for a few months. Do investors right now have more faith in corporate America that is warranted?
What worries me (and clearly worries the FED also) is that the market has been resilient despite disappointing earnings thus far this year. And why keep postponing the inevitable rate increase? All the economic news certainly justifies a rate hike – Europe now has inflation rather than deflation, and according to the US Bureau of Labor Statistics “Real average weekly earnings increased 0.6 percent over the month due to the increase in real average hourly earnings combined with a 0.3-percent increase in the average workweek.” They also reported: “On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers was unchanged in July after increasing 0.2 percent in June.” Like a deer in the headlights, the FED is hesitating. But the committee also knows that if it doesn’t move soon, things won’t be pretty.
If the FED waits too long, this (see graph, illustrating a disquieting trend since it was published in the Financial Times earlier this year) will only get worse and derail both financial markets and the economy.
Bottom line, we’re screwed if the FED does act sooner rather than later, and we’re really screwed if it doesn’t act. Either way it’s hard to imagine interest expense not putting downward pressure on earnings. Corporations used debt to buy back stock, make acquisitions aggressively and hike dividends. Have they gone too far? Once laden with liquidity, the reverse may now be true. We’ve seen many companies announcing cost cuts already – even without higher interest rates.
Anecdotally, this announcement (there have been so many) came out today concerning CISCO:
The 5,500 job cuts would present 7% of its total workforce. That’s a much lower number than the 20% layoff some reports suggested Tuesday afternoon, but still one of the largest job cuts in Cisco’s history.
Cisco expects the next quarter to show -1% to 1% year-over-year revenue growth and EPS of $0.58-$0.60. Analysts are expecting actual revenue to decline 1.6% and EPS of $0.60.
Although the company actually reported better than expected earnings, the stock went down on this news – the cost cuts, despite good earnings, just might be a hint that the company is preparing for potholes on the road ahead.
If S&P 500 earnings at best will be only $100 over the next 12 months (still an improvement over where we are now) then even if my discount rate doesn’t change it means a target of 2000 – not appealing. Of course, if rates are bumped or the economy gets hit with some negative surprise – then down we go again. And did I mention that September/October cometh? Seasonally ugly months at the best of times. Cash looks like a good place to be to me. Maybe Bill Gross (who mistakenly believed the FED would hike in June) will finally be right. He’s due! (watch the video).