In the current economic and financial environment, equity market movement is primarily a function of liquidity and fundamentals. I mention liquidity as the first factor as the current rally in the market is more a function of liquidity than fundamentals. This article discusses the fundamental factor of S&P 500 earnings and the reasons for believing that earnings have peaked out for the medium term.
The charts below (data from S&P 500) gives the numbers for operating earnings per share and as reported earnings per share for the S&P 500 index until the fourth quarter of 2012.
The operating earnings per share for the S&P 500 peaked out in the second quarter of 2012. The next two quarters have witnessed a 9% decline in the operating EPS. The as reported earnings per share also peaked out in the first quarter of 2012 with the following quarters showing a gradual decline. The reported EPS has declined by 10% over the last three quarters.
In just this fact, it is clear that the corporate sector has witnessed a relative slowdown in the recent past. On the other hand, the S&P 500 index has surged by nearly 15% since the second quarter of 2012. There is a clear disconnect between the index movement and corporate earnings in the last two quarters. As mentioned earlier, the recent surge in the index has largely been liquidity driven.
Readers might argue that equity markets are a discounting mechanism and it is therefore not right to compare current earnings with current valuations. The counter argument is relatively simple in this case. Europe is in a recession with economic activity expected to remain sluggish in the foreseeable future. The IMF projects recession in the Euro zone in 2013 with mild growth in 2014. It is important to mention here that nearly 40% of S&P 500 earnings come from the Euro zone. Economic activity in the US also remains highly uncertain. I must admit here that US looks relatively better compared to the Euro zone. However, concerns remain at elevated levels and the latest job report is a warning signal. Growth in emerging Asia (especially China and India) is also sluggish and IMF forecasts do not suggest returning to robust growth over the next two years.
Therefore, what exactly are equity markets discounting?
The answer again relates to the unintended consequences of easy monetary policy. With ample liquidity available, equities are surging higher in the absence of meaningful positive cues.
Coming back to the main topic of discussion, S&P 500 earnings have indeed peaked out for the medium term. I don't see the second quarter 2012 peak earnings revisited over the next 1-2 years. A strong backing for this argument comes from the global economic growth reason stated above. The chart below gives the global PMI, which is again trending down after a brief recovery. This underscores my point of continued sluggish global economic activity.
If this conclusion is true, investors need to be cautious when it comes to considering fresh exposure to the markets. Without doubt, the markets are stretched in terms of valuation and a correction is imminent over the next 3-6 months. The S&P 500 is currently trading at nearly 16 times operating EPS and 18 times reported EPS. Giving an honest opinion, I am not sure if markets will correct today, tomorrow or in the next few months. I can however say with a lot of conviction that the current levels are not worth considering fresh exposure to US stocks. On the contrary, if the index surges further, investors can consider lightening their equity position and remain in cash. A correction for equities will be a bull market for cash.
Investors and readers also need to understand that I am not suggesting that S&P 500 will be a bad investment henceforth. Investors can certainly consider exposure to the index and some quality stocks on correction. At this point of time, it is advisable to be on the sidelines with cash.
A correction can be used to consider exposure to -
SPDR S&P 500 ETF (SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. Also, with excess money flowing into risky asset classes, the S&P should trend higher over the next 3-5 years. Therefore, the expected correction can be used to consider fresh exposure to the ETF. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.
Johnson & Johnson (JNJ) - is a good investment option. I like this highly diversified healthcare company, with products as well as regional diversification. Further, the sector catered to by JNJ is not very prone to economic shocks. JNJ has been a good dividend payer in the past, with a dividend yield of 3.4%. In my opinion, the stock is excellent for a long-term portfolio. It also commands a higher rating than the U.S. sovereign rating.
Vanguard Energy ETF (VDE) - The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector. With a low expense ratio of 0.19%, the ETF is a good investment option in a sector, which has good upside potential in the long term considering incremental demand from Asia and continued expansionary monetary policies.