- 93% of companies in the S&P 500 have reported earnings with current TTM As Reported EPS (AREPS) at $87.66, reflecting a decline of 2.4% on an inflation adjusted basis; peak cycle earnings on an inflation adjusted basis remain at $89.97 set in February of 2012.
- 10-year Cyclically Adjusted Price-to-Earning (CAPE) based on recent S&P 500 prices stands at 24.0X compared to 21.8X a year ago; multiple expansion driven by a year-over-year price index increase of 17.6%, offset by 9% growth in CAPE earnings.
- Forward earnings expectations reflect outsized growth of 25.5% and 22.9% on a nominal and real basis, respectively; this is in stark contrast to the recent deceleration of recent earnings relative to its 10-year trend.
- Aggressive monetary policy remains the major catalyst supporting a constructive outlook on the equity markets and likely already discounted based on elevated valuations.
- Recent earnings trends, questionable economic data, and imbalances in the financial and economic landscape suggest current growth expectations will not be met and risks remain to the down side.
- Despite recent strength in defensive sectors, investors should be selective and focus on higher quality names with long track records of dividend and earnings growth through entire business cycles
With 93% of companies in the S&P 500 index reporting Q1'13 results, trailing twelve month reported earnings (AREPS) stands at $87.66. This reflects a 2.4% decline from a year ago adjusted for inflation. Nominal earnings year-over-year declined by 1.0%. Peak cycle earnings remain at an estimated $89.97 in February 2012 (and peak price index adjusted to today's dollars was in August of 2000 at 2,002).
Figure 1 S&P 500 Historical Earnings
10 year Cyclically Adjusted Earnings (CAREPS) increased by 9.0% over the past twelve-months as the decline in the past year was more than offset by the roll-off of 2003 earnings. The decline in AREPS and growth in CAREPS helped normalize the trailing earnings to 26.7% above CAREPS compared to 40.5%, a year ago. Given the long-term growth trend of approximately 1.8% compounded annually, AREPS has averaged 8% above trend since the 1920s.
Figure 2: S&P 500 As Reported Earnings vs. 10-year Average
Using March earnings and inflation price index data - the Cyclically Adjusted PE is 24.0X based on yesterday's closing - compared to 22.1X a year ago, based on a real price index of 1,410 and CAREPS of $63.45. Multiple expansion has been driven by a 17.6% increase in the real price index offset by CAREPS growth of 9.0%. While CAPE is not a timing tool, it clearly shows that we are at the upper end of the valuation metric average. The most recent average that increases the weight of the all-time peak in 2000, is the only long-term average above the current valuation. The CAPE has averaged 25.3X since 2000 and 22.0X since 1982, which marks the beginning of the last Secular Bull market.
With a decline in AREPS, multiple expansion is clearly based on optimism of forward looking estimates. Current S&P 500 AREPS estimates for calendar year 2013 and 2014 are for $107.60 and $117.52, respectively based on 5/9/13 published data from S&P. This implies year-over-year growth of 22.9% to March 2014 on a real basis and 25.5% on a nominal basis. More realistic (but still optimistic) growth year-over-year from bottom-up, operating earnings estimates is estimated at 14.4%. These estimates reflect a marked shift in trend from modest decline of 2.4% to double digit growth.
Economic Big Picture
Global economic data in my opinion suggests a continued slowdown in the global economy. While the U.S. has been a bright spot as the housing market and related industries have rebounded, data is still not robust in the U.S. and corporate earnings in the S&P 500 remain multi-national. The JP Morgan all-industry PMI provides a good macro-view of the ongoing global slowdown after the initial stimulus efforts and pent of demand ran off in late 2009 and 2010. The current diffusion index reading of 51.9 in April, slipped from 53.0 in March. (A reading above 50 is reflects an expanding economy and below 50 contraction.) Current readings indicate a slower economy than currently forecasted.
Figure 3: JPMorgan's Global PMI (Manufacturing & Services)
Levers Have Been Pulled
Beyond the overall slowing of the global economy, there are imbalances in the current financial and economic landscape that will also create challenges for outsized earnings growth.
- Real GDP productivity (Real GDP per capita) growth has been sub-par for the past 8 plus years as productivity has averaged ~1.3%. Continued low productivity growth should be expected with a continued decline in labor participation rates and lack of major technological advances since the ICT (internet communication technology) advancement since the late 1990s.
- Demographics are an increasing headwind. Labor participation rates continue to decline from the 2000 highs of 67%. The last Secular Bull market benefited from increased labor participation due to an increasing number of women in the labor force, which plateaued in the 1990s. The current participation rate has dropped to 63.3% and is back to levels in the early 1980s. While the economy recovers and employment levels pick up for cyclical reasons, baby boomer retirements, which are structural in nature, will likely keep a lid on any major reversal in participation rates.
- With annual population growth at ~.7%, including immigration, a baseline Real GDP growth of ~2% should be expected. Add inflation of 1.5% to 2.5% and you get a revenue baseline of 3.5% to 4.5%.
- Corporate profit margins remain at historical highs at ~9.9% of GDP (peaked at 10.3% in Q'32011) versus a long-run average of 6.1%. The last Secular Bull market began in 1982 with corporate profits averaging 4.4%. While margins might not revert to historical averages - continued expansion should be limited as discussed in the next bullet points.
- Savings between households and the Federal government has declined since the mid-1960s. In 2008 the combined rate turned negative. Personal savings rates ranged between 7.5%-10% from the 1960s through 1980, before long-term decline. Personal savings bottomed at 1.0% in 2005 and is currently at 2.7%. Federal budget has been in a deficit position essentially from the 1960s until today with a noted brief but positive rebound in the late 1990s. The current deficit is 6.9% of GDP. (Negative trade balances have also contributed to the lower savings rate as savings was and is shifted to foreign countries.) A reversal of this trend will negatively impact growth rates.
- The impact of lowered savings over the past several decades is an increase in debt levels. The U.S. debt cycle had been rising since the 1980s with a peak in 2007. The cycle was stopped with the 2007-2009 Great recession but has not been reversed. Household and Federal debt levels combined increased from ~80% beginning in the last Secular Bull market to 183% as of Q1'13. This level has been above 180% since Q1'09. While it can be argued that this debt level can be sustained as the U.S. can issue currency to pay for its finances - it clearly is no longer a lever for pulling growth forward and driving the economy and corporate revenue and earnings.
Figure 4: U.S. Household and Federal Public Debt as % GDP
Based on economic growth in the 3.5% to 4.5% range and corporate margins flat at best - I would expect annual corporate earnings growth to stay in that vicinity until a catalyst for higher productivity rates appears. Share buybacks and a 2% dividend yield will improve total return results above the baseline 3.5% to 4.5% earnings growth. Work from John Hussman (Hussman Funds) indicates that based on recent prices and dividend yields, the forward 10 year total return on the S&P is in the 3%-4% range.
Market returns and economic growth often show little correlation over the near-term as expectations swing on a pendulum from optimism to pessimism, but longer term these growth rates and market returns will likely track reasonably well for long-term investment purposes.
What to Do?
It should come to no surprise that in this environment with valuations at the higher-end of averages and a visibly slowing global economy, investors should be patient with entering new equity positions. For long-term investors and dollar cost averaging, I favor high quality stocks that provide long-term growth in dividends and earnings through the business cycle. Furthermore, I would focus on lower volatile names that have reasonable valuations. When looking at ETFs I continue to favor two PowerShares ETFs, the S&P 500 High Quality Index (SPHQ) and S&P 500 Low Volatility Index (SPLV).
As for individual names, an example of a company that I have been favoring is Microsoft (MSFT), which was highlighted as part of a note (The Four Horseman) on February 27th as an interesting value. I have an estimated value in the $40-$45 range based on the company's historical Enterprise Value to Invested Capital Ratio (EV/IC). When capitalizing for R&D the company has ~$142.1 billion in invested capital (including cash and marketable securities). Adjusted return on invested capital (ROIC) has averaged 22.8% or approximately ~13% in excess of its cost of capital (GM:WACC). An implied EV/IC ratio based on the ROIC/WACC relationship is 2.4X, which is slightly above its 5 year average of 2.2X. The company currently trades at a EV/IC multiple of 1.6X.
Given the growth of invested capital on a compounded basis of 14% and generating economic profits - a Economic Value Add (EVA) discount valuation with a 10 year EVA horizon growing at 10%, a 20% ROIC, and no terminal growth, puts the valuation in the $41 range. With a dividend yield above the S&P 500 at 2.8%, I find MSFT as an attractive candidate for long-term portfolios looking for growth and stability.
Figure 5 highlights that over the past 5.75 years Microsoft's Market Value Add (MVA), which is the excess valuation above its invested capital has been declining given lower future growth expectations. One can also see that there has been a steady growth in underlying invested capital at a 14% compounded rate (including excess cash and R&D, which has been capitalized.) However, based on the profitability that Microsoft has been able to deliver over time, the current MVA should be higher as stated previously at least to its longer-term average of 2.2X versus the 1.6X current, which would reflect a per share value at $45.
Figure 5 Microsoft Historical Enterprise Value
Figure 6: Microsoft EVA Discount Valuation Estimate
Again focusing on high quality names with business models that can operated profitably through an entire business cycle often will lead to focusing on larger companies that are in the more defensive sectors such as utilities, health care, and consumer staples. Technology stocks such as Microsoft, Intel (INTC), and Cisco (CSCO) have become an additional opportunity set.