Slightly disappointing NFP numbers spurred expectations of a mid-2014 tapering, driving stocks on the upside. The idea of stock returns being closely linked to the size of the Fed's balance is well ingrained in investors' mind, but the chart below shows that the relationship between stock market returns and the Large Scale Asset Purchases (LSAP) of the Federal Reserve is not that straightforward.
An interesting pattern of the recent weeks has been the recurring swings in the correlation between stocks and bonds. This is because the stock/bonds link is clearly standing within the bounds of an indeterminate regime. You may have it right on the forthcoming path of US yields, but the uncertainty on where US Stocks would be heading to would remain.
The lingering concern for investors today is the level of valuations. A glimpse at the chart below shows that the Price/Earnings ratio (P/E) of the S&P 500 is close to what could be considered "rich" (as the P/E is close to 15).
Let's be more precise here: the absolute level of the S&P 500 has no meaning per se. What matters is not the fact that today's price level be well above that of previous peaks but rather that it remains within the bounds of what could be considered a reasonable valuation (that is below 16x yearly earnings).
Many analysts have expressed concerns that over the last 12 months, equity returns have been largely driven by P/E growth instead of earnings growth. This is what the blue area shows in the chart below.
But a look at the past 35 years shows that stock returns are always a combination of earnings growth and P/E increases. The dotted squares represent the periods or negative equity returns. Two different regimes can be distinguished:
i. In the late 1970s and 1980s, negative returns were associated with falling prices while trailing earnings did not display significant drops.
ii. During the latest two market corrections, equity returns have also been associated with sharp declines in profits. This macroeconomic feature can be related to the dot-com bubble burst and the brutal stop associated with the Great Recession.
Putting today's trend into perspective, we clearly see that the contribution of the P/E increase to stock returns may have been strong this year but remains relatively short from a historical point of view.
Now the question is double: as US profits remain at their highest level as a share of GDP, what might be their forthcoming trend (the chart below shows that the downward adjustment in profits has been rather sharp in the past)? How did stock prices behave in the quarters following the peak in profits?
Before I answer those questions, it is worth remembering what a traditional economic cycle should look like. In the months following a recession, profits would grow through productivity gains and topline sales increases met without hiring more people (the profit-to-GDP ratio would rise). As the recovery would turn into a stable growth level, profitability would rise up to a point where a stretched job supply would turn into higher wages and therefore lower profit growth (the profit-to-GDP ratio would stabilize and edge down but profits would still grow). Then the overheating economy would have to be restrained with a tighter monetary policy (the profit-to-GDP ratio would fall).
Unfortunately for us, we are no longer in a "traditional" cycle: in spite of several years of recovery, the unemployment remains at 7.2% while wage growth is still muted (2.1% year over year). The forces that would drive profits downward are much less significant than before. In addition, monetary policy is well into unconventional territory, which suggests that any restraint from higher yields would take time to come. Therefore, it is not because profits are historically high that they will have to fall sharply in the next quarters. In addition, I clearly believe that a moderate fall in the profit-to-GDP ratio would be a good sign as it would mean more investment or more compensation in the economy, hence more sales in fine for corporate businesses.
Lastly, if history were a guide (beware) and if profits were meant to start falling soon as a share of GDP, the short run prospects would not be that bad for stocks. As can be seen below, the post-profit-peak returns of the S&P 500 over the last decades has on average been positive.
Bottom Line: given that the link between stock market returns and (1) the Fed balance sheet and (2) US Treasury yields has sharply weakened over the last few months, any view on forthcoming stock returns should be based on more traditional tools, namely valuation.
I have shown that not only the current level of the S&P 500 P/E is not abnormal (although heading up to the upper bracket of "fair value"), but that it is normal for P/E to take over earnings in contributing to stock returns when the economy is well into the recovery.
The unusually high level of profits today can be explained by the state of the labor market, growing inequalities, the lack in investment spending incentives and the low level of interest rates (to name a few). History shows that post-profit-peak years have generally shown some decent performance for US stocks. In addition, I would argue that a fall in the profit-to-GDP ratio in the US would be a blessing for stocks and the economy, as it would reflect more organic growth for businesses (capacity expansion) and/or a stronger growth in compensation (and probably domestic sales). A sound backdrop for positive stock returns