U.S. stocks enjoyed a memorable year in 2013. And this advance was just the latest in an impressive string of virtually uninterrupted gains for the stock market since bottoming amid crisis in early 2009. While impressive on the surface, the resoundingly positive results from last year are unfortunately built upon a fragile foundation. And these gains have come at a juncture in the market cycle that may now be subjecting long-term investors to far greater risk on the horizon than they may realize.
Overall, the U.S. stock market as measured by the S&P 500 Index (NYSEARCA:SPY) advanced by +30% last year. These robust returns took place in an environment where corporate revenue and earnings growth were virtually non-existent. This is problematic due to the fact that year-over-year trailing earnings growth is highly correlated with year-over-year stock market returns.
(click to enlarge)
Many investors are understandably dismissing this disconnect with the explanation that the gains from 2013 were simply predicting what is expected to be vibrant economic and operating growth in the year ahead. After all, current estimates according to Standard & Poor's are projecting a +19% increase in operating earnings growth from the most recently reported quarter in 2013 Q3 through the end of 2014. This, of course, leads to the reasonable conclusion that there is no need to worry and we should plunge head first into stocks ahead of another solid year.
Even before we get into the real danger of this conclusion, it should be at a minimum more closely scrutinized for the following reasons.
First, predictions for such robust earnings growth have the potential to disappoint. As a most recent example, estimates at this exact time one year ago in January 2013 was for operating earnings growth to increase by +16% from what was then the most recently reported quarter in 2012 Q3 through the end of 2013. Instead, we have seen earnings growth running considerably below these heady projections at less than +5%. In short, such forward projections should be taken with a block of salt along with the recognition that they can be wildly different than what actually takes place. And in an environment where companies are revising forecasts for the coming quarters lower at a historically high rate, the likelihood is increasingly trending toward results that once again may fall short of currently ambitious forecasts in 2014.
Also, even if corporate revenue and earnings growth were to accelerate in the coming year to meet or exceed these expectations, the stock market gains from the past year have effectively already brought the pricing of these improving fundamentals forward. Certainly, the stock market has the ability to post impressive gains even in an environment of decelerating earnings growth. The second half of the 1990s was a clear demonstration of this fact. But history has shown that the longer this disparity exists, the greater the likelihood that the eventual arrival of earnings growth to close the gap may simply come too late to prevent a stock market consolidation at minimum such as took place in 1994 or a full blown market correction such as we saw from 2000 to 2002.
Lastly, the optimism about the potential for economic and operating improvement in the coming year largely ignores the underlying valuations from which we are trying to advance higher. Of course, valuation metrics are not determined by price alone. For example, the price-to-earnings ratio has a numerator and denominator that are both subject to change at any given point in time. At 19.6x trailing 12-month reported earnings, stocks are seeking to move higher from an already lofty perch in 2014. And such an outcome is dependent on everything playing out as neatly implied by current extrapolations. Of course, we all know what they say about the best laid plans.
It is from this final point on valuation that the real danger to long-term investors begins to emerge. For S&P 500 Index earnings at $100 per share do not represent a return to normality by any means. Instead, it represents a meaningful outlier. We remain today in a period of extreme volatility unlike anything that we have seen since the era of the Great Depression. And thanks to the bubbles repeatedly inflated over the past couple of decades by increasingly aggressive monetary policy intervention and periods of recklessly excessive leverage, we remain in an ongoing phase of wildly gyrating earnings and stock price performance.
The following chart shows year-over-year 12-month as reported earnings growth for the U.S. stock market going back nearly 150 years. Lulled into complacency by a generation's worth of relative earnings and pricing stability, investors have understandably come to expect that the experience during the decade of the 2000s was merely a blip on the path to returning to this same predictability. But when taken from a long-term view, we appear on the path of increasing amplification in volatility instead of a dampening that may take many more years to play out if history is any guide. As a result, wild swings in earnings should continue to be expected going forward. And given that the most recent lurch in earnings was to the upside, the next swing is likely to the downside.
So what then is the danger that is being overlooked by most long-term investors? It is the following. Earnings as of the most recently completed quarter in 2013 Q3 were $94.37 on an as reported basis. And projections are for reported earnings to rise above $100 and push toward $110 in the coming year. But while one can certainly extrapolate such an outcome based on recent data points, does such an outcome make reasonable sense in the long-term historical context? Unfortunately, not at all.
Stock market earnings are currently running well ahead of their long-term pace. When examining the long-term trailing 12-month real earnings on an as reported basis on the S&P 500 Index, the historical trendline suggests that the mean earnings today should reside in the $63 range. At present, stock market earnings are currently running nearly +2 standard deviations above what is implied by its historical trendline.
Knowing that earnings are already stretched well above their long-term trend and that we are in an environment of increased secular earnings volatility, what reasonably is the most likely path of least resistance for earnings going forward? Given that it has taken historically low borrowing costs and aggressive corporate stock buyback activity to keep earnings effectively no better than flat since early 2012, should we now expect earnings to reaccelerate for another +20% leg higher in 2014 to a level that would be +3 standard deviations above the mean now that the liquidity taps are being slowly shut off and policy war has just been declared on economic inequality at a time when corporate profit margins are already at historical highs? While anything is possible in today's liquidity intoxicated markets, the far more likely outcome is an eventual regression back to the historically implied mean. Such a move is not likely to occur all at once. Nor does it have to get started tomorrow or anytime soon. But probability heavily favors this outcome at some point in the near-term future.
This likely regression to the mean for earnings resides at the heart of the danger facing most long-term investors. Today, the stock market as measured by the S&P 500 Index is already priced at a lofty 19.6x trailing 12-month as reported earnings. But let's suppose that S&P 500 earnings regress from their current level at $94.37 to their historically implied mean of $65. Would investors be willing to pay more than 28x earnings, a valuation level seen only once in history during a period of steady to rising earnings when the tech bubble was inflating toward its peak, to continue to hold stocks at current price levels? Taking this a step further, suppose earnings actually returned below their trendline as they typically do for roughly half of the time throughout history. Suppose S&P 500 real earnings of just $45 under this scenario, which was the midpoint of an extended range from the late 1980s until the inflating of the housing bubble in the mid 2000s. Would investors be prepared to pay more than 41x earnings under such a scenario to keep stocks at current levels? If history is any guide, investors are typically inclined to take a good bit of risk off the table under such scenarios when earnings are in decline.
Thus, the stock market would likely trade at meaningfully lower levels if earnings were to regress to the mean at some point in the future. This is particularly problematic for long-term investors today for two key reasons.
First, relatively few stocks are likely to escape unscathed from such a regression to the mean in overall market earnings. And this includes the many high quality stocks that are currently trading at rich relative valuations with price-to-earnings, price-to-sales, price-to-book and price-to-cash flow readings that are all well above historical averages. A look at a rock solid, iron clad blue chip like Procter & Gamble (NYSE:PG) from the last crisis in 2008 provides a conservative example in this regard. Over the course of just a few months, P&G saw its stock price drop from $63 per share in mid September 2008 to $38 per share in March 2009, a staggering drop of -40% in a very short period of time. Did their global product roster stacked with billion dollar brands suddenly become 40% less beneficial for the company at that time? Absolutely not. In fact, revenues held steady and earnings increased over this troubled time period for the market. Instead, investors amid the mass liquidations at the time decided they no longer wanted to pay 22x earnings for the company. Instead, they wanted to pay 14x earnings, hence the -40% decline in the stock price. And this was a company that was at the time trading on par relative to its recent historical valuations heading into the crisis. Those that were trading at a relative premium at the time fared far worse in most cases. Stock prices eventually bounced back last time around, but what about the next time?
Second, unlike the market traumas from 2000 to 2002 and again from 2007 to early 2009, the Federal Reserve has now deployed most of its monetary firepower in supporting the markets over the last quarter of a century. Sure, they can launch into QE4, QE5 and so on, but the risks are far greater in increasing your already bloated central bank balance sheet toward $5 trillion or $6 trillion than it was crossing the $1 trillion threshold for the first time back in 2008. And one gets the sense that the Fed has finally come to the conclusion after a quarter of a century that the wealth effect is elusive and an artificially rising stock market does not lead to a sustainably growing economy. Instead, it promotes unwanted economic inequality more than anything else. Thus, one cannot rely on the Fed riding to the stock portfolio rescue the next time the market sharply corrects. Instead, steep declines may be followed by a prolonged sluggish recovery for many stocks, which of course is the reality that the broader economy has already been living for years since the crisis stabilized back in 2009.
The danger overlooked by most long-term investors in the current market is that earnings are running well above trend in what continues to be a highly volatile operating environment from a secular perspective. It is said that most investors have a market memory limited to just two years. With this in mind, it is easy for many market participants to become sanguine and complacent given how well markets have recently performed. But the probability is increasingly tilting in favor of earnings eventually regressing back toward the mean as implied by their long-term trendline, almost certainly taking the stock market with it.
None of this means that investors should abandon stock allocations today. In fact, an allocation to stocks remains as worthwhile as ever and remains an important part of a broadly diversified investment strategy. And although they are now much harder to come by than they were five years ago at the depths of the crisis, a number of stocks continue to offer attractive value and returns potential in the current environment. What it does suggest, however, is that investors must resist becoming complacent or overconfident in the current environment. Just because the stock market had a stellar 2013 does not mean that the same will occur in 2014 or beyond, particularly given the lack of fundamentals behind last year's advance. Risks remain widespread and profound as we navigate our way through the ongoing secular bear market. They are arguably amplified today following what has been an extraordinary run over the last five years, for downside risks are typically far greater near market highs than at lows. Thus, investors would be well served as we move through 2014 and beyond to keep in mind that the greatest risks facing the markets today may be those that we are unable to see until it is too late.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Additional disclosure: I am long stocks via the SPLV and selected individual stock holdings.