Is a storm brewing?
The difference between earnings and expectations
S&P 500 GAAP earnings per share for the calendar year 2011 were $86.95. The actual GAAP earnings per share for 2015 were $86.47. I may be old school, but I thought what investors were supposed to pay for was increasing future earnings. My source for GAAP earnings is in this article. If you click on the link and scroll down to the table titled "S&P 500 Index Earnings Type," you can also find a comparison by year of GAAP earnings and "Adjusted" or Operating earnings. Additionally, you will see the price-to-earnings ratio (P/E) by year. Notice that in 2011, the trailing twelve-month earnings for the S&P 500 was 14.5, while at the end of 2015, the same ratio was 20.5. So, investors are not paying the 41 percent more for basically the same amount of earnings.
Of course, one year ago, the expected earnings for 2015 were much higher, as is generally the case in nearly every year. So, one year ago, investors bought stocks on the expectation that earnings were going to rise. But earnings fell instead. Take a look at the following chart to see how accurate earnings estimates have been in each year since 1985. Also, notice that from 2000 through 2008, with only two exceptions (2004 and 2005), the drop in expectation over the course of each year has generally been far worse that in those years preceding 2000.
Q1 2016 earnings expectations have fallen nearly 16 percent over the past year, from a very healthy positive number to a very unhealthy negative number of around 8.5 percent. I am not arguing that stocks cannot go higher from current levels. I am just trying to raise the question as to for what investors think they are paying. I thought we should pay for increases in earnings per share, not falling earnings. I suppose I could be confused about what investors want. The answer, of course, is appreciation. But what is the impetus for that appreciation? What is the value that is being created by the companies that investors are willing to pay so much more for the same thing that they could have bought for so much less four years earlier?
Earnings per share are now calculated on about $2 trillion worth less of the stock since 2009 because of corporate buybacks. And yet, even with millions upon millions of fewer shares outstanding, the earnings are less now than in 2011. What did shareholders get for that $2 trillion? Certainly not higher earnings.
Interest rates are no lower than in 2011. Inflation is no lower than in 2011. Those have been arguments as to why P/E expansion has been occurring relative to historical levels. So, I just do not see any real justification for the prices being paid for stocks today. All that seems to be used now as justification is that companies are "beating" estimates. Well, they can beat all they want, but if earnings continue to fall, beating those lowered expectations is not creating real value, only imagined value or hoped for value.
Yes, at some point in the future, earnings per share will once again rise to levels higher than have ever been recorded in the past, and that will be, by definition, value creation. But as earnings merely beat expectations that are far below the earnings of the prior two years, companies have not done what I would expect in terms of creating value.
Sure, the U.S. dollar has risen against foreign currencies, but the cost of energy has fallen by even more. Oh right, U.S. companies are no longer as dependent on energy as in the past, so those savings cannot be captured here. But the reality is that the U.S. economy is no longer as dependent on manufacturing and exporting of capital goods as it once was, because our companies have moved much of the new manufacturing capacity overseas. Thus, while we here in the U.S. do not use as much energy, our companies are still using a lot more in their respective facilities overseas. The savings should be captured over there and should be offsetting the impact of the higher U.S. dollar. That would be the case if demand were constant or rising.
That leads me to believe that global demand, while publicly reported to have been waning, is probably even more of a problem than corporations and political leaders are letting on. Otherwise, the savings from energy on rising demand would provide significant cost savings. That does not appear to be happening on a broad scale. I found the following quote from a Bloomberg article interesting:
"Chinese companies canceled more than double the amount of bond offerings in March compared with a year earlier, as mounting defaults increased financing costs…The surge in scrapped offerings reflects investors' growing concern about default risks amid the worst slowdown in a quarter century."
Slowing economic activity is not the only problem facing the world today. U.S. dollar-denominated debt has grown tremendously since the Great Recession, especially in emerging market nations. I have written more about the debt problems faced around the globe here, so I will not get bogged down by the subject here. Suffice it to say that there are more debt skeletons than just the energy sector lurking in closets around the globe.
Is the Fed really in control?
I suppose the better question is to ask how much control is being wielded by the Bank of Japan. I am not suggesting that the U.S. is in the same predicament as Japan yet. But by putting all our faith in the Fed, we could easily find ourselves on the same path someday.
Another way to look at it is to consider the great success that has come from the efforts of the European Central Bank (ECB). The ECB has pulled out all the stops to nudge the eurozone economy into a higher gear of growth. This quote from The Economist sums up the answer:
"The recovery in the 19-strong euro area is continuing but it is nothing to write home about. Growth had picked up to 0.5% in the first quarter of 2015 (compared with the final quarter of 2014), the strongest performance since the upswing started in the spring of 2013. Since then, however, the pace of expansion has slackened, to 0.4% last spring and an average quarterly rate of 0.3% in the second half of last year."
How many trillions of euros does it take to screw in a light bulb in Europe? We do not know yet, because they are obviously still in the dark. Sorry, but I just could not help myself.
Europe is still mired in a fight against deflationary forces caused primarily by demographics. As people age and near retirement, there is a tendency to spend less and save more, pay down debt, downsize, etc. When one actually does retire, it is often the case that one has less disposable income than one did during the working years. An aging population in Japan has shown us what the natural outcome of this situation can be. Europe is now in the early stages of where Japan was 20 years ago. The U.S. is close behind Europe. Then comes China.
What are the differences? Japan has very restrictive immigration laws. Europe has had more lenient immigration laws, and the U.S. has practically open borders. Thus, immigrants slowed down the effect of aging populations in the U.S. and in much of Europe. But immigration has not completely countered the trend, and we will all have fewer people actively working for each person who is retired. The social welfare state that is Europe was not built for that consequence. Neither were the social security and Medicare systems in the U.S. Adjustments could be made to make the systems viable for many more decades, possibly longer. But will those adjustments be made? If not, we will eventually follow the path of Japan.
Of course, those are not the only problems faced by developed economies as governments spend more and more time and tax money on things like defining what constitutes a banana in Europe. I could have a lot of fun with this topic, but I will allow your imagination to consider what sorts of things governments, including the U.S., spend our taxpayer money on. After you have considered all of what you may think the most absurd possibilities, I suspect you will be far short of reality. Take, for instance, the USDA funding of $1.85 million for potato breeding research. Should this not be the responsibility of the private sector? The list of such programs is embarrassingly long. But I digress.
There is little to criticize the Fed actions taken to save the economy during the Great Recession and immediately thereafter (well, there could be, but I would rather not go there). But to continue emergency policies year after year reduces the effectiveness of the Fed over time. There are two sides to this argument: the Fed is all powerful, and the Fed is slowly, but surely, losing its effectiveness. Since mid-2014, I have fallen within the second camp. I do not know when the Fed loses its grip on the markets, but I do expect it will happen eventually.
There is nothing to prove either side of the argument. We just need to wait and see how things turn out.
Strengths in the economy leading to more growth?
Then, there is the argument that with so many positives in the economy, surely the market is just taking a breather before heading higher. The strengths that are usually pointed out are housing, employment and stocks. Everything seems to be at or near record levels, certainly far better than where we were in the midst of the last recession. How can anyone consider the economy to be weakening?
I will start with housing. Of course, housing has not recovered fully in terms of unit sales, but that is not to be expected. We do not want another bubble, after all. But prices in major metropolitan areas, such as San Francisco, Boston, Denver, Dallas, Portland, and Charlotte, have all regained, and in some instances, surpassed the peak valuations of 2006. (Source: St. Louis Fed and S&P Case-Shiller Home Price Index)
Much of America is still lagging in real estate values relative to the 2006 bubble period, but the fact still remains that some of those areas were in a bubble then and have jumped well ahead of the rest of the nation again in terms of appreciation. Do those values make sense relative to incomes? In some cases the answer is yes, but not in all areas. But putting that argument aside for a moment, I want to ask another question: When real estate value reached lofty levels back in 2006, was that a good indication of continued economic growth? Of course it was not.
Now, let us look into employment. To do that, we need to look at a chart, again from the St. Louis Fed, that shows us total U.S. employment over the years. Notice that employment tends to reach a new peak just before each recession and then falls off during the recession. So, is a new peak in employment a good indication that the economy will continue to grow into the future? I do not profess to know if we have yet hit a new peak in employment. However, to say that because we have just hit a new peak in employment means the economy is going to grow is not what is illustrated by looking at the history of employment in the U.S. The point is that employment is a lagging indicator and not a leading indicator. So, how well employment is doing only tells us something about the economy in the past.
Just look at the chart in the link above and check where the peak was in January 2008. At that point, we all thought that the housing crisis was going to be contained, because the subprime mortgages amounted to less than seven percent of the total. At least that is what we were told back then. The peak in housing came around the third quarter of 2006, and employment peaked at the beginning of 2008. Employment did not tell us that we were already in a recession that began in December 2007 until after the fact. The example was the same in 2000 and in every recession since 1940. It will not tell us what to expect in the future this time either.
Well then, we can rely on stocks, because this certainly have proven to be a leading indicator, right? Yes, it has and will be, but we need to listen to what it may be trying to tell us. The message is rarely straightforward from stocks until it becomes blatantly apparent - as in the top was in months before anyone would believe it.
The S&P 500 Index hit its peak in March 2000, dropped hard in April and then traded in a range until September of the same year, and did not actually break to a new lower low than the one made in April until early October 2000. GAAP earnings in 2000 were actually above the 1999 level and did not fall off the proverbial cliff (on an annual basis) until 2001. Of course, quarterly earnings began to fall off later in 2000, but the economy would have seemed in much better shape then compared to now, since we are now in the third consecutive quarter of earnings falling year over year.
^GSPC data by YCharts
Now, in the Great Recession, the S&P 500 Index tried to tell us something, but most investors were not listening because they did not want to hear what it was trying to say. It hit a record peak of 1576 in October 2007 and dropped to 1257 by March 2008, before rallying back to 1440 in May 2008. The index had recorded lower consecutively lower highs and lower lows. In May 2008, the primary trend was still down, just as it is now. Then, the bottom began to fall out.
^GSPC data by YCharts
In both instances, the market traded lower but within a range for several months before it became apparent to investors that a recession was imminent. And the S&P 500 Index has been trading in a range, unable to make a new high since May 2015.
^GSPC data by YCharts
Am I trying to convince readers that a recession is imminent again? No. What I am saying is that we need to listen to what the market is trying to tell us. I think it is saying that we should be cautious.
I invest for income, value and growth, in that order. Dividends have been rising nicely, but future increases will be dependent upon growth in earnings and cash flow. I expect dividend increases will tend to be muted over the next few years relative to what we have experienced in the last five years. If earnings deteriorate further, we could see more dividend cuts. At the current valuations, I see very few examples of good value available to investors. Growth, or appreciation, is unlikely to be vigorous from these lofty valuation levels. Price appreciation generally follows earnings. The current trend in earnings is still down. When the primary trend in earnings growth turns markedly higher, I may get interested again. Until then, I would rather sit on cash rather than expose my portfolio to unnecessarily high risk. That is not to say I am predicting a market crash. It is simply my opinion that there is little of value available in the markets today to entice me into risking the possible loss of my hard-earned savings. I will wait for a better value proposition.
As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.
For those who would like to learn more about my investment philosophy, please consider reading "How I Created My Own Portfolio Over a Lifetime", or for those who would rather listen to a podcast on the same subject, you may want to consider my interview by IITF.com, which can be found here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.