Tony Jackson in the Financial Times this week examines what he calls the "unsustainable paradox," bonds yielding less than equities. He also asks, with corporate profits as a percentage of GDP at near-all-time levels across much of the Western world, can earnings continue to rise?
Apparently, Jackson is doubtful. He attributes the recent swelling of corporate coffers to the flood of cheap labor unleashed by China and the emerging markets, which have depressed labor costs. (As an aside, think about that the next time some pundit states that there are "no wage pressures" in the U.S. Of course there are wage pressures, but because of the disintegration of the unions and lack of employee leverage, it is manifesting itself politically in the form of protectionism, demands for health-care reform and rejection of free trade rather than the traditional labor marketplace).
Jackson then rejects the notion that the market has already discounted falling earnings by pointing out the vicious corrections witnessed when companies like U.K. retailer Marks & Spencer miss earnings (or poor guidance from Intel (NASDAQ:INTC) or whoever you want to use). To top it off, most analysts only expect the earnings downdraft to last to mid-year, at which point favorable comps will see rising earnings yet again.
But if the E in P/Es drops precipitously, then the paradox of bonds yielding lower than equities resolves itself, probably leaving a sizable dent in many portfolios.
Whether Jackson is correct remains to be seen but I am currently reading David Dremen's Contrarian Investment Strategies: The Next Generation. Dremen presents some interesting historical figures showing how stocks measured on an earnings, book value or cash flow basis, react to both positive and negative surprises. Stocks with low valuation based on these metrics (traditionally considered value stocks) seem to react best in both situations, with negative surprises having subdued impact, due to low expectations, while positive surprises leading to outperformance well beyond the period in which the surprise occurred.
Unsurprisingly, those stocks which analysts and the market deemed to have the most promising prospects, and thus high valuations (traditionally considered growth stocks), face an exhausting treadmill, as good results only fuel ever-higher expectations. And this only ends when a negative surprise crushes the stock price and compresses the multiple.
Against this backdrop, it may be useful to rethink the current hoopla about growth outperforming value that is making the rounds in all the financial media. While I've never bought into that dubious distinction to begin with, if the FT's Tony Jackson is correct, investors willing to pay up for projected growth are betting on the come. They may face rocky times if/when this paradox unwinds.