By Joseph Y. Calhoun
It wasn't a pretty week for stocks globally. Almost every major market was down - one prominent exception was Japan - and the minor ones were down more. China experienced a 6.5% hiccup mid-week that everyone seemed to want to see as, at least, the beginning of the end of that bull market, so it probably was nothing more than a buying opportunity for those willing to buck the consensus. As for Japan, well, if you've been reading these weekly scribblings for any length of time, you know my feelings on that market.
The U.S. stock market has been struggling all year, and unless the economic data starts turning up soon, it seems likely to continue. I say that because more QE doesn't seem to be an option and the Fed is intent on hiking rates sometime this year; monetary policy is not going to be a tailwind. The discount rate isn't going any lower. And so, if stocks are to advance, it will be because earnings are turning higher - something that has been missing for the last two quarters; more on that later - or because investors are willing to pay an even higher multiple than they already are for U.S. stocks. I suppose multiple expansions are possible, but I'd just point out that higher P/Es can be achieved without stock prices rising. Less E accomplishes the same thing as more P.
And yes, stock buybacks could potentially be enough to keep EPS rising even if overall earnings aren't, but there is a limit to the stock buyback game. At some point - and I think we are rapidly approaching it - balance sheet concerns will outweigh the desire to hit the quarterly earnings number. Or at least I hope so. In any case, corporate earnings appear to have peaked for now. The GDP update Friday showed corporate profits, after adjustments for inventory and capital consumption, were down 5.9% after a smaller drop in the 4th quarter. The economy contracted in the 1st quarter by 0.7% if you believe the BEA and their seasonal adjustments, and the 2nd quarter so far isn't looking a lot better (And by the way, does Canada have the same seasonal adjustment issues with GDP?) so earnings gains are going to be hard to come by.
The economic data released last week continued the trend of less than expected and hoped for. There were some positive exceptions as usual, and I wouldn't minimize them. The data on housing - new home sales and pending home sales - looked pretty darn good. And the durable goods orders did show a significantly better read on capital goods for the second month in a row - although the overall trend is still down for durables - which might bode well for capital spending. But… the manufacturing side of the economy is still struggling mightily with the slowdown in the oil patch. The Dallas Fed manufacturing survey was a complete disaster at -20.8. And while the Richmond Fed's survey posted a positive number - barely at 1 - the Chicago PMI Friday was a bucket of cold water for the optimists.
The weak economic environment has, as I said earlier, kept a cap on U.S. stocks so far this year, Despite the headlines about all-time highs, the S&P 500 is up all of 0.7% over the last 3 months and a whopping 2.9% over the last half year. By contrast, foreign markets have done much better. EAFE, a broad international index, is up over 5% while China, Japan and Europe have all done even better over the last six months. Part of the reason for that is merely the recent correction in the dollar index, but it is also due to growth prospects that are improving, at least relative to the U.S.
Yes, China is still slowing but even at a reduced pace, it is growing faster than almost anywhere in the world with the possible exception of India. And yes, Japan's domestic economy still has problems a weaker currency won't cure, but corporate earnings are growing faster there than any other developed economy. There's hope in Spain where 1st quarter GDP grew 2.7% year over year and 3.6% annualized from the 4th quarter. And even Italy managed to post a positive GDP growth rate in the 1st quarter, although it was pretty meager. Of course, all these economies are dependent to one degree or another on the U.S., so if we fall into recession - something I don't see… yet - all bets are off.
In any case, none of this - the recent underperformance of U.S. shares - is surprising to anyone who has been paying attention to the debate about U.S. stock valuations. The bearish argument has been that high profit margins make valuations look less extreme but when margins are normalized, valuations - and risks - are near all-time highs. There has been a robust debate about why margins are high and whether they will mean revert and to what level, but the entire debate centers around margins. The bulls have argued that margins are high for good reasons and need not fall back to the long-term mean - it's different this time.
The bulls have been winning that argument because stocks have been going up, and margins have stayed stubbornly high, but that may be changing. In the big picture macro sense, margins have peaked already and with the most recent GDP report have now fallen from over 10% to just under 8%. The drop for the S&P 500 hasn't been as extreme; operating margins peaked in Q3 2014 at 10.1%, fell to 8.98% in Q4, and 9.38% in Q1. The bottom line is that margins fall during recessions and slowdowns, and while recession seems unlikely right now, the slowdown is obvious. With productivity growth stalled and top line growth stagnant, higher U.S. margins and earnings seem unlikely.
In the U.S., we have waning economic growth (the widely expected Q2 rebound is missing so far), falling sales, falling earnings estimates and margins contracting from very high levels. Compare that to Europe where growth is turning up (tentatively), margins are already compressed and earnings estimates are rising. Margins haven't started to rise yet - and may not - but at least there is the possibility of some upside from current depressed levels. And actual earnings have yet to meet those optimistically rising estimates, so don't break out the bubbly yet. But overall, it seems the two areas are on opposite sides of the cycle.
In Japan, returns on equity and profit margins are among the lowest in the world and roughly half the S&P 500. Part of Abe's revival plan is to get companies to target higher equity returns, and the effort is paying off. It isn't just a weaker Yen that is driving Japanese corporate profits. I've said before and will reiterate that I think Japan has entered a secular bull market.
U.S. stocks have spent the last six months going nowhere fast while international markets have taken the lead. The shift is being driven by changing fundamentals or at least a perception of changing fundamentals. That is being reflected not only in stock market performance but also in the currency markets. Despite last week's rally, the dollar peaked in March, and unless the U.S. economic data picks up, and the expected second half rebound becomes reality, the dollar's big rally is probably over. If that is true, the outperformance of international assets seems set to continue.