The U.S. stock market has turned parabolic. After steadily rising since late 2016, the S&P 500 Index has shifted into a higher gear to start 2018. Exciting? Indeed. Justified? Maybe, maybe not. Dangerous? That too.
“I am your Fairy Godmother, and I must warn you. If you pretend too hard, everything you pretend will come true.”
--Fairy, The Cactus Wildcat, 1954
Stock market investing has become almost like child’s play lately. Almost like a fantasy, stocks (SPY) have reached the point today where it has almost become given if not expected that they are not only going to rise over time, but they are going to rise each and every trading day along the way. In many respects, the stock market has become too good to be true.
At times like today, it is easy to give into the notion that what we are seeing today is going to continue on forever. But to assume as much is to believe that fantasy has given way to reality. The stock market (IVV) is a highly cyclical beast with more than two centuries of history to prove as much. And while some might entertain the notion that we may have finally discovered investor nirvana, it is at times like these that investors should not give over to euphoria but instead should be at their most skeptical. For it may not get any better than the wonderment that we continue to experience today.
“Danger is my middle name”
--Ronnie, The Cactus Wildcat, 1954
The U.S. stock market (DIA) is doing fantastically well. While the casual observer might consider this a good thing, it is actually a situation that is becoming increasingly dangerous.
Consider the chart of the S&P 500 Index (VOO) below.
Now remember that the S&P 500 Index is the premier stock market benchmark. It is the index against which the performance of any investment product is measured whether it makes sense or not. It essentially is the market for so many of its participants.
It has been steadily rising since late 2016. But instead of losing momentum as it rises into the stratosphere, it has been picking up steam. This has been particularly true since the middle of the fourth quarter of 2017 and even more so since the start of 2018.
Put simply, it seems that the market melt up that so many have been musing about over the last many months is now underway in earnest. Where does it stop? Nobody knows. But it is always important to remember that melt ups are dangerous. And the more a market melts up, the more it is likely to melt down as it makes its way back down the other side. For a melt up is not defined by the strength of underlying fundamentals. Instead, it is defined by the exact opposite – a departure beyond fundamentals and into the realm of fantasy. And such is where we are in the current market environment.
Exactly how dangerous can a melt up become? Consider the following with today’s stock market. Given how far it has floated to the upside, the S&P 500 Index theoretically could, starting on Monday, immediately fall into a straight line descent to the downside and shed roughly -20% of its value. Not only would such a decline fall into the technical definition of a bear market by some, but it would be an absolutely jarring development for so many investors, particularly those newcomers to the market in recent years that know nothing other than bright shades of green flashing across their screens each and every trading day.
But even if we saw an immediate decline of -20% from today’s all-time highs, it would not actually qualify as a bear market. In fact, it would not even represent a break in the ongoing uptrend of the current bull market. In fact, a -20% decline would represent nothing more than a garden variety pullback toward the mean of the longer-term uptrend in today’s stock market.
That’s how far ahead of itself the stock market has gotten today. So when you hear references that the U.S. stock market is trading at its most overbought levels in modern history, this is in essence what is being implied by that statement, which is that the market could see one-fifth of its value lopped off in a fortnight and the uptrend would remain very much intact. Are you ready for such an outcome?
“Danger is my middle name”
--Cob, The Trumpet Of The Swan, 1970
But wait! Isn’t the latest stock market rise being supported by actual fundamentals? More specifically, aren’t the recent tax cuts giving an increasing voice to corporate earnings growth, the lifeblood of sustained stock market increases that has been lacking for so many years during the post crisis period? The bottom line answer? Not as much as even the most skeptical among us would have hoped.
It was a widely held assumption heading into 2018. Corporate tax cuts passed through Congress and signed by the White House at the end of 2017 were going to provide a meaningful boost to corporate earnings, which would help propel stocks to new all-time highs in 2018. New all-time highs? Emphatic check. Meaningful boost to corporate earnings? Meh, not so much.
Consider the following. At the start of 2018 on January 1, the forecast for annual as reported “GAAP” earnings on the S&P 500 Index for 2017 Q4 was $114.69 per share driven by a healthy 12% quarter over quarter increase in 2017 Q4 quarterly earnings per share to a record $31.77 per share. Where is this same forecast now, just four weeks later and with one-third of companies in the S&P 500 Index having officially reported earnings for the quarter to date?
The annual number for 2017 Q4 on the S&P 500 Index has been slashed by -5.42% to $108.47 and the quarterly reading has been gutted by nearly -20% to $25.55 per share. This is not robust growth. Instead, it is the exact opposite.
Of course, we have a perfectly rational and defensible explanation for this previously unforeseen by analysts just four weeks ago outcome in 2017 Q4 earnings, which is that many corporations have taken massive one-time charges to adjust for the rule changes that came with the tax cut legislation. As a result, these one-time items can simply be ignored as they are essentially noise that are obscuring the longer term improvement in earnings that we should expect in the coming quarters and years. Right?
OK. But this earnings boost is not showing up in the as reported GAAP readings for much of the entirety of 2018. For example, the forecast for 2018 Q1 annual earnings just four weeks ago was $119.05 per share. Today, it has been slashed by more than -4% to $113.99 per share. The same can be said for the 2018 Q2 and 2018 Q3 annual readings, which are lower by -2.85% and -1.60% since the start of the year. Explanation? This is once again a byproduct of the charges being taken in 2017 Q4.
For if one isolates on the quarterly GAAP earnings per share readings on the S&P 500 Index for 2018 Q1, Q2, and Q3, we see that they have actually been revised higher by +3.5% to +4.5% over the past four weeks since the start of the year. Put simply, short-term pain in 2017 Q4 for intermediate-term to long-term gain in 2018 and beyond. The fact that the latest annual estimates for 2018 Q4 are higher by +4% once the “pain” quarter in 2017 Q4 rolls off is more explicit evidence to this point.
Putting this all together, one might reasonably conclude that the stock market is still behaving rationally. It is looking past the downward revisions that are taking place today as a result of the one-time items hitting the books in 2017 Q4 and focusing instead on the upward revisions that are streaming in for 2018 and beyond. This is a fair observation.
But here is the challenge for the stock market going forward. It is now trading at 26.5 times trailing 12-month GAAP earnings. And if trends continue, it could easily be trading at more than 27 times earnings on this same measure by the end of 2017 Q4 earnings season even if the stock market falls completely flat from here. This is expensive by any measure. And this is true even given where interest rates that so many have accepted as given as rising over the course of 2018 continue to linger today.
In short, stocks long, long ago priced in the earnings improvement that we are finally seeing today. And it’s not as though the forecasts are being revised upwards by leaps and bounds. To the contrary, they have only been adjusted higher by +3.5% to +4.5% to date. Given that stocks are already higher by twice as much in 2018, we essentially have a stock market that was already running way ahead of itself running even further ahead of itself today.
To this point, the forward P/E ratio in 2018 Q4 on the S&P 500 Index once we fully move past all of these one-time charges in 2017 Q4 is still a lofty 21.0 times earnings, which is historically expensive in its own right. And this assumes that everything plays out to plan from here and that any rise in interest rates in the coming year is accompanied not only by the anticipated earnings growth but also inflationary pressures that remain relatively under control and a market liquidity environment that remains sufficiently abundant to support further stock market gains despite the fact that quantitative easing is expect to shift to quantitative tightening over the course of 2018. In a word, ambitious.
Losses imminent? No, as these risks are nothing that today’s intrepid bull has not overcome in the past. But dangerous? Yes. Quite.
“Danger’s my middle name”
--Austin Powers, Austin Powers: International Man Of Mystery, 1997
So the stock market is running ahead of itself. Perhaps this is actually the harbinger of the good economic things to come. After all, we are only one month into the New Year and a majority of companies in the S&P 500 Index have yet to report and bring tidings of cheer to investors about how much better things are going to be in the coming quarters. Indeed, we should expect more downward revisions to 2017 Q4 earnings and more upward revisions to 2018 earnings to continue in the coming weeks.
But how much should we realistically expect these economic and corporate earnings benefits to continue flowing in the coming quarters. Put simply, is the recent improvement in corporate earnings something sustainable? Or will it end up being nothing more than the latest silly sugar high that artificially inflates asset prices without any real substance behind it.
After all, anyone that has sat in a corporate finance class can go through the mathematical exercise where companies can meaningfully increase their earnings through share repurchase hocus pocus. But the problem with share repurchases is that while they do make the bottom line better and go a long way in increasing shareholder wealth over time, they do not result in capital expenditures being made, in new products being innovated, in factories being built, and in new workers being hired to receive income and travel to the marketplace to buy new products in fulfilling their role in making the economic circular flow diagram hum.
In short, the key to making this tax cut legislation turn into something real and sustainable is that the corporate windfall has to make its way through to capital expenditures in a meaningful way. Otherwise, it will end up being nothing more than short-term stock market fluff and the squandering of another 7% being added to the already bloated national debt over the course of the next decade with little to show for it.
Unfortunately, initial indications in this regard are less than encouraging. According to a survey conducted by Willis Towers Watson as reported by Bloomberg, corporations are not chomping at the bit to increase hiring and fire up the machines, at least not yet. Sure, we have heard the headlines about bonuses being paid out to workers at major multinational firms. But these are not wage and salary increases. Instead, these are one-time bonuses in most cases that may not be repeated in the future.
Meat and potatoes versus Pixy Stix sugar high. And on the meat and potatoes front according to the Willis Towers Watson survey of 333 companies with more than 1,000 employees, only 4% of companies said that they had “increased wages for all employees” as a result of the recent tax cut legislation. Moreover, only an additional 3% said they planned to do so in the next year while another 13% stated that they were essentially thinking about it. As for the remaining 80% of firms surveyed, they replied that they are not considering giving raises at all.
Now maybe so many companies are holding back the cash they might have deployed on their existing workforce to simply go out and hire new employees. Maybe they are forgoing wage increases because they want to divert all of this extra money to CAPEX. Of course, many survey respondents talked about automation, which can also often result in the net loss of jobs at any given firm. Then again, corporations may continue to turn toward what they perceive to be the superior choice from a business risk standpoint is to opt for further stock repurchases to boost the bottom line.
After all, if corporate management has a choice between entering into projects involving meaningful capital expenditures with uncertain future cash flows or entering into a share buyback program where the increase in the bottom line can be more easily predicted and fine tuned, it is understandable that they would continue to opt for the latter.
It will be interesting to see how corporations use their tax cut windfall at the end of the day, and many are clearly in the early stages of figuring this out. But if initial readings are any indication of what is to come, the associated sustained economic and corporate earnings impact may not be as meaningful as originally hoped, particularly if meat and potatoes CAPEX is forgone in favor or Pixy Stix sugar high share buybacks.
“Who does Number Two work for?”
--Austin Powers, Austin Powers: International Man Of Mystery, 1997
Who the stock market is actually working for is another point of danger that investors must consider as today’s melt up continues to unfold.
One might view the current stock market rise as a confirmation of the good things to come. Put simply, the stock market has traditionally been a predictive mechanism that moves nine months in advance of the broader economy. Thus, the recent acceleration to the upside is simply a broad range of market participants positioning in advance of the economic and corporate earnings improvement that is expected to come.
If this was the period prior to 1987, I would completely agree with this perspective. If this was the period up to 2008, I would generally agree with this view. But this is the post crisis period in 2018, and the stock market has long ago abdicated its role of providing any meaningful or worthwhile indicator of anything about the economy other than serving as a reflection of how much global monetary policy makers can inflate asset prices if they put their minds and money printing machines to the task.
After all, if the stock market was indeed a meaningful predictor of the economy, why then has it does so exceptionally well for nearly a decade despite the fact that the underlying economy has been generally sluggish and uneven up until supposedly now (whether we actually get the sustained economic growth that so many are now expecting remains to be seen – the persistent flattening of the yield curve and the unemployment rate already at historical cyclical lows among other key indicators are telling a decidedly different tale)?
Regardless, perhaps the stock market is still serving as an indicator today of the wonderment that is yet to come. But when looking under the surface to explore the forces that are driving these recent gains, such a conclusion becomes far more dubious. After all, if investors were truly turning optimistic about the prospects for the economy, corporate earnings, and its feedthrough effects to the stock market despite its already rich valuations, they presumably would be rushing out of the bond market (BND), particularly with interest rates supposedly on the rise, and buying into the stock market with wild abandon.
But what we find when looking at the actual fund flows data is the exact opposite is taking place. According to long-term mutual fund and ETF flow data from the Investment Company Institute, the U.S. stock market has not added a single dollar on net since all of the excitement about corporate tax cuts started to build in September 2017. In fact, we have seen -$25 billion in net outflows from domestic equities by investors over this time period, including -$16 billion in net outflows since the tax legislation was officially passed at the very end of 2017.
If investors are so excited and optimistic about what is about to come for the economy and the stock market thanks to some of the recent policy changes, they have a funny way of showing it with their actions in selling out of the stock market on net. This of course is nothing new, as domestic equity investors have withdrawn more than -$225 billion from mutual funds and ETFs since the start of 2015 and more than -$1 trillion since the financial crisis supposedly ended back in 2009.
As for bond (AGG) mutual funds and ETFs as of late, they have seen net inflows of +$149 billion since September 2017 including +$36 billion since the start of 2018 when the bond bull market supposedly came to an end. Notable indeed.
Who then has been buying stocks all of this time? Primarily corporations through massive share repurchases. Central bank-related demand has also played a meaningful part. Overall, the “net inflows” into equities resulting from these sources of demand since the calming of the financial crisis have more than offset the net outflows resulting from institutional and retail investors like you and me steadily walking away from stocks over time.
So when continuing on this stock market magic carpet ride to the upside, it is important know who is joining you on the trip.
Now one might look at this with a constructive view and say that it is only a matter of time before institutional and retail investors are finally sucked back into this market, which will provide meaningful fuel for the next leg higher in stock prices. Perhaps this will come to pass, but it stands to reason that if institutional and retail investors have not been lured back into stocks at this point despite a quadrupling in the S&P 500 Index in what is currently the second longest bull market in history to date, what exactly is going to inspire them to return en masse going forward?
Conversely, one could also look at this reality as more dangerous. For when corporations that have already increased their debt-to-equity ratios to their highest levels in recorded history finally stand down from further stock repurchases, which is very likely once the next recession finally rolls around, at the same time that central banks are finally (FINALLY) now starting to turn down if not shut off the liquidity spigots while starting to reach for the plug in the drain, who then will be the marginal buyer of stocks to help propel them on their next leg higher or simply maintain them at their currently premium prices. Dangerous indeed.
“His name was Daunger dreaded ouer all,
Who day and night did watch and duely ward,
From fearefull cowards, entrance to forstall,
And faint-heart-fooles, whom shew of perill hard
Could terrifie from Fortunes faire adward:
For oftentimes faint hearts at first espiall
Of his grim face, were from approaching scard;
Vnworthy they of grace, whom one deniall
Excludes from fairest hope, withouten further triall.”
--The Faerie Queene, 1590
Today’s stock market is increasingly exciting. But with increasing excitement also comes increasing danger. And today’s story of danger is as old as time and the markets themselves. We’ve seen this tale told so many times in the past. Sometimes danger remains hidden from view. Other times it emerges from the shadows and puts a dreadful scare to the investor fortunes previously thought impervious. But danger is never fully eradicated. Instead, it often looms most at the moments when it is least expected.
So as today’s stock market continues to ramp skyward, remember that one should not correspondingly reduce their risk aversion. If anything, investors should be increasing their risk awareness and paying increasing mind to their downside risk protections. In short, increase your preparedness, not your complacency.
More importantly, fully recognize as we collectively enjoy this continued ride higher into the stars for stock prices (+5000 on the S&P 500 Index anyone? I’m not ruling it out) that the forces driving the stock market higher may not be what they seem according to the headlines. Stock valuations are already rich and the acceleration in corporate earnings may not be as robust or sustainable as hoped. And those that are actually driving the market higher today may not actually be the best and most reliable passengers on the stock rocket ship.
The stock market today. Exciting indeed. But remember that danger is still it’s middle name.
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.
Disclosure: I am/we are long RSP,SPLV,TLT. 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.