This past April 16, I published an article entitled “Stock Price Drivers Don't Get Much Better Than This - Get Cautious.” The core of my argument was that U.S. corporate profits are at or near peak. As a result, I said “For all I know, the market will be up another 10% this year. But over the next five years? I am steadfastly pessimistic.”
Since then the S&P 500 index rose by 2%, so good thing I gave myself that caveat of “up 10%” to temper my pessimism. But it does appear that the news on corporate profits is steadily worsening. I expect that fact to swamp the growing optimism on interest rates, so I remain convinced that my pessimism is warranted. As such, I don’t want to own the market, but I am happy to own some overlooked, low P/E stocks, which I mention below.
My “peak profits” argument
I start with an S&P 500 EPS history and consensus forecast:
Sources: Yardeni Research, from I/B/E/S data by Refinitiv
The chart shows the huge run-up in S&P 500 EPS from about $60 in 2009 to about $165 today. But the pace of growth slowed over the past year. Q1 ’19 EPS was up a modest 7% from a year ago. Wall Street consensus estimates expect that growth to slow to 5% during Q2 and 4% during Q3. (Ignore any Wall Street top-down estimates more than a few quarters out – they are always too optimistic.)
The profit margin problem. I can see by your puzzled expression that you are surprised by this decelerating profit trend in America that has already been dubbed great again. But Corporate America is now wrestling with two challenges – (1) trying to maintain its historically high profit margins and (2) recent slowing global economic growth. I’ll start with profit margins:
Source: Bureau of Economic Analysis (BEA)
This chart shows that American businesses steadily improved their pre-tax profit margins from 1990 to 2015. This feat was the key ingredient behind the nearly 6-fold stock market rally over that period. But the chart also shows that profit margins stalled since 2015, and decreased over the past two quarters. There are lots of reasons, as there are for any economic activity, but I believe the primary reason is rising labor costs. My evidence is the following two charts:
Source: Bureau of Labor Statistics (BLS), from St. Louis Fed FRED database
The first chart shows that U.S. annual wage increases jumped from 2% to 3% since 2015, obviously adding to business costs. The second chart shows that U.S. corporate profit margins are linked to import volume. Imports to the U.S. are frequently low-cost sources of product because of the exporting companies’ lower labor costs. Non-oil imports as a share of GDP topped out shortly after 2010. A further rise in wages seems likely, considering the low unemployment rate, rising minimum wages and a middle class unhappy with high income inequality. And imports are obviously clearly at risk to our multiple trade battles.
The sales problem. While we have been obsessing about the Fed and Coco and Beyond Meat (NASDAQ:BYND), global economic growth has been steadily slowing, as this chart illustrates:
Source: Yardeni Research
Confirming worrisome news seems to pop up every day. Here are some snippets from Monday’s economic news:
- China - “China’s economic slowdown has exposed how some of the country’s biggest private companies are struggling to manage excessive debt taken on amid easy lending.” (Wall Street Journal)
- U.S. - “Home Building, New-Home Permits Have Softened This Year.” (Wall Street Journal)
- Japan – “Japan machinery orders fall most in eight months in worrying sign for economy.” (Reuters)
- Germany – “Factory orders in (Germany] dropped 2.2% in May.” (New York Times)
- South Korea – “Recent data have revealed a worsening in Korea's economy, with exports falling sharply, especially in the tech sector, leading to official revisions lower to growth and inflation forecasts.” (Street, July 3)
Are you also seeing a pattern?
OK, but the Fed will bail everyone out, right?
A lot of pundits, including our Twitter Pundit in Chief, believe the Fed can micromanage GDP growth with each 25 bp rise or fall in its funds rate. But exactly how much does a change in the fed funds rate really impact stock values?
Far less than you might think. The most logical link is that lower interest rates should encourage more spending on GDP components that are typically debt-financed. Two major debt-financed GDP components are home construction and business investment. So let’s see how interest rate changes – I use the 10-year Treasury rate – influence them:
Sources: Federal Reserve and BEA
Sources: Federal Reserve and BEA
Changes in interest rates explain only 30% of the changes in both home construction and business investment. Not irrelevant, but clearly not the only drivers. So it is not obvious at all that the Fed can jumpstart economic activity at will.
Another logical possibility is the “asset allocation effect” – the lower interest rates are, the more attractive stocks look. That makes theoretical sense. So I compared the last six months’ changes in the 10-year Treasury yield and the S&P 500 index, going back to 1973. Only a 2% correlation! Essentially random error. So yes, the stock market rally during June seemed well correlated to more optimism that the Fed is set to ease soon. But don’t get used to it.
So what’s an investor to do? Buy low P/E stocks.
Just because the overall stock market is pretty expensive doesn’t mean that there are no individual stocks forlornly stuck in the bargain bin. Luckily for you, I’ve identified several for you in previous Seeking Alpha posts. Here are their P/E ratios, along with some comparative P/Es of stocks contributing to the overall market’s richness:
Source: Yahoo Finance
My thumbnail summaries of the likely bubble stocks are:
- Wayfair (NYSE:W) and Uber (NYSE:UBER) both need at least five years, and maybe a full decade, before they are even profitable.
- Netflix (NASDAQ:NFLX), Amazon (NASDAQ:AMZN) and Grubhub (NYSE:GRUB) need at least five years of super EPS growth to justify their current P/E rates.
- McDonald’s (NYSE:MCD) is in a highly competitive business with a low-single digits secular sales growth rate.
- Walmart (NYSE:WMT) is in a steel cage death match with Amazon and hasn’t grown earnings in many years.
- Apple's (NASDAQ:AAPL) core product, the iPhone, is maturing and could see substantial margin erosion.
The stock market’s 18 P/E is at the high end of its historical range. While not yet in clear bubble territory, are you really willing to bet that a bubble is imminent?
My beloved low P/E stocks. They all are at half or less of the overall market multiple, yet the Street expects earnings growth from all of them. If I am right, earnings growth that the overall market very likely won’t be able to deliver. I’m very happy owning them all. Here are links to my posts about them:
Disclosure: I am/we are long MTG, RDN, AAL, AGNC, ALLY. 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.