zondag 23 juli 2017

Earnings Growth Is Driving The Markets?

The bulls currently have the “wind at their backs” as the continued “hope” the Trump administration will foster an age of deregulation, infrastructure spending and tax cuts which will boost corporate earnings in the future. Shortly after the election in 2016, Jack Bouroudjian via CNBC wrote: “Let’s be clear, this market run up to the 20K level has a much more solid foundation for valuation. We are not looking at a P/E which has been stretched beyond historical norms as was the case in 1999, nor are we looking at a dot com bubble ready to implode. On the contrary, between digestible valuations and the prospects of real pro-growth policies, we have the foundation for a run up in equities over the course of the next few years which could leave 20K in the dust.”
The problem is 9-months later there has been no advancement on that legislative agenda while the markets have surged more than 18% since the election. The market has already priced in the expected earnings growth from the “promised” Trump agenda which puts the market in danger of disappointment. “Given that stocks have surged based on ‘hopes’ of deeper tax cuts, a tax cut only roughly half of previous estimates certainly puts valuations at risk. Once again, the market has already priced in earnings growth through 2018, making disappointment a much higher probability”...


“Considering that forward estimates are generally overstated by 33% on average, the risk is high of disappointment. As shown below, there was a $10 difference between what earnings were expected to be in 2017 at the beginning of 2016 and today. Furthermore, forward earnings have only risen by $4.15/share for the end of 2018. Yet, as shown, above prices have more than priced in that future growth“...


# However, as Dr. Lacy Hunt recently discussed, this may not be the case. “Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented. Additionally, tax reductions work slowly, with only 50% of the impact registering within a year and a half after the tax changes are enacted. Thus, while the economy is waiting for increased revenues from faster growth from the tax cuts, surging federal debt is likely to continue to drive U.S. aggregate indebtedness higher, further restraining economic growth. However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success. The test case is Japan.
In implementing tax cuts and massive infrastructure spending, Japanese government debt exploded from 68.9% of GDP in 1997 to 198.0% in the third quarter of 2016. Over that period nominal GDP in Japan has remained roughly unchanged. Additionally, when Japan began these debt experiments, the global economy was far stronger than it is currently, thus Japan was supported by external conditions to a far greater degree than the U.S. would be in present circumstances.” With analysts once again hoping for a “hockey stick” recovery in earnings in the months ahead, it is worth noting this has always been the case. Currently, there are few, if any, Wall Street analysts expecting a recession at any point the future. Unfortunately, it is just a function of time until the recession occurs and earnings fall in tandem.
# Valuations; Another argument often used to support the “bullish” meme is that valuations aren’t as high as they were in 2000. While that is true, there is a vase fundamental difference between now and then. In 2000, as valuations surged toward 42x CAPE earnings, there were MANY technology companies with negative earnings which skewed the valuation measure. Most of the companies are now gone, or the ones that survived finally begin generating earnings. While valuations are NOT a good market timing indicator, and are not predictive of the end of a bull market advance, by all historical measures, they are expensive. Most importantly, while high valuations certainly aren’t predictive of bear market onsets, they are HIGHLY predictive of very low returns in the future...


One of the other arguments to justify higher valuations has been that interest rates are so low. Okay, let’s take the smoothed P/E ratio (CAPE-10 above) and compare it to the 10-year average of interest rates going back to 1900...


Importantly, the statement of “lower future returns” is very misunderstood. Based on current valuations the future return of the market over the next decade will be in the neighborhood of 2%. This DOES NOT mean the average return of the market each year will be 2% but rather a volatile series of returns (such as 5%, 6%, 8%, -20%, 15%, 10%, 8%,6%,-20%) which equate to an average of 2%....