Sunday, December 10, 2017

Earnings, Not Multiple Expansion, The Key To Favorable 2018 Equity Returns

It seems like an eternity since the S&P 500 Index experienced a pullback of more than 5%. In fact, the last greater than 5% pullback occurred over a year ago during the period of June 8, 2016 to June 27, 2016. This lack of downside volatility has taken place during a nearly uninterrupted increase in the market that began in February last year. Additionally, the market advance since the end of the financial crisis looks remarkable as well. Little or no downside volatility might be understandable if the equity markets were trading sideways this entire time; however, that has not been the case as can be seen below.



Wednesday, November 29, 2017

Strong Corporate Profit Picture A Key Component In Today's GDP Report

Included with today's second estimate GDP report by the Bureau of Economic Analysis is the preliminary estimate for third quarter corporate profits. The corporate profit measure is reported in several different formats, i.e. with and without inventory valuation and capital consumption adjustments. As I noted in a June post, more information on the adjustments can be found can be found in this BEA Briefing Paper (PDF).

The profit growth before tax and with the inventory valuation and capital consumption adjustments equaled 5.4% on a year over year basis. Without the adjustments, year over year profit growth equaled 10%. Importantly, NIPA profits have a nearly 1.0 correlation to IBES S&P 500 forward earnings and historically peak four quarters, or a year before the IBES forward earnings estimate. This preliminary corporate profit report is not signalling a peak in IBES S&P 500 forward earnings.


Also, with the preliminary corporate profit growth figure one can evaluate the NIPA P/E. The growth in NIPA corporate profits has resulted in a slight decline in the NIPA P/E as can be seen in the below chart. As I noted in the June post referenced above, what is useful with the NIPA profit measure is the fact it covers a larger earnings base for the U.S and covers more industries as it is not limited to public companies. Additionally, the NIPA figure makes an effort to adjust for the differing accounting measures being utilized by companies.


By reviewing some of my posts written over the past few months, the lack of any meaningful market pullback has been one recurring theme. However, with the continued strength exhibited in corporate profit growth, the market's path is certainly warranted as stock prices follow earnings. Also, the strong profit picture is beginning to result in a downtrend in the market's NIPA valuation, without a significant correction taking place. That does not mean high valuation equities will not correct more significantly, like what occurred in some technology stocks today. All in all, today's revision higher in Q3 GDP and the prelimnary profit report are both tailwinds for the economy and equity markets, all else being equal.


Tuesday, November 28, 2017

Soaring Consumer Confidence

Consumer confidence soared to a 17-year high in The Conference Board's report today. High levels of consumer confidence tend to translate to an improved retail sales environment as can be seen in the below chart. With consumers accounting for approximately 70% of economic (GDP) activity, today's confidence report portends a positive retail sales environment during the holiday shopping season.


On the other side of the coin though, The Conference Board's third quarter CEO Confidence measure was reported with a slight decline in early October as represented by the green line in the below chart. About two weeks ago we reported on the NFIB Small Business Optimism measure and it declined as well in its recent report; however, small business optimism remains at a high level.


Overall, confidence levels for business and consumers are at relatively high levels and this should be a tailwind for economic activity near term.


Sunday, November 26, 2017

The Sentiment Cycle Phase: "Buy The Dip"

Aside from fundamental market data, the equity market tends to follow a sentiment cycle as described by Justin Mamis, a famed market technician and author, who wrote several books on technical analysis. One of his books, The Nature of Risk, contains a discussion on the equity market's sentiment cycle. Below is The Sentiment Cycle chart included in The Nature of Risk.


In The Nature of Risk Mamis notes the market sentiment cycle begins with stocks climbing the proverbial "wall of worry." In a post I wrote in July 2009, Where Are We In The Market Cycle?, I noted the market seemed to be coming out of the financial crisis and had moved into this "wall of worry" phase of the sentiment cycle. Then in June of 2014 I noted in a blog post, VIX Is Low But Investors In Denial Stage Of Market Sentiment Cycle, I surmised the market was likely in the "denial" phase of the sentiment cycle. Today, I believe we are in or near the "buy the dip" phase of the market sentiment cycle.


One missing aspect with the market today is the lack of slowly increasing trading volume like occurred in the run up to the market top in 2008 and seen in the above monthly market chart. However, the lack of any significant market pullback since mid year 2016 is certainly representative of investors being content with "buying on the dips."

The sentiment cycle length seems to be an extended one in this bull market cycle and we can list any number of reasons for the extension. However, from a sentiment and technical perspective, this cycle, although long in duration, likely has further upside as buying "enthusiasm" seems absent. A confirming enthusiasm data point would be increasing volume into a so called blow off top.

Lastly, in Justin Mamis' last newsletter, he highlighted The Sentiment Cycle chart and had the following to say about it:
A cycle begins with stocks climbing “a wall of worry,” and ends when there is no worry anymore. Even after the rise tops out, investors continue to believe that they should buy the dips...Unwillingness to believe in that change marks the first phase down: “It’s just another buying opportunity.” The second, realistic, phase down is the passage from bullish to bearish sentiment...Selling begins to make sense. It culminates with the third phase: investors, in disgust,...dump right near the eventual low in the conviction that the bad news is never going to stop…
I think investors would have a hard time arguing against the fact that "buy the dip" is prevalent in recent stock market action. 


Saturday, November 25, 2017

Answering Market Questions Over Thanksgiving

In addition to receiving a few questions about Bitcoin from a few relatives over Thanksgiving, the other common question/comment was "can you believe this stock market, how long can it last." I confess I do not believe in market timing nor do I have a crystal ball; however, that does not mean one should put their head in the sand and ignore important market signals. Aside from the importance of monitoring weekly economic data reports, investors can review a couple of high level data points to gain perspective on the health of the economy and companies broadly. Just as earnings growth is important to evaluate at the company level, market level earnings are important as a rising tide may be lifting all boats. There is truth to the fact that stock prices have a tendency to follow earnings and that is clearly evident in the below chart.


From late 2014 through early 2016, S&P 500 earnings (green line above) were range bound and moved sideways during this period. The S&P 500 Index moved sideways over this time period as well. The market bottomed in February of 2016 and the beginning of the S&P 500 uptrend coincided with an improving earnings picture.

The below chart is a different look at the earnings picture by showing the 12-month forward growth rate expectations for the S&P 500 Index. The chart shows earnings growth at 10.1% looking twelve months out into the future and if stock prices follow earnings, market returns could be in the low double digits too.


I suppose the market's resilience, i.e., very little downside volatility could be viewed as a concern. The last greater than 5% market pullback occurred over a year ago, in June 2016, and the average intra-year pullback since 1980 is 14%. 


The market will experience another pullback and some investors seem to be waiting for this event before investing any additional cash into stocks. This in and of itself may be a reason the market is experiencing shallow pullbacks as investors seem to be 'buying on the dips.'

I could show a number of charts indicating the market is trading above its long term average valuation level. Often missing from these valuation charts is the back drop or perspective of valuations in a low interest rate environment. Stocks can and do trade at higher valuations when interest rates are low like they are today.


One of Warren Buffet's favorite valuation measures is the market cap of corporate equities to U.S. GDP. Some strategists expressing a bearish equity market point of view will show the below chart to support their negative perspective.


Again, at the risk of sounding like a broken record, corporate profits as a percentage of GDP remain near record levels.


And finally, what about the economy? The last two quarterly GDP reports show economic growth at 3% or higher. This is pulling up the below trend economic growth rate that has been reality since the end of the financial crisis. A faster pace of economic growth is a large positive. 


At the end of the day, the market may seem like it is priced for perfection, but in a low interest rate/low inflation environment, this does not seem unreasonable as noted above. Corporate earnings and the economy are both experiencing growth and growth that is accelerating. These two variables alone are positive for stocks. I have written a couple of recent posts about the length of this bull market cycle that began in early 2009 and the benefit for investors to review their overall asset allocation. A pullback will take place, but all else being equal, the economy and corporate earnings seem to be on sound footing.


Sunday, November 19, 2017

NFIB Small Business Optimism Index Highlights Tight Labor Market

Last week NFIB's October report on Small Business Optimism fell short of expectations, but remained at a high level at 103.8 versus 103 in the prior report. A few highlights from the report:
  • "The tight labor market got tighter for small business owners last month, continuing a year-long trend. Fifty-nine percent of owners said they tried to hire in October, with 88 percent of them reporting no or few qualified applicants."
  • "Consumer sentiment surged based on optimism about jobs and incomes, an encouraging development as consumers account for 70 percent of GDP," said NFIB Chief Economist Bill Dunkelberg.

And continuing to track the market's performance from December of last year (January's report) when NFIB reported one of the highest NFIB readings, the current S&P 500 Index return is outpacing prior market returns associated with high NFIB readings as seen in the below chart.


With a surge in consumer sentiment and a small business environment that is showing continued strength in hiring, these two factors alone should serve as a tailwind for the economy and market in the months ahead.


Saturday, November 18, 2017

Are Bearish Investor Sentiment Responses Translating Into Actual Action?

The S&P 500 Index is only down .60% from its November 8, 2017 high yet individual investor and institutional equity sentiment has turned significantly less positive. This negative sentiment has not translated into broadly lower equity prices though, but knowing sentiment measures are contrary indicators, they are approaching levels that would be suggestive of higher equity prices ahead.



Sunday, November 12, 2017

Equity Corrections Will Occur Again, Maybe Sooner Than One Expects

If there is one factor that perplexes me about the current market environment it is the lack of volatility since the election. The last time the market experienced a greater than 5% correction was in June of 2016 and the last double digit pullback was in February 2016. Going back to 1980 the average intra-year market decline for the S&P 500 Index is 14.1%. I have written a number of recent posts on the positive global economic environment, at the risk of sounding like a broken record, that may be serving as a tailwind for equity market returns around the world.

On the surface, if one knew mutual funds were holding elevated cash positions, they might conclude that this is a bullish data point since the cash can be deployed in additional equity investments. On the other hand, elevated liquidity in equity funds may be a sign of investors rapidly allocating more funds to equities and this might actually be a negative sentiment measure. In fact, as the below chart shows, there is a high correlation to elevated liquidity in equity funds and market tops.



Friday, November 10, 2017

If History Repeating; Another Five Years For Equity Bull Market

Shortly after the 2016 election in a post titled, Equity Market Beginning To Resemble Bull Market Of The 1950's And 1980's, I discussed how the equity market continued to trace a similar path as the market in the those two earlier decades. A part of my conclusion indicated the anticipated policies under a Trump administration would resemble policies implemented in the 1950's and 1980's, like tax reform and infrastructure spending. Reality is setting in and not much seems to be getting done in Washington on those two fronts; however, the current market continues to follow a similar path as in the 50's and 80's. Better sentiment and regulatory reform, even though by executive order, seems to be having a positive influence on companies. If the past is any guide then, the bull market might have at least another five years to run as can be seen in the below chart.


Thursday, November 09, 2017

Biases Influence Investment Decisions

Every investor makes investment decisions that are influenced by ones biases that form over time. These biases may come in many forms but they tend to fall into a couple of categories, emotional or cognitive. I mention this because it is not that uncommon that I sit down to write a blog post on a certain topic thinking the post's conclusion will go in one direction, but end up with a different conclusion after evaluating some of the research. Some of these blog topics are developed by flipping through a lot of charts, which I do frequently. One such chart is below and shows the relative performance of the S&P 500 Dividend Aristocrats to the S&P 500 Index.