Weighing the Week Ahead: Can Earnings Growth Justify Current Stock Prices?
We have an array of interesting data in the week ahead including inflation news, more employment numbers, and sentiment from consumers and small businesses. Most importantly we have the start of earnings season.
Despite this, the political story will dominate, at least for a bit longer. While this is newsworthy, it is not the key element for investors. What best depicts this challenge to find the right focus?
Let us turn to Chance the Gardener! The simple-minded gardener who knows only what he has learned on television is a fount of wisdom.
Chance the Gardener : As long as the roots are not severed, all is well. And all will be well in the garden.
President “Bobby” : In the garden.
Chance the Gardener : Yes. In the garden, growth has it seasons. First comes spring and summer, but then we have fall and winter. And then we get spring and summer again.
President “Bobby” : Spring and summer.
Chance the Gardener : Yes.
President “Bobby” : Then fall and winter.
Chance the Gardener : Yes.
Benjamin Rand : I think what our insightful young friend is saying is that we welcome the inevitable seasons of nature, but we’re upset by the seasons of our economy.
Chance the Gardener : Yes! There will be growth in the spring!
From one of my all-time favorite movies, Being There, with Peter Sellers as Chance the Gardener. Everything about this movie is excellent, and you will see parallels to modern times.
For our purposes, the theme of optimism versus current facts is on target. In my last post I asked what we might expect by Springtime. Making this more specific (and less symbolic than Chance’s version), we should wonder:
Can earnings grow enough to validate current stock prices?
Last Week Summary
In my last installment of WTWA, I summarized the long list of uncertainties and asked what more we would learn in the next few months. While this was not the theme for the punditry, we will find it to be a useful reference.
I always start my personal review of the week by looking at some great charts. This provides a foundation for considering news and events. Whether or not we agree with Mr. Market, it is wise to know his current mood.
I am featuring Jill Mislinski’s chart of the market week. Her approach combines several key variables in a simple readable format.
Sector movement is another important clue to market trends.
Once again, Juan Luque provides us with some words of wisdom from the Incline trading desk:
In the first week of 2021 the S&P 500 posted a new record high with over a 1.8% weekly return. Investors see with positivism the ratification of Biden as the new elected President and the Democrats gaining control of the senate, because of the prospects of additional stimulus. The big mover in the past weeks is the Energy sector. It is clear how it moved through the lagging quadrant and is fast approaching the leading quadrant with weekly gains of 8.52%. The Real Estate sector has reversed its momentum and fell into the lagging quadrant with a 2.38% loss for the week. Health Care was another big winner slowing down its path towards the lagging quadrant. Finally, the Financials sector had a terrific week with gains of 6.24% and is speeding along the leading quadrant.
The market gained 1.8% on the week with a trading range of 4.5%. You can monitor the continuation of lower volatility in my Indicator Snapshot, featured in the Quant Corner below.
The Visual Capitalist has an interesting look at the performance of various asset classes in 2020. You get the drawdown, annual performance, and increase from the low in a single chart.
The News Overview
Each week I break down events into good and bad. For our purposes, “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!
My continuing assessment is that many of the normal economic indicators are not helpful in the wake of the COVID lockdown decline. Too many sources are focused on a change in direction, even if very modest, which has painted an overly optimistic picture. As the economy stalls, there will be a rapid switch in the diffusion indexes. The early signs are emerging. I expect some dramatic shifts over the next month or so.
- Vaccination has become a reality. Almost 19 million doses have been delivered, including seven million in the U.S. (Bloomberg)
- The pace, however, is disappointing to most.
- Expanding eligibility is a possible solution. President-elect Biden is planning to accelerate first doses before some recipients have had the second dost. Gov. Cuomo is acting to avoid unused or destroyed vaccine. Even this approach may not be completed until April.
- Analyst expectations are rising in contrast to the usual pattern. John Butters (FactSet) reports that this is the second consecutive quarter of increases. He writes:
In a typical quarter, analysts usually reduce earnings estimates during the quarter. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 4.5%. During the past 10 years (40 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 4.2%. During the past 15 years (60 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 5.2%.
- Stock prices have outstripped earnings gains since the start of 2017 reports Brian Gilmartin.
Interesting SP 500 EPS statistic:
- 2021 est SP 500 EPS: $167.25 +23% expected y/y growth
- 2020 est SP 500 EPS: $137 -17% y/y decline (estimated w Q4 ’20 earnings releases pending)
- 2019 actual SP 500 EPS: $162.93 +1% y/y growth
- 2018 actual SP 500 EPS: $161.93 +23% y/y growth
- 2017 actual SP 500 EPS: $132.00 +12% y/y growth
If 2020 and 2021 expected SP 500 EPS doesn’t change much, the “average” growth for SP 500 earnings since Jan 1, 2017 is 8%.
The “average, annual return” for the SP 500 since Jan 1, 2017 is 16%.
- More than $112 billion has been sent electronically, so it is already in recipients’ bank accounts. This represents about 2/3 of the total for the program. (WSJ)
- Faster than the first round because the government now has bank account information for several more groups of people, like Social Security recipients and beneficiaries of other programs.
- Hitches are inevitable.
- Payments to inactive accounts are returned with no immediate ability to resolve.
- Money may go to former spouses.
- Initial jobless claims remained at an elevated level of 787K, the same as the prior week but higher than the 752K expected. Continuing claims declined slightly, probably reflecting those who have reached the maximum period of benefits.
- ADP private employment declined by 123K much worse than expectations of a 120K gain or November’s 304K gain.
The chart below reflects typical expectations for the ADP: Match the BLS result or it is an error. I strongly disagree. This is a different methodology and may well be better on some occasions. Analysis is stronger if the ADP report is viewed as another independent indicator (although they keep changing their methods to match the BLS).
- Payroll employment for December declined 140K, much worse than expectations of a 112K gain or November’s upwardly revised (from 245K) 336K increase. I continue to regard this as a large overestimate of total jobs. The BLS method assumes that new businesses offset non-respondents. Here is the table for the final responses. We will know more about this problem when the Business Dynamics report comes out at the end of January.
- Labor force participation declines account for the unchanged headline unemployment rate of 6.7%, in line with expectations. Dr. Robert Dieli’s excellent monthly report on employment effectively explains this key point.
- Small businesses lag far behind employment at the start of the year or for similar periods in 2019.
Was this merely a knee-jerk reaction to the new Democratic majority in the Senate? It is too soon to say, but important to monitor, as we do weekly in the Indicator Snapshot, even when it seems like little is happening. Here is a longer time period to provide additional perspective.
Last week I wrote that I hoped for improvement in this news section during my time off. I am eager to drop this topic or to emphasize improvement. Sadly, things have gotten worse. I follow many data sources and include only a few each week to illustrate the universal story, and I also do statistical tracking of my own.
- The worsening trend includes nearly every state.
- Positive test results remain over twelve percent for the entire U.S. I have been tracking this since June, and it is at the highest level in my data series.
- Cases per day have reached a new high. (91-DIVOC)
The stall in economic growth is beginning to show outside of employment.
- Mortgage applications were lower over the last two-week period. (Calculated Risk). It has been a great year. Will it continue?
- Rail traffic measured via Steven Hansen’s (GEI) economically intuitive sectors remains in a year-over-year decline and is getting worse. The red line in the chart below shows the rollover in the economic sectors.
Auto sales show a similar partial rebound pattern.
Events at the U.S. Capitol. Wednesday’s rampage will earn an infamous place in history with hundreds of amateur real-time videos to provide evidence. The survey results show a wide disparity in opinions about responsibility.
And no, this is not an investment story. Many of my “ugly” items are not. For the investment world it was a non-story since stocks rose during and after the events. Here is my Twitter comment from Wednesday’s evening:
I frequently scoff at the post-hoc explanations of market moves. These facile statements always find something to highlight–soon accepted as “official.” Imagine pundits in a room without market foreknowledge. Show them tonight’s news. Would they predict higher stock futures?
Right on schedule, the experts provided explanations for the continued rally. Somehow, that seems to make it seem even worse.
We have an active calendar for the coming week. Inflation data (both the CPI and PPI) are expected to show a significant uptick. The NFIB Small Business Optimism index will be especially interesting in the wake of the Georgia election results. Retail sales have supported the economic rebound, but a December decline is expected. We will also have the University of Michigan sentiment results from early January and December’s industrial production.
The first corporate earnings reports will get less attention than they deserve, and political events will get more.
Briefing.com has an excellent weekly calendar and many other useful features for subscribers.
Theme and comment
The successful development of vaccines in record time regardless of delays and rates of cooperation. The economy has turned sluggish, but not to worry. Stimulus is on the way!
Most investors have experienced a time where skepticism about forward earnings was standard practice. Looking only at past earnings, markets seemed perpetually expensive.
Investors now have a new sense of optimism. They are looking beyond near-term events and peering into the future, perhaps well into the future. It raises a crucial question:
Can corporate earnings grow enough to justify current stock prices?
Opinions about whether the market is cheap always inspire intense debates with more heat than light. When a valuation measure does not seem to “work” then the adherents trot out a parade of excuses. A favorite is that valuation is a poor timing method. Let us take a closer look.
J.P. Morgan’s excellent Guide to the Markets is published quarterly but updated even more regularly. It is a treasure trove for the data-driven investor. Here are two important charts. The first shows that it matters little which valuation measure you pick from among the most popular choices.
I prefer the (unpopular) forward earnings approach. Here is a look at that. There is a wide variation and low correlation for the upcoming one-year return, but a solid relationship over five years.
Left out of this is the effect of extremely low interest rates. For years, the reliably bearish portion of the punditry contended that this was irrelevant. Then it became a Fed-manipulated TINA (there is no alternative) which created artificial euphoria. Even Prof. Shiller (more than a little late to this party) is out with new research suggesting that perhaps an extra equity premium is deserved when interest rates are very low.
The result is a valuation gap: Either stock prices are too high or expected earnings are too low. FactSet provides a great chart of the history over a decade.
The problem is best illustrated through a specific typical case. In my constant search for stock ideas, I have seen hundreds of charts like this one. My example is drawn from Chuck Carnevale’s excellent FASTGraphs tool. This is part of my stock analysis for every name that I consider. It is the most efficient method to get the key data a fundamental investor need. And it even lets you alter various key assumptions.
Please note the similarity with FactSet’s chart of the overall market. Caterpillar is a great company.
- Earnings are growing throughout a business cycle.
- Debt is reasonable and the credit rating is excellent.
- The company is a dividend aristocrat, (Barron’s) having increased the dividend for 25 straight years.
- Investors are enthusiastic about the company’s role in a possible infrastructure program.
All good. That said, in seventeen years the company has never had earnings high enough to justify the current stock price. If the multiple would revert to normal levels, the stock would fall to about 82. For earnings to grow enough to validate the current price one must look beyond the 2022 estimates – perhaps well beyond. It is a long time to wait.
Looking Across the Economic Valley
Barron’s reports, Earnings Season Is About to Begin. Investors Are Already Looking Past it. Read the entire article to see the discussion of data and stocks, helped by “ultrasupportive monetary and fiscal policies.”
In sharp contrast, Carmen Reinhart, chief economist of the World Bank, covers many crucial points in her interview with Leslie P. Norton of Barron’s. And yes, she is the co-author of the influential book warning about debt, This Time Is Different: Eight Centuries of Financial Folly.
How many countries have gotten back to their pre-crisis level of per capita income? We’re not there yet. Let’s take a standard, well-known global forecast, like the World Economic Outlook from the International Monetary Fund, or the Global Economic Prospects from the World Bank. Both projections, even with a V-shape rebound, still don’t get you to your pre-crisis per capita income level. That takes longer. If you look at past serious crises, that full recovery, getting back to, at a minimum, where you were before the crisis hit, is a multiyear process.
Don’t confuse rebound with recovery. We’re going to see this snapback, because we had output and employment collapses the likes of which are four standard deviations and more away from any normal downturn. The temptation is to say, aha, we’ve recovered. Not the same thing.
In the U.S., some of the risks to recovery are declaring victory prematurely and withdrawing stimulus prematurely. To get recovery on a sustained footing, we still need to see more fiscal stimulus. Good news on the vaccine notwithstanding, we are still seeing record infection rates.
Let me highlight another headwind to growth. By almost any realistic assessment, the issue we are looking at is more nonperforming loans. You don’t get this kind of economic contraction and not affect household and business balance sheets. What do financial institutions do when they’re facing compromised balance sheets? They curtail lending. This was a classic case in Europe after the 2008-09 crisis. In varying degrees, you’re going to see tighter lending standards, less new lending in an environment with so much uncertainty.
Another conclusion offered by UPFINA.
2021 is starting off with important news on vaccines, the elections, and stimulus. 2020 had the biggest drawdown in a positive year ever. 2021 is set to have strong EPS growth, but multiple contraction will probably limit the potential gains. We might even see losses even with +20% EPS growth. Despite the weakness in mobility, the NY Fed’s weekly economic index and the ECRI leading index show better growth. Goldman is forecasting higher 2021 GDP growth because of the stimulus. If another one passes, growth could be even higher which would probably also lead to excess inflation.
In the spirit of Chance the Gardener, I am tracking the Springtime themes I developed in my last post. It will not replace the Indicator Snapshot. It is temporary. It might help us to focus on the most important questions for the next few months.
Most of what you will read in 2021 forecasts. As expected, we are seeing precise targets for the market’s 2021 performance. To make such a prediction you need to know all the following:
- Progress on the pandemic, vaccine, and reopening
- Translation into overall economy, best sectors, earnings
- Mr. Market’s perception of these facts
The prediction pundits hardly start on these key topics.
I recommend Timothy Taylor’s The Planning Fallacy or How I Ever Get Anything Done. It has both investment value and personal value. And it well describes crucial current problems.
The “planning fallacy” refers to a psychological theory that people systematically underestimate how long it will take them to complete a given task. My work life is one long example of the planning fallacy. I set deadlines for myself, scramble to meet them, miss the earlier deadlines, rinse, lather, and repeat until the work somehow gets done.
And continuing, after quoting Tversky and Kahneman on considering the distribution of completion time.
At some level, this explanation strikes me as exactly correct. I am overly optimistic when thinking about how long it will take me to do a task because I assume that everything will go smoothly and that I won’t be interrupted or distracted by other immediately pressing tasks. When I edit a paper, I think about the actual editing going smoothly, not about what happens when I hit a snag that takes a day or two to resolve or what happens when the rest of my life sneaks up on me and demands attention.
I have a rule for my investment clients. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update, featuring the Indicator Snapshot.
For a description of these sources, check here.
Technical measures remain bullish in both short and long-term time frames.
My continued bearish posture for long-term investors is based upon both valuation and fears about the continuing recession. As always, I expect good times – but not yet.
With the addition of important data, it is time for a review of Jill Mislinski’s Big Four Indicators.
“Davidson” (via Todd Sullivan) has earned our respect over many years. He has an out-of-consensus take on valuation, based upon the SP500 Value Investor Index. The post explains the calculation. The chart below shows the result.
Final Thought for Investors
I had hoped to make some preliminary comments about the impact of the election. I will soon, but right now it is too much speculation for too little gain. Here is a preview of a coming attraction:
- What can be accomplished with a thin majority?
- Across the aisle efforts
- Coalition building
- Who are the new key players?
- End of the McConnell block. If there is majority support in the Senate, bills have a chance to pass.
- The nuclear option (AKA the end of the filibuster).
- Appointments expedited for Biden.
- Executive orders – expanded by Trump. What will Biden do?
I continue to maintain higher than normal cash levels as a cushion against the continuing recession. It is possible to do this and still meet your goals provided you do not make extreme decisions. My two major stock programs both returned over 40% last year. My income program met the 9% cash yield goal for the ninth consecutive year.
I am working on a bond substitute program to generate reasonable low volatility returns via an extremely selective REIT program developed along Great Reset principles.
Most important takeaway
Investors turn to the wrong sources for their investment decisions. Who would you trust for information on economic and market prospects?
- Stock Market
- Billionaire investors
- Financial news
- Opinions of friends
If your answer is “none of the above” you are on the right track!
Watch the economic and earnings progress. How big is the valley, and how long will it take to cross it?
If you have not already done a review of your current portfolio – asset allocation, sector exposure, and risk – you are behind schedule! I will soon have a new White Paper on the bond substitute REIT program. You can get on the list. You can still get my paper on risk. If you act quickly you can also be part of the latest Great Reset Wisdom of Crowds survey. Participants get the first access to results and related discussions.
There is no charge and no obligation for either White Papers or the Great Reset Group. Just make your request at my resource page.