The last two years gains in the SP500 have been mainly through multiple expansion, i.e. just price not earnings:
This year, so far, earnings growth has accounted for just 17% of the gains. Digging into that earnings growth, revenues have been weak:
So companies have boosted earnings-per-share through buybacks, at a rate on par with 2007.
Historically, companies have funded buybacks through borrowing:
This time is no different.
October produced a record in corporate debt issuance, and investors have piled in to this market to drive spreads to record lows this year. They have even snapped up the riskier Covenant-Lite corporate debt which offers little protection if the company gets into trouble – to another record level:
In short, investors have gone all-in on the corporate sector, both in equities and debt. The corporates have used the debt to buy back shares, thus artificially boosting earnings-per-share whilst revenues languish. Even with that, earnings growth has only accounted for 17% of share price rises this year. The rest has been speculation built on the ‘new norm’ of Fed accommodative policy trumps all. Record low debt spreads and historic extreme equity valuations result, and now present high risk to those invested.
Earnings guidance for Q4 (reporting season kicks off in early January) is the most negative on record:
Source: Thomson Reuters
The main reason for this is because companies have expected revenues to improve, so cut their guidance for earlier quarters but kept their year end targets in tact. Revenues have failed to materialise and therefore there is a big gap between year end forecasts and actuals, producing that big red bar for Q4 earnings.
Here we can see the persistent theme over the last two years of companies having to lower their quarterly guidance in line with economic reality:
Of course, in response to lowering guidance analysts then reduce estimates, and with the bar set very low, companies can then peversely exceed estimates and produce a satisfying earnings beat rate, which helps shore up investor confidence. The truth of the meagre earnings and dire revenues becomes distorted.
The bidding up of equity prices without associated earnings growth has produced historic extreme valuations, averaged below:
I suggest there are 3 secular cycles in the above chart. The 1920s saw an economic boom period with a positive demographic dividend, and by the end of the decade the thinking was that this boom was here to stay, a new norm, which gave rise to the speculative bubble and then collapse in 1929. It was not a new norm after all, and it took around 18 years to wash out excesses, to take valuations to a low enough level from which a new secular bull could erupt.
The 1950s and 60s was another (post war) economic boom period with a positive demographic dividend, and again new norm thinking took valuations to greed levels. The wash out was also around 18 years until valuations were at similar secular bull starting levels (note the demographic dividend was absent in the washout period).
The 1980s and 1990s then provided a third economic boom period with a demographic dividend in the major nations, excepting Japan in the second decade. This concluded with another ‘new norm’ bubble, and dot.com thinking took valuations to an all time exuberance record, and since then I believe we are in a gradual process of washout which should last another few years yet. US demographics peaked around 2000, Europe around 2005 and China around 2010, and we won’t see a collective demographic dividend return until 2020 or beyond. I believe this is why we face a weak economy and a gradual slide into deflation, and central bank intervention can do little to change this. Rather, central bank actions only encourage people into riskier assets by suppressing cash and bond returns, and make the cost of borrowing to do this ultra low. Hence we see another big disconnect now between the stock market and the economy.
Look again at the high outliers in the valuations average chart above: all were the peaks of economic and demographic booms (even 2007 where developing countries contributed a much bigger share to global GDP as China rose towards its demographic and economic peak). In contrast, the current exuberance is set against a weak economy and unprecedented collective demographic headwinds, which I believe makes it the most dangerous outlier yet. The ‘new norm’ this time is the Fed accommodative policy trumps all. It is a bubble.
There are multiple signs that we are reaching the top of this equities bull market (see my recent post Equities Bear Market Coming), and I believe we will see a bear market that will finally produce the washout to low extreme valuations. The negative demogaphic window is set to make this bear a deflationary shock, which means nominal values will have little protection. In other words, stock market falls will be harsh. On these grounds, Russell Napier quotes 400 on the SP500 as a possible bottom. This is maths plus history, not the peddling of fear.
The result would be something like this: a large megaphone with a lower nominal low than 2009:
Based on margin debt, euphoria, and valuation, the bear market looks set to erupt imminently. That means the Fed would be effectively out of ammo. It has had not the usual opportunity to end stimulus and raise rates to more regular levels, from which it can then ease in the face of a downturn. This should add to the ferocity of the downdraft.
By leading indicators the current window of positive economic data should turn out to be a peak, rather than the global economy finally seeing a new dawn. With commodities finely poised, I do not know whether they will rally as equities top out (in late cyclical style, similar to 2007-8) or break down as demand-supply slack outweighs. If the former, then we would see a temporary inflation until rising commodities help tip the fragile world economy into a deflationary recession. If the latter, then further commodity falls should do the job of completing the slide into outright deflation. Because of the credit excesses again (margin debt, corporate debt), a bear market would likely be unforgiving similar to 2008, i.e. forced liquidation of assets, with few asset classes spared. This time, however, treasury bonds would not seem so safe. Gold has a limited performance history under deflation, but I believe it has potential to be the go-to asset here.
The pretender to the throne, Bitcoin, which temporarily became as valuable as an oz of gold, looks to have burst, whilst gold’s washout looks very similar to 1976:
The weak hands have been purged and equities show signs of topping. The next few years are an ideal anti-demographic window for gold to shine, and deliver the dow-gold ratio extreme which we have so far not seen. The question is whether it an escape a downward spiral of forced liquidations.