An important week this week: more big earnings, first Q2 GDP release, FOMC and the last week of July.
Stock price increases the last 2 years have been 80% multiple expansion, front-running an anticipated return to ‘normal’ GDP growth of around 3% and earnings growth of around 10%, which has yet to occur. Stocks are now at historic overvaluation by any measure apart from forward p/e, which is based on such expectation rather than the reality-to-date. Demographics and debt tell us such normalisation is in fact not going to occur this time, and when stocks have reached these valuation levels historically, they have always tumbled into a bear market.
The earnings growth rate for each quarter of 2014 was initially estimated at 10%. Q1 came in at 2.2%. Q2, so far, has come in at 6.7%. Qs 3&4 are still pitched at 10%, but for Q3 so far, 32 companies have issued negative EPS guidance and 15 positive. The message is expectations for earnings are still exceeding reality. Even though Q2 earnings have so far been better than Q1, they do not meet requirements, and stocks have struggled to advance in July. The implication is Q3 and Q4 would need to deliver serious bumper earnings to sustain the bull market.
The lack of realism extends to the economy. Q1 GDP came in at -3%. That means Qs 2,3&4 need to deliver 5% growth each to hit the 3% averaged annual. Yet data items already released for Q2 have caused analysts to reduce their forecasts for Q2 GDP to 3% average. If that is anywhere near the reality, then as per earnings it implies Q3 and Q4 need to be bumper, to keep EOY on track. Yet as things stand, leading indicators predict growth to peak out in Q3 and economic surprises continue to weigh negative. Jobs are improving but they are a lagging indicator.
Source: Ed Yardeni
Why are many analysts and economists stubbornly unrealistic about earnings and the economy? I suggest they don’t understand the role of demographics and the unprecedented collective demographics downtrends in the major nations, which are preventing the return to ‘normal’. Historically, we typically saw the economy heat up by this point leading to a rate tightening cycle which played a role in terminating the bull market in equities. Central banks don’t have the luxury this time – no rate rises are possible as the weakness persists. The tightening is in the form of QE tapering, as rates have been made redundant as a tool.
The low rate environment is touted as a positive for equities, that valuations must be considered relative to rates. Yet as Schiller says, low or high rates have not historically affected the predictiveness of CAPE. Similarly, I have pointed out before that in the 80s rates were at historic highs yet investors marched in to equities due to low valuations, and 1937 is a good mirror to now where high valuations and low rates gave way to a bear.
Another misperception is that we in a secular bull market in equities since the SP500 decisively broke above its 2000 and 2007 highs in 2013; that valuations washed out sufficiently in 2009 as a secular low; and that as we have yet to go even begin the series of interest rate rises that will eventually choke off the economy we have fuel to keep rising until 2016 or so.
Firstly, net of inflation the SP500 is still beneath its 2000 peak.
Secondly, secular bulls and bears are always demographic bulls and bears, and the message is that we are still very much in a long term bear that began around 2000:
Thirdly, valuations have a long way down to go before washing out to historic norms:
And, as already covered, central banks do not have the luxury have a series of rate rises.
Margin debt has been released for June, and in keeping with the bullish breakout in equities in that month, it rallied. July so far has been overall flat in the markets, hence an important last few days of the month this week. Barring a significant bullish breakout, I would not expect margin debt to exceed its Feb high in July, which would keep the topping epicentre as Feb/Mar. But the sharp increase in margin debt in June has made that more critical.
Source: DShort / UKarlewitz
I suspect tomorrow’s Q2 GDP print is going to be the key. As things stand (see last 4 posts) the evidence supports a top being in in equities, which implies disappointment in reaction tomorrow and ultimate breakdown in this Dow wedge:
Two quarters earnings data and two quarters GDP data may provide the tipping point in perspective on equities rather being simply extreme overvalued rather than front-runners of a strong recovery. If equities break down the last few days of July it will make a key difference on many charts.