The
highly-anticipated first-quarter earnings season is in full swing,
with traders eager to see how US companies are faring. While
expectations are low, these profits releases still collectively pose
serious risks for today?s overvalued and overextended US stock
markets. A few high-profile misses could prove all it takes to
unleash a long-overdue serious selloff. Investors and speculators
alike need to remain wary.
Most
publicly-traded companies report their comprehensive quarterly
financial results in the month after a calendar quarter ends. This
deluge of reports released in a matter of weeks is called
earnings season by traders. And it?s exceedingly important, as
underlying corporate profits are the ultimate fundamental driver
of stock prices. Supported by earnings, they can only climb over
the long term if earnings grow.
Shares of stock
represent fractional ownership stakes in underlying corporations.
And the way they are valued in the marketplace depends on their
future earnings streams. The larger the ongoing profits any company
earns, the higher its stock price will be. While bouts of popular
greed or fear can temporarily disconnect stock prices from
underlying corporate profits, ultimately stock prices are slaved to
earnings.
And this underway
Q1?15 earnings season isn?t looking pretty. As April dawned, Wall
Street estimates for overall corporate earnings growth for the elite
stocks of the flagship S&P 500 stock index (SPX) had just crumbled
to -4.6% year-over-year! This was a wild swing from the +5.3%
analysts had expected back at the start of Q1 in early January. It
was the sharpest drop in earnings expectations since way back in
Q1?09.
While Q1?15 SPX
earnings expectations have improved slightly to -4.0% as of this
week, that is still a major decline. A variety of factors are being
blamed. The
parabolic US dollar blasted 8.9% higher in Q1, a massive rally.
This is a big drag on earnings with about half of the elite
SPX component companies? sales coming from outside the US. The
stronger dollar makes US goods and services more expensive abroad.
And that lowers
demand and sales. Energy companies? profits have collapsed too.
While crude oil only fell 12% in Q1?15 compared to plummeting 41% in
Q4?14, quarterly-average oil prices still collapsed by 50% YoY.
This gutted oil companies? profits, which are traditionally a
bastion of earnings strength within the SPX. Cold winter weather
and the West Coast port shutdown also contributed to the slumping
profits.
Stock bulls argue
that the first quarterly drop in corporate earnings since 2009, just
after that once-in-a-century stock panic, is no big deal. It?s only
projected to be a 4% decline they say, and they believe the factors
that are driving it are transitory. The US dollar isn?t going to
rally forever, oil?s not going to fall forever, and winter and the
port shutdown are over. They expect corporate profits to rebound
later this year.
Only time will
tell if their 2015-profits optimism is justified. I have my doubts
though. Wall Street firms and their stock analysts get paid based
on assets under management. So they have huge financial
incentives to always stay bullish on stocks, since they want to
convince their customers to keep their capital fully invested.
Analysts? future earnings estimates are almost always too rosy,
perpetually being revised down.
All the groupthink
exuberance about the US-corporate-profits outlook also seems to fly
in the face of the long parade of weaker-than-expected economic data
in recent months. As a whole, corporate profits are ultimately
constrained by the growth rate of the broader US economy. If it
continues sputtering along, or makes a turn for the worse, there?s
no way SPX companies? full-year-2015 earnings will meet estimates.
But the greatest
risk posed by deteriorating corporate earnings swirls around today?s
wildly-overvalued US stock markets. While a 4% annual
profits decline may be digestible in fairly-valued stock markets, it
could very well cause today?s exceedingly-expensive ones to choke.
Earnings are at the very core of stock-market valuations, the
denominator of the all-important price-to-earnings ratio that
measures them.
Historically P/E
ratios were always considered conservatively in
trailing-twelve-month terms. That looks at current stock prices
divided by the last full year?s, effectively the last four
quarters?, actual corporate profits. These trailing results are
hard data set in stone, there is nothing ambiguous about them. By
that classic TTM P/E metric, today?s prevailing stock prices are
dangerously expensive as you will soon see.
Wall Street fears
scaring investors away with well-justified valuation worries, so it
avoids talking about trailing P/Es like the Black Death. Instead it
fabricates a pure fiction known as the forward P/E. While
the P is still the current stock price, the E is analysts?
estimates of the next four quarters? profits. Those are not
only nothing but guesses in a volatile world, analysts are
notoriously wrong in predicting the future.
Their optimism is
boundless, driven by intense pressure from their employers to
convince investors to stay fully deployed in stocks to maximize Wall
Street?s hefty percentage-of-asset-under-management fees. So the
earnings estimates that feed into fictional forward P/Es are almost
invariably too high. Of course this means the relatively-low
forward P/Es Wall Street constantly cites really underestimate true
valuations.
This forward-P/E
cult has become so dominant that these days whenever you hear about
P/E ratios on CNBC they are always going to be forward estimates.
Historically, P/E ratios were always assumed to be classic
trailing-twelve-month P/Es. Since estimates vary, forward P/E
ratios do too. But the number I see most often today is around
17x. Wall Street claims the SPX component stocks are trading around
17x earnings.
Compared to the
century-and-a-quarter
historical
average US-stock-market valuation of 14x earnings, 17x certainly
doesn?t sound extreme. Stocks are on the expensive side based on
future estimates, but not excessively so. But this picture changes
dramatically using actual trailing earnings. Today the 500 elite
SPX component stocks are collectively trading way up near 26x
earnings, ominously close to 28x bubble territory!
Whenever I write
about these dangerous overvaluations, I get tons of pushback from
skeptics. They all wonder how I can claim 26x while all the
mainstream sources they see claim 17x. The answer is simply the
difference between hard historical trailing-twelve-month earnings
and ethereal guesses on the future. But since today?s rampant
overvaluations are so important for traders to understand, here?s
our exact methodology.
At the end of
every month, we capture the stock prices, conservative
trailing-twelve-month P/E ratios, dividend yields, and market
capitalizations of every S&P 500 component company. In those rare
cases where P/E ratios exceed 100x, we cap these outliers at 100x to
minimize their distorting impact. Then we average all 500 of these
individual SPX-component P/E ratios, both simply and weighted by
their market capitalizations.
This process is
very simple and easy for anyone to replicate in a couple hours.
Build a spreadsheet of the S&P 500 component companies, grab their
TTM P/E ratios from Yahoo! Finance or Google Finance, plug them into
the spreadsheet, and average that column. The result is shown in
this chart, data that Wall Street is desperately trying to distract
investors from seeing. Stock valuations are exceedingly high
today!
The light-blue
line is individual SPX-component TTM P/Es averaged, and the
dark-blue line weights them by individual companies? market
capitalizations. Market-cap weighting helps ensure the overall
index P/E isn?t skewed by smaller companies less representative of
investors? actual holdings. Either way, today?s stock-market
valuations are crazy-high as of the end of March just before Q1
earnings season.
In simple-average
terms, the elite S&P 500 stocks were trading at a staggering 25.9x
earnings! And in market-cap-weighted-average terms, their
collective P/E wasn?t much lower at 24.0x. These levels are
dangerously high. Once again 14x is historical fair value for US
stocks. 21x is expensive, and twice fair value at 28x is
hyper-risky bubble territory. Valuations are actually close
to that with earnings deteriorating!
Corporate profits
are rolling over and starting to fall at a time when stock prices
are as overvalued as they have been
since the early
2000s. As earnings retreat, the E in P/E will slide which will
ratchet up overall valuations. That ?mere? 4% projected drop in Q1
profits from the SPX components that Wall Street is claiming is no
big deal would push valuations up to 27.0x earnings! That ought to
terrify prudent investors.
Stocks get
expensive at just 21x on a trailing-twelve-month basis.
Provocatively the last cyclical stock bull that peaked in October
2007 crested at an SPX P/E of 23.1x in simple-average terms. That
resulted in a subsequent cyclical bear that mauled the SPX 57% lower
in 1.4 years! While that particular one culminated in an ultra-rare
stock panic, cyclical bears typically cut stock prices in half
after cyclical bulls.
Overvalued
stocks, combined with stock-market cycles, are the major
harbinger of bull-market toppings and imminent bear markets. Not
only can SPX valuations scarcely get more extreme than today?s lofty
levels, but the stock-market cycles are extreme too. This
magnificent cyclical bull has blasted the SPX 213% higher in 6
years, far beyond the average of a doubling in less than 3 years.
It is very long in the tooth.
On top of that,
it?s been an astounding 3.5 years since the last 10%+
correction in the SPX! In normal healthy bull markets, such
essential sentiment-rebalancing major selloffs happen about once a
year or so on average. So the US stock markets have rarely been
more overvalued or
more overextended,
right at the first time corporate earnings are contracting since
soon after 2008?s stock panic! This presents serious risks.
With the SPX way
up near 26x earnings on an average trailing-twelve-month basis, a
lot of institutional money managers who understand today?s actual
valuations are nervous. They know that stocks are really
expensive, but they can?t sell and risk lagging behind their
peers? performance until they have a good reason to. And a handful
of high-profile misses on Q1 earnings could provide their necessary
justification.
Earnings seasons
past have proven that major companies falling short of expectations
can spark sharp selling. This is even true in stock markets that
aren?t overvalued and overextended. Given how weak the overall US
economy is, and the howling US-dollar headwinds, the odds are high
that some subset of first-quarter results is really going to
disappoint in the coming weeks. Traders need to remain wary.
Today?s dangerous
valuation extremes are the direct consequence of the Fed?s
third
quantitative-easing campaign that ramped up in early 2013.
Before that, this cyclical stock bull was righteous. Check out the
chart above again. Even though the SPX rallied dramatically in the
initial years after the stock panic, valuations remained stable and
even retreated. That signaled that corporate earnings were
actually growing.
But since early
2013, valuations have shot straight up pacing the stock
markets. The Fed?s QE3 debt monetization and associated jawboning
ignited a huge artificial stock-market rally that wasn?t supported
by underlying corporate earnings. It was pure multiple expansion,
P/E ratios inflating because stock prices were rising far faster
than profits. This sharp increase in valuations only moderated a
bit last year.
And that certainly
wasn?t because corporate earnings started catching up with stock
prices. Instead US corporations took advantage of the Fed?s
heavily-distorted debt markets to borrow cheap money and buy back
their stocks. SPX-component-company buybacks soared to $553b last
year, the highest since 2007. That was up 16% from 2013 and
about four times 2009?s levels! That?s an incredible $46b-per-month
rate.
That debt-fueled
buyback binge reduced the number of outstanding shares, and thus the
denominator of the earnings-per-share equation which is the P/E
ratio?s E. So not only are today?s valuations extremely high, but
that?s even after being lowered by financial engineering rather than
growing businesses. The Fed?s upcoming rate-hike cycle, the
first in 9 years, is almost certainly going to garrote this
stock-buyback boom.
With the
unsustainable buyback pace on the brink of rolling over, the
downside risk to these extremely overvalued and overextended stock
markets is even higher. Today 14x fair value for the SPX based on
its components? average TTM P/E is way down around 1200, a
staggering 43% lower than today?s levels! The next bear market, an
inevitability in the forever-cyclical markets, will maul stocks back
down under fair value.
And the coming
high-profile misses in this first-quarter earnings season could very
well kick off that selling. Even if the shrinking earnings are
centered in energy stocks, the overall market downside risks are
still serious. Energy stocks traditionally have lower P/E ratios
than the general stock markets, as investors are never as excited
about commodities as they are about hot sectors like technology.
Those low P/Es are history.
There?s an
oil-stock index known as the XOI, and the big majority of its stocks
(the US-based companies) are also SPX components. At the end of
March before this disastrous Q1 earnings season, these XOI
components already had an average TTM P/E of 21.8x. Just a year ago
in March 2014, it was 14.8x. So energy-company valuations are
already rising on plunging profits, and this will only worsen after
their Q1 results.
The normally-low
energy-stock valuations help offset the lofty tech-stock valuations
within the SPX, so rising energy-company P/E ratios will really
force up the overall SPX valuation. Wall Street will do all
it can to try and mask this. Another trick it uses to blind
investors to overvaluation is aggregation. Instead of
looking at individual-SPX-component P/Es, it adds all their earnings
together to look at as a single number.
These total
earnings are divided by the SPX?s level to get an index P/E. But
aggregation is very misleading. A handful of companies with huge
profits like Apple can mask poor earnings and high P/Es in many
dozens of other SPX companies. Aggregated P/E ratios are even
worse when they are figured on a fictional forward-earnings basis,
which Wall Street analysts do constantly on CNBC these days.
In light of all
this, the downside risk posed by high-profile earnings misses is as
high as it?s ever been this earnings season. Investors and
speculators alike need to remain on guard, and ready for a
long-overdue selloff. This can be gamed with SPY, the flagship S&P
500 ETF. Investors can hedge their long holdings with SPY puts, and
speculators can bet on SPX downside with SPY puts or outright SPY
shorting.
With valuations
extreme and market cycles long overdue to reverse, cultivating an
essential contrarian perspective has rarely been more important to
investors and speculators alike. If your only sources of market
information are mainstream, you are going to miss the reversal
warning signs because they won?t be reported. All you will hear is
the usual stocks-to-the-moon cheerleading, which will cloud your
judgment.
We can help at
Zeal, as we?ve long published acclaimed
weekly and
monthly
newsletters for contrarian speculators and investors. You can
harness our decades of hard-won experience, knowledge, and wisdom,
as well as ongoing research, to help you thrive in these risky
markets. Our newsletters dig deep to explain what?s really
going on in the markets, why, and how to trade them with specific
stocks. Subscribe
today!
The bottom line is
this first-quarter earnings season now underway poses great downside
risks to these lofty stock markets. Overall corporate earnings are
actually expected to fall for the first time in 6 years, even by the
Pollyannaish Wall Street analysts. This deterioration is happening
at a time when stock-market valuations are already dangerously high,
actually extreme on the classic trailing-twelve-month basis.
And not only will
lower profits force these valuations even closer to bubble
territory, but today?s stock markets are super-overextended and
distorted thanks to the Fed?s epic manipulations of recent years.
It?s not only been far too long since a major selloff to rebalance
sentiment, but most traders don?t even think one is possible
anymore. This makes for a ripe environment for earnings misses to
unleash serious selling.
|