Today's updates are listed below (with direct hyperlinks). The most significant points are:
1. Two weeks ago, reported earnings per share was identified as one of the most significant vulnerabilities for the stock market. With more companies reporting (now at 61%), the forecast for reported EPS in 2019 slipped below $140 (i.e., $138.05).
However, the $2 decline wasn't lost; analysts added it to the forecast for 2020 (now reflecting a robust 17.6% increase to $162.33). However, if the forecast for 2020 EPS tracks recent years, final EPS for 2020 would deliver near $145 per share.
Here's the revised chart with the most recent forecast updates, including S&P's forecast for 2021: Earnings Trends: History & Future.
2. Most versions of the Crestmont Research Stock Market Matrix, except the one designated as "Year-End," are based upon the average daily closing index across the year.
Average yearly values are more relevant for many investors that dollar-cost average into the market (e.g., most corporate 401(k) plans, many IRAs, and many individual savers that accumulate monthly) and for investors that draw from portfolios across the year (e.g., retirees).
The S&P 500 Index surged in 2019 by 28.9% when measured at year-end. However, the average daily close across 2019 eked-out a 6.1% bump over the average for 2018.
The zig and zag gremlins made up for an opposite result in 2018, when the average daily index rose 12.1% while the year-end index fell -6.2%. Across the two years, both versions were within half a point of a 9.5% annualized gain.
Over the past five years, in the graph below, year-end was higher in price and gain for three of the years and average-daily topped for two. The annualized gains for both methods were within half a point of 9%. Over time, the two methods end at the same place--it is the same index, just different ways of reporting. Nonetheless, year-to-year results often vary substantially, which can impact comparisons investors' results to published index changes.
For this year's Matrix, most versions will reflect a surprisingly small gain. But remember, last year's Matrix reflected gains despite a year-end decline. Beware the distortion from the zig and zag gremlins.
3. As reflected in several updates listed below, the economy is not a consistent driver of the stock market. Nonetheless, optimism about near-term prospects for the economy can provide a strong psychological boost to the market. This is likely to be a continuing driver of the market into 2020.
4. The outlook for 2020 has a weighty list of "on-the-other-hands." The market has strong momentum upward, the economy continues to deliver solid results, and Fed policy is somewhat accommodative.
On the other hand, most measures of stock market valuation reflect relatively high levels. Also, the length of time since the last 10% correction and 20% bear market is extended.
Regardless of uncertainties in the short-term, the investment environment for the next decade indicates well-below-average returns based upon current starting valuation.
As a result, we are confronting very challenging short-term and long-term conditions for investors and advisors. Despite the environment, investors can still achieve investment success with skillful investment selection and appropriate risk management.
SELECTED ITEMS FROM BELOW:
Stock Market Matrix
Returns depend upon the starting and ending point. This series of charts presents the compounded annual returns for an investor that began investing during any start year since 1900 and ending with any subsequent year. The versions presented reflect those for taxpayers and for tax exempt or deferred investors, as well as returns on a nominal and real (after inflation) basis. The charts are prepared for printing on a single sheet of 11" × 17" paper or on two 8 1/2" x 11" pages for subsequent alignment. See the assumptions and legends for important details.
Earnings Trends: History & Future
This graph presents both (1) the historical trend for actual reported earnings per share (EPS), including a forecast by Standard & Poor's, and (2) an inset graph presenting the historical record for S&P's forecast over the past five years. To put the historical trend and future forecast into perspective, the graph includes Crestmont's assessment of the long-term baseline trend for EPS. Crestmont's baseline also puts into perspective whether current and forecast EPS are above or below the long-term trend for EPS. Also, the inset graph reflects S&P's EPS forecasts for recent years; forecasts begin about two years in advance and proceed until the year is finalized.
P/E: Forward Operating Averages 12
One of the most significant oversights (or distortions!) in stock market value analysis is the reference to the "historical average" for the price/earnings ratio of the stock market. Too often, the current P/E is based upon an upcoming period (forward earnings) and is based upon a modified version of earnings (operating earnings). That forward-looking, earnings-adjusted P/E is then compared to the historical average for P/E that is based upon the trailing year of as-reported net income. It's almost like comparing a reading of temperature on the Fahrenheit scale to the Celsius scale. P/E based upon trailing as-reported earnings averages 15-16 (depending upon the period); P/E based upon forward operating earnings averages 11-12. This graph provides a realistic view of the history for forward operating P/E.
Financial Physics
This presentation introduces the core “Financial Physics” model. The key factors include Real GDP, Inflation, Nominal GDP, Earnings Per Share (EPS), and P/E Ratio. Since Real GDP has been relatively constant over extended periods of time and all other factors are driven by inflation, a primary driver of the stock market is inflation-as it trends toward or away from price stability. Given the current state of low inflation and the likelihood of it either rising (inflation) or declining (deflation), P/E ratios are expected to generally decline for a number of years. As P/E ratios decline and EPS grows, the result will be another relatively non-directional secular bear market.
Crestmont's Research: Putting It Together
Guests and clients often ask for a succinct explanation about how to tie together the various elements of research and perspective that are presented within Crestmont’s website. This executive summary represents an initial draft toward explaining, through a series of steps, the relationships of some of the research. Several of the charts within this website are referenced.
It's Not The Economy
Despite the general contention that the economy and the stock market are inexorably connected, the facts get in the way of confirming common wisdom. This chart presents the average stock market return and average GDP growth by decade and by secular bull/bear market cycle. Economic growth is not the primary driver of stock market returns; stock market returns are driven primarily by a cycle in the P/E ratio (see the Secular Cycles chart above). Although economic growth does increase the denominator in the P/E (earnings), actual returns are generally the result of trends in the P/E ratio. This and other research that Crestmont has conducted dispels this conventional notion.
EPS Reality
The reality is that the business cycle is different than the economic cycle–GDP growth is much more consistent than EPS growth. EPS declines can occur during periods of economic growth. Across the 68 years since 1950, earnings declined during 23 of them despite positive economic growth in all of those years…34%! Real GDP growth (excluding inflation) has lagged the historical 3% average thus far in the 2000s and '10s. But even if the economy looks positive for the next few years, history highlights that EPS is not immune to decline—especially from such a currently high level of profit margins.
Worst Recovery Since...Ever?
It has been said repeatedly that the current sluggish economy is the result of the recent “worst recession since the Great Depression.” It’s probably time to reassess the medicine, rather than continue to blame the illness.
This chart does not advocate a particular economic policy, rather it provides contrasts of historical experience.The rate of economic growth can have a significant effect on stock market valuation, the market P/E, and future returns: see Game Changer
GDP - Real Economic Growth
Real GDP in the decade of the 2000s was significantly below average. It is unclear whether the economy downshifted to a new level of slower growth, or whether pent-up economic production will drive a high-growth decade in the 2010s or beyond that again restores the long-term average.
GDP & Population Growth
Economic growth, as measured by GDP, is driven by two components: population growth and labor productivity. Population growth represents a surrogate measure of the quantity of labor in the economy. Although there are numerous measures that are more refined (e.g., labor force participation, total employment, etc.), over time total population growth has provided a reasonable estimate for high-level analyses of the first component of economic growth.
GDP & Economic Productivity
Economic growth, as measured by GDP, is driven by two components: population growth and labor productivity. Labor productivity reflects the ability for increased output from the existing quantity of labor in the economy. Various government agencies and independent analysts produce measures of labor productivity. For high-level analyses of the second component of economic growth, a productivity measure using overall economic production provides the most comprehensive and consistent measurement of economic productivity.
GDP - Nominal: 10-Year Rolling Components
Nominal GDP consists of real GDP plus inflation. This chart presents the two components of nominal GDP for all ten-year periods since 1900. The ten-year periods smooth some of the variability of economic growth and the inflation rate to display the contributions of each component over longer periods. Of particular note, the loss of real economic growth during the 1930s was made up in subsequent decades thereby restoring the long-term trend of fairly stable real economic growth over time.
GDP - Nominal & EPS
Nominal GDP and Earnings Per Share have a close and fundamental relationship. Nominal GDP is driven by the economic cycle, with real GDP providing core growth and the inflation rate adding a degree of variability over time. Earnings growth is driven by the business cycle, which revolves around the economic cycle with swings that have greater magnitude and frequency. The primary driver for the core baseline of earnings over time is nominal economic growth (yet GDP does not consistently drive EPS in the short-run).
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