Running on Faith: Are Stocks Discounting Too Powerful an Earnings Recovery?
We are in the heart of second quarter earnings season, with the “beat rate” above average thanks to an extremely low bar.
Stocks’ substantial run since the March lows has been P/E-driven, not EPS-driven.
Concentration, courtesy of the “big five” represents potentially-significant risk; but there are fundamental differences between 2000 and 2020.
About 130 of the S&P 500’s companies have reported second quarter earnings, and while weakness has shown itself in a few areas of the stock market; in general, earnings season has been better-than-expected. But we shouldn’t conflate better-than-expected with strong. Yes, 80% of companies have beaten analysts’ expectations (as per Refinitiv); but the expected decline in earnings for the second quarter is currently -40% (representing the blend of actual results for companies having reported and expectations for subsequent reports). A lesser 68% have beaten revenue estimates. You can see historical/current/future earnings growth rates in the table below; also broken out by S&P 500 sector.
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 7/27/2020. For illustrative purposes only.
Thanks to the grave uncertainty unleashed by the pandemic, nearly half of S&P 500 companies have withdrawn full-year earnings per share (EPS) guidance; so analysts have been flying a bit blind during the pandemic. With analysts having lowered their estimates to a significant degree, the spread between the percentage of companies that have raised guidance and lowered guidance this season (through Friday) is currently at +10 percentage points (as per Bespoke Investment Group). The rub is that with the escalating economic damage from COVID-19’s resurgence, the ascent of forward guidance could falter.
In terms of valuations, the significant move up off the March 23 S&P 500 low has been a P/E-driven surge; not an earnings-driven surge. From a recent low of 13.1 on March 23, the forward P/E for the S&P 500 has surged to 21.5. That is getting eerily close to the P/E highs of the late-1990s into the market’s bubble peak in 2000, as you can see in the chart below.
Forward P/E’s Ascent
Source: Charles Schwab, FactSet, as of 7/24/2020.
Stocks’ often-odd relationship with earnings
Lest you think the stock market has lost its mind (which perhaps it has), it is historically “normal” for rallies in stocks to accompany still-weak earnings. As the table below shows, the best range for earnings in terms of accompanying stock market performance is -20% to +5%. The data is culled by our friends at Ned Davis Research; and I recently asked them to look at that particular bracket to see the performance difference if earnings were rising into that bracket vs. falling into that bracket. In the case of the former, stocks have returned nearly 26% on an annualized basis when earnings were in that bracket. Yes, stocks have had their worst performance during periods when earnings were imploding (by more than -20%); but given their “discounting mechanism” nature, stocks tended to rise sharply in anticipation of the improvement (i.e., they don’t “wait” until it’s already clear).
Source: Charles Schwab, Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. Past performance is no guarantee of future results.
It’s not a stretch—at least from my perspective—to think that the market’s move may be discounting too lofty a coming recovery in earnings. As you can see in the first chart below, looking at the past 20 years, there has been a 0.9 correlation between the S&P 500’s performance and subsequent 12-month EPS. On the other hand, as you can see in the second chart below, if you look at the period since the S&P 500’s low on March 23, you see a near-mirror image correlation of -0.8. (The correlation was also negative coming off the March 2009 low). To justify the market’s rally off those lows, earnings will eventually need to do more than just beat an extremely low bar (which ended up being the case in 2009).
Stocks vs. EPS, 2 Timeframes
Source: Charles Schwab, FactSet, as of 7/24/2020.
Valuation as sentiment indicator
The forward P/E shown in the beginning of this report is one of many valuation metrics on which I keep tabs. The others are included in the table below; and as you can see, valuation is in the eye of the beholder, and a function of which metric is chosen. As I’ve often noted, I could find the most bullish and most bearish of investors; and hand each of them a valuation metric that perfectly supports their view. Although standard P/E ratios suggest the market is extremely expensive; most valuation metrics that use a “lens” of interest rates/inflation—like the Fed Model and equity risk premium (relative to Treasuries)—suggest the market is inexpensive.
Source: Charles Schwab, Bloomberg, FactSet, The Leuthold Group, Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. As of 7/24/2020.
The reality is that although we think of valuation as having quantifiable components—regardless of the metric—in reality, it’s as much of a sentiment indicator as it is a fundamental indicator. Momentum- and hype-driven markets—like in the late-1990s, and arguably today—can lift valuation levels into the stratosphere. This year, it’s particularly evident in the mega-cap tech-oriented stocks that now dominate recent performance; as well as the market capitalization of the major indexes. Below is a chart showing the relative performance of the NASDAQ 100 to the S&P 500; and as you can see, it recently surpassed the peak from 2000.
NASDAQ 100 Relative S&P 500 at Record
Source: Charles Schwab, Bloomberg, as of 7/24/2020. Past performance is no guarantee of future results.
Too much hype in too few stocks?
Much of the strong performance of both the NASDAQ 100 and the S&P 500 is thanks to a small number of stocks. In fact, the top five stocks by market cap (Apple, Microsoft, Amazon, Google and Facebook), now make up nearly 23% of the S&P 500, as you can see in the chart below. That means 1% of the stocks—measured in simple, equally-weighted terms—now practically make up their own quartile in market cap terms. That is significantly higher than the prior 2000 peak of about 18%.
Top 5 Has Ruled
Source: Charles Schwab, Bloomberg, as of 7/24/2020.
By the way, of the top five stocks, only two (Apple and Microsoft) are actually in the tech sector. The others are in a combination of the consumer discretionary sector (Amazon) and the communications services sector (Google and Facebook). As such, let’s call them “techie” stocks. Although the concentration of the top five, as noted above, has surpassed the peak in 2000; the forward P/E of those five stocks is nowhere near the 2000 peak of more than 100. (The spike in 2018 was due to ~50% rallies in Google and Amazon from late-2017 to early-2018; with the subsequent decline courtesy of 2018’s near-bear market.)
Top 5’s P/E Less-Extreme vs. 2000
Source: Charles Schwab, Bloomberg, as of 7/24/2020.
Because these stocks are so dominating within the S&P 500, the index itself can close significantly higher at the end of a trading day even when most of the index’s stocks are declining. In fact, a week ago today (July 20), we saw a 30-year record in terms of the strength of the index and the number of its member stocks down on the day. SentimenTrader looked at all times when the S&P 500 was up at least 0.75% on a day, with negative advancers-minus-decliners. There were 12 prior occurrences—11 of which were in 1999-2001 and one in 2008—and, needless to say, they were followed by very weak returns; with the risk/reward ratios heavily skewed to the downside.
I do think there is a lot of risk of the aforementioned concentration. But there is at least a small caveat: There are some fundamental differences between leadership then and leadership now. There has been a lot of attention on the love affair with techie stocks by newly-minted day traders and the broader cohort of younger retail investors. However, given that the Nasdaq 100 has returned more than 1,000% since the 2009 lows, its ascent is likely more than just a function of new day traders.
There has been a broad accumulation of positioning, as noted by Goldman Sachs in a recent note, which constitutes a very significant stock of ownership today. Although the new cohort of day traders is showing excessive exuberance; when looking at single name positioning (or CFTC data on index futures positioning), the sentiment picture is more balanced. Goldman Sachs has detected a “pattern of discipline” by institutional investors—a starkly different picture than was evident in 2000. In sum, euphoric sentiment remains “pocketed” and isn’t as pervasive as was the case in 2000.
As the old idiom “pigs get fat, hogs get slaughtered” suggests, being overly greedy can be an investor’s ruin. Remember, greed is not a financial issue—it’s an emotional issue. I don’t know if the concentration problem is a bubble set to burst at some point. But navigating that possibility doesn’t require trying to define it and/or forecast the timing of its popping, if it is indeed a bubble. We continue to recommend that investors remain disciplined—especially with regard to periodic rebalancing/profit-taking. Remember, successful investing is not about what you know (or don’t know), but what you do.
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Rule of 20: Stocks are considered fairly valued when the sum of the S&P 500 forward P/E ratio and the year-over-year change in the consumer price index (CPI) is equal to 20 (or inexpensive when it's below 20).
Shiller's Cyclically-Adjusted PIE (CAPE): This model uses an inflation-adjusted price for the S&P 500 and divides by reported earnings over the prior 10 years.
Tobin's Q: Developed by Nobel Laureate James Tobin, it's a fairly simple concept, but laborious to calculate (calculations are done by the U.S. government and the ratio's readings are provided by the Fed). It's often called the Q Ratio and is the total price of the U.S. stock market divided by the replacement cost of all its companies. A high Q (greater than .85) implies overvaluation.
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