From The Wall Street Journal:
‘The new year rally in technology stocks lifted the Nasdaq Composite to its eighth consecutive weekly rise and propelled the index out of the bear market it entered in late 2018.
‘Tech companies have largely reported fourth-quarter results that exceeded expectations, while easing fears among investors about trade tensions and rapid interest-rate increases have also propelled the index higher. The Nasdaq closed more than 20% above its Christmas Eve low, which marks a new bull-market run.
‘All three major U.S. stock indexes ended the week up more than 2%. The Dow Jones Industrial Average also notched its eighth consecutive week of gains for its best eight-week stretch since September 2009, rising more than 15%.
‘The Dow industrials rose 443.86 points, or 1.7%, to 25883.25 Friday, while the S&P 500 added 29.87, or 1.1%, to 2775.60. All 11 sectors in the broad index notched gains. The index’s technology sector is among the best performers this year, with a 12% climb, trailing only industrials, energy and real-estate stocks.’
I’ve been saying for a while now that this rally is just about done. And the stock market has proved me consistently wrong. That’s what the market does. It confuses. It confounds. It frustrates.
It pushes you into making a mistake. You fold, simply because you don’t want to be wrong anymore.
But let’s stay rational, and ask: What has really changed over the past month or so to justify US indices moving back towards their all-time highs?
Well, the Fed is sitting back and keeping interest rates on hold. This provides confidence, and confidence provides liquidity. Confidence and liquidity are important short term market drivers.
In fact, when these two forces are in action, nothing else really matters.
But if you want to take a slightly longer view, what does really matter for ongoing price appreciation is earnings. When company earnings increase across the board, sentiment is usually strong too. This combines to have a powerful impact on prices, via an expansion of the price-to-earnings (P/E) ratio.
It works like this: Say a company increases earnings from 10 cents to 12 cents per share. That’s a 20% increase. At the same time, positive sentiment sees the company trade on a P/E ratio of 15 times the new earnings, up from 12 times the year before.
That’s a 25% multiple expansion. So, increased earnings, plus improving sentiment, results in a 45% share price increase.
But here’s the problem I see with today’s improving sentiment: It’s happening at a time when earnings growth is weak. Actually, earnings aren’t just weak. They’re declining.
As the Australian Financial Review reports:
‘The outlook for S&P 500 corporate profits has dimmed greatly in the past few weeks, increasing the likelihood of an earnings recession in the first half of this year.
‘Earnings are poised to drop 2.2 per cent in the March quarter, FactSet senior analyst John Butters said in a February 15 note, a gloomier outlook than two weeks ago when the data pointed to a 0.8 per cent decline. If earnings do pullback this quarter, it would be the first year-over-year retreat since the second quarter of 2016.’
The article goes on to say that consensus expectations is for just 1% earnings growth in the June quarter and 2.4% growth in the September quarter. For the first nine months of the year, then, earnings will barely grow for S&P 500 companies.
Yet the market continues to rally? In effect, the S&P 500’s P/E ratio continues to expand while the prospects for earnings growth gets worse. To me, that’s a worry.
Of course, the market might just be looking through a period of flat earnings growth and see strong growth emerging again in late 2019 and into 2020. And while I have great respect for the market’s ability to see into the future, this is definitely a glass more than half full interpretation.
We’re due for a decent decline in earnings
The reality is that earnings have been in a bull market since 2009, disturbed only by a period of flat growth during 2015 and 2016. You can see this in the chart below, from Yardeni Research.
There’s a bit going on in the chart. But just focus on the red line, which shows analysts 12-month forward earnings estimates. This is a leading indicator of the actual results. As you can see, the line has only just started to turn down.
The trillion dollar question is whether the turn reflects a top of the cycle event (like in 2001 and 2008) or a mild slowdown like 2015/16?
A 10-year plus uninterrupted run in earnings growth is very unusual. The odds suggest we’re due for a decent decline in earnings. That’s why I continue to be wary of this sentiment driven rally.
Editor, The Rum Rebellion