Continued surprise in how well US equity markets are holding up:
Given the relatively poor US economic data so far in 4Q12, I continue to be surprised the US equity market (as measured by the S&P 500) has done as well as it has in the latest mini rally from the most recent low of S&P 500 1353 on Nov. 15 2012 up to the most recent closing peak (S&P 500, 1447 on Dec. 18th 2012). But it is the seasonally strong time of the calendar year for the North American equity markets.
Though, I should not be surprised. It’s been the same pattern of marginal new highs, followed by a couple quick duration 10 to 20% sell-offs a year, and then the intermediate-term uptrend starts again. It’s been going on for almost four years now. Though the Nasdaq has reached a new intermediate term high (passing the previous 2007 high, but still well below the March 2000 all time high), the S&P 500 and the Dow Industrials have not yet passed their previous October 2007 highs. The Russell 2000 small cap index made an all time high on April 29 2011 at 865 (the Russell 2000 is currently at 832.10).
As said in previous posts, despite all the media hype, the current price levels on all the US equity markets are nothing to get excited about (if your objective is to be long US equities). Given the continued economic weakness combined with the fact that equity valuation is still in the high end of the historical ranges using proper valuation methods (more on valuation another day as previously mentioned).
If there are some positives in this equity environment, three of the main items are as follows:
1) It could be called a stock pickers market if you’re good enough to catch the intermediate-term bottoms during the sell-offs and anticipate US equities have further upside from these near peak levels that justify the downside risk. Otherwise you’re taking on significant downside risk to gain 10% to 15% from the bottom of each mini-rally.
2) Large cap corporate earnings have continued to grow over the years and the high valuations on the S&P 500 companies are not nearly as bad as they were in March of 2000 (all time high for the Nasdaq) and the time period (late 1999, early 2000) for the all time high for trailing P/E ratios.
3) It could be said by some that large cap companies/equities that have enough free cash flow to pay a cash dividend could be treated as a version of high yield debt(given the low yields on junk bonds). Though I don’t necessarily agree with this assessment myself. I’ll never buy the pure equity of a company just to pick up a dividend (convertible debt is a different story). The nominal dividend per share is just a product of the current/past cash flows. I primarily look at future operations that will enable the company to generate future free cash flows, which should, in theory be returned to shareholders in the form of dividends. Dividends can disappear very quickly as we’ve seen in the recent past when the outlook for a company takes a turn for the worst.
The following list of topics continue to support my cautious stance on the US equity markets…
Weakening trend in S&P 500 companies above their 200 day simple moving average:
Courtesy of StockCharts.com: Percentage of S&P 500 Companies Above Their 200 Day Moving Average
As is usually the case with my analysis of trends, it’s not so much the absolute level of the percentage of companies above their 200 day simple moving average (about 67% of S&P 500 companies currently) that draws my attention, but the peak to peak trend is declining. Every rally, less and less companies participate in carrying the US large cap indices higher. This is not a good sign as the graph shows. Eventually, there are not enough companies for everyone to pile into. And the sell-offs tend to be quick and the draw-down significant, catching the “market followers” by surprise.
Here’s a longer term version of the number of S&P 500 companies above their 200 day simple moving average.
Courtesy of Stockcharts.com: Percentage of S&P 500 Companies Above Their 200 Day Moving Average (Point and Figure graph)
Notice how the sell offs in 2010 and 2011 occurred at higher absolute levels for the percentage of companies above their 200 day moving average.
Retail sales continue to be “not so great”…though consumer focused equities continue to lead the US equity market:
Courtesy of the International Council of Shopping Centers (ICSC): Weekly Chain Store Sales (Dec. 26 2012)
For the week ending Saturday Dec. 22nd (Report dated Dec. 26th 2012), the year over year month-to-date percentage increase for December was 1.7%, the forecast of the ICSC is 3.0% year over year growth for the entire November-December time period (November 2012 was also 1.7%). Meaning as I write this, the current week between Christmas and New Year’s had better be very good or the sales growth forecast is not going to be hit.
Increasing Margin Debt on the NYSE:
Courtesy of the New York Stock Exchange: Margin Debt (Securities Market Credit)
Margin debt on the NYSE has been increasing since mid 2012. Many on Wall Street see this as a short-term bullish signal and that the risk trade is back on. I can’t argue with this fact with respect to increasing margin. But what it does confirm for me is the the downside risk to this US equity market continues to increase given the absolute level of margin as of end of November 2012 relative to the all-time high for margin set back in July of 2007 (just before the S&P 500′s most recent peak) and the fact that the overall market cap of US equities has not really increased since that time . The next big sell-off may not stop at 15% if the economic performance continues to worsen to the point where it’s showing up in corporate earnings and operating margins.
It will not be pretty on the long side trade if too many significant players get caught leveraged beyond their means (it’s already happened in a few individual company trades. Apparently, some firms firm got caught leveraged long with Apple).
Betting on continued earnings growth to drive equity prices is a risky move:
Here’s a graph of the S&P 500 Index vs. US Corporate Profits After Tax that can be interpreted several different ways. One of my favourite data series relationships to study.
Though the stock market is supposed to discount future free cash flows, it’s obvious the stock market price levels are primarily concerned with what’s happening today and tomorrow with earnings. That’s why in recent history, stock prices tend to overshot too high and for too long relative to the future stream of free cash flows to the shareholders (aggregate for the market). Operating cash flows and free cash flows go through up and down cycles, but on an aggregate present value basis, operating cash flows don’t fluctuate as much as the stock markets. One year of negative operating cash flows and free cash flows (even in the next year or two) makes up a relatively small part of the present value of a company.
Courtesy of the St. Louis Fed Research: S&P 500 Index vs Corporate Profits After Tax
One can interpret this graph on the cautious side (which lines up with my current views) that the “correction” of the overvaluation of the S&P 500 Index that was built up during the mid to late nineties has not run it’s course yet and will last for several more years. Simply, trailing P/E contraction to fix the overvaluation has not run it’s course yet. At worst, it could take another 10 years for trailing P/E’s to come down “below average” to finally correct the excesses(too low interest rates, a fake, overly leveraged, residential real estate supported economy, etc.) of the 1987 to 2008 era. The thesis being that the US equity market at least needs to go through a prolonged period where earnings grow faster than the S&P 500 index. Similar to the period from around 1969 to 1980.
Another way to interpret the graph (which is the main stream, Wall Street way) is that we’re in uncharted territory with respect to government and central bank intervention in the developed economies of the world. At negative real short-term interest rates and maybe even negative real long-term interest rates (assuming a realistic value for net consumer inflation, and not the overly low value that the government attributes to net consumer inflation) the old rules no longer apply. One can always include the fact that the S&P 500 really no longer reflects the US economy like it did twenty years ago and the companies that make up the S&P 500 index are more global than they are US companies.
My issue with the current main stream thesis that earnings growth can continue to support the US equity market is that margins are at all time highs (more on operating margins another day). Operating margins, just need to come down slightly off the all time highs, they don’t even need to go back to near average and S&P 500 earnings growth stalls. The continued slow economic growth in the US economy and slowing economic growth in other important economies(Europe, China, etc.) just makes the future earnings growth driven picture harder to believe. It’s going to be very difficult for the US equity markets to move higher on trailing P/E expansion as happened in the late nineties if earnings growth stalls.
Until next time.