The Elusive Spark Needed for the Rally to Continue

S&P P-E Ratio

Against most expectations, U.S. stocks are turning in a respectable performance this year. The S&P 500 is now up 7% year-to-date, recovering from what would charitably be described as a shaky start to the year (source: Bloomberg).

That’s the good news. The bad news is that the gains, which are coming against the backdrop of a prolonged earnings recession, have been entirely driven on multiple expansion. In other words, investors are willing to pay more per dollar of earnings. From the lows earlier this year, the trailing multiple on the S&P 500 has risen by roughly 22% (source: Bloomberg).

The rapid ascent in the market multiple has left stocks expensive. The S&P 500 is now trading at 20.5x trailing price-to-earnings (P/E), well above the historical average of 16.5x, according to Bloomberg data. While investors can partially justify this on the basis of a lower discount rate, i.e. low interest rates, it is worth highlighting that even in the context of low rates, valuations are elevated. Yields have been consistently low, averaging 3.25% for the 10-year Treasury bond, since 2003 (source: Bloomberg). Yet, during this same period valuations have still only averaged 17x trailing earnings.

Look for faster earnings and economic growth

If stocks are to advance further, sustainable gains need to be predicated on faster earnings growth. That, in turn, is a function of nominal GDP (NGDP), real growth plus inflation. Looking back over the past 60 years, the level of NGDP has been strongly correlated with non-financial profit growth. During this period NGDP growth has explained roughly 20% of the variation in profit growth.

The relationship is not hard to understand. While individual companies can take market share from rivals, that can’t sustain growth across the broader market. At the aggregate market level, faster economic growth is necessary to drive faster revenue growth. Although it is true that international sales have grown for most large-cap companies, making the U.S. dollar another critical variable, nominal domestic economic growth is still the primary driver of corporate earnings.

One can argue that markets can advance as valuations press higher, even in the absence of faster growth. For example, the chart below shows the trailing P/E on the S&P 500 pushing above 20 in the spring of 1997, and investors who remained in the market enjoyed another three years of spectacular gains. Of course, the tech bubble ultimately ended badly.

That was then, this is now

Unfortunately, the factors that fueled the latter part of the 90s bubble are not likely to be repeated. From the spring of 1997 until the end of 1998, yields on both the 2- and 10-year Treasury notes fell roughly 200 basis points (2%), while inflation continued its multi-year decline. At the same time, growth surged on the back of stellar productivity. Today, productivity is at multi-year lows, demographics are working against growth and any further drop in inflation or rates would likely come in the context of deflation, not a supportive environment for stocks.

The best hope for the market lies in faster growth. In the absence of faster NGDP, investors are making a different bet: that a combination of paltry bond yields, buybacks and elevated margins make equities the “least bad” bet. That is not a gamble that is likely to end well.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

Late Summer / Late Cycle

Profit Share of GDP

Here in Boston, cooler nights and unwelcome back-to-school advertisements tell us summer is beginning to draw to a close and autumn is approaching. Like seasons, business cycles often signal their coming demise.

One thing that recurs with greater regularity during the last phases of business cycles is a scramble by companies to purchase competitors. Corporate acquisitions have been rising and are now near peaks seen in other cycles. Late in the cycle, companies often see flagging internal rates of growth and seek to boost growth through mergers and acquisitions. Historically, companies often overpay for such acquisitions late in the cycle. We’re seeing that now with widespread takeovers and significantly higher premia in prices paid.

Another signal of changing cycle dynamics is the profit share of the economy. The share of gross domestic product going to the owners of capital in the form of net profits often dips in the final 12 months of a cycle.  The United States is now experiencing the third quarter of such profit deterioration as the owners’ share of the expansion starts flowing to other parts of the economy, rather than to profit gathering.

Late in the cycle, companies often seek to add debt to their balance sheets in order to boost profit growth. Frequently, this results in a broad scale deterioration of credit quality, which is subsequently made worse by the onset of recession. US consumers also tend to add debt to their collective balance sheets in the late phases of a cycle. And indeed we see that the borrowing of both corporations and consumers, which has been comparatively subdued in this cycle, is now starting to rise.

Signs not totally aligned

Not all the usual signs of recession are present now in the US. Some typical late-cycle signs have yet to appear, and this should cheer investors. Typically the shape of the yield curve becomes distorted in the late months of a cycle as short-term rates rise above long-term rates, reflecting market expectations of subdued growth ahead. We’ve seen a flattening of the yield curve in this eighth year of the cycle, but not an inversion of yields, as short rates remain slightly lower than long rates.

Another late cycle characteristic is widespread fear of inflation taking hold and accelerating. The US Federal Reserve often acts to forestall inflation pressures by raising short-term rates, which can slow the economy’s momentum.  So far, signs of gathering inflation pressures are scant, but worth watching. As our regular readers know, there are currently no signs that the Fed is about to act aggressively to prevent an inflation spiral.

As long-term investors, we know that fundamentals matter most. In this cycle we’ve seen profit margins hit near-record levels. Likewise, operating income compared to revenues and free cash flow compared to market capitalization have been consistently high for over six years. The return on equity of companies in the major US indices has been outstanding.

Fundamental shift

But in the past three quarters, margins and profits of US companies have been pressured, and not just by weak energy prices. Cost pressures in other sectors have appeared as rising general and administrative expenses and weak sales growth combine to trim profits. That environment makes it harder to grow profits than was the case in the first six years of the business cycle. Worryingly, this shift comes at a time when the S&P 500 price/earnings ratio has reached over 18 times expected 12 month forward earnings, a valuation measure which lies on the high side of history.

Despite the arrival of back-to-school ads in early August, and the return of neighborhood youth to US college campuses later in the month, we can choose to shrug off the passing of summer and instead relish the last warm sunny days. But the evening breezes now bring a chill to the air that we didn’t feel in June or July — a chill that should not be ignored. What we find most concerning is that late in the cycle, market behavior often seems to be propelled more by hope than fundamentals. Maybe that is happening today, as market averages for both large and small caps rise while revenues, margins and profits continue to diminish. It may be comforting to look the other way and pretend the days will remain warm and bright. But investors keen to hold on to their wealth should not let the hope of catching the final gains of the cycle keep them hanging on too long.

 

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

What a Most Unusual Election Season Could Mean for Markets

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The current U.S. presidential election season is unusual, with unpopular candidates, vast policy differences and equity market volatility at historically low levels. This week’s chart shows that we could see market volatility moving higher as the Nov. 8 Election Day approaches.

The chart above shows how volatility has moved in past presidential election cycles (the blue line) and where it has been so far this year (the green line). Equity markets tend to react more to macroeconomic factors and corporate earnings than elections, but volatility typically picks up in the month before a U.S. election. We see this trend repeating itself this year, as volatility has been usually low.

Markets in the run-up and beyond

Democratic presidential nominee Hillary Clinton has been leading the polls, and betting markets point to a solid Clinton victory. The United Kingdom’s vote to leave the European Union, however, showed such predictors can be wrong. If Republican nominee Donald Trump’s poll numbers improve, we could see the uncertainty surrounding his future policies putting downward pressure on risk assets such as equities. It could also trigger a near-term flight to U.S. Treasuries.

Yet Treasury strength could be limited. Both candidates have campaigned on increased fiscal spending on infrastructure, which would result in more Treasury issuance. We could see this nudging up Treasury yields and supporting the U.S. dollar. Gold may be a better hedge in the short run.

Investors have tended to pull money from U.S. equity funds in the month before election day in the past four presidential elections, EPFR Global data show. Market volatility usually subsides after elections. We could see a turn in sentiment toward emerging market (EM) assets if this year’s anti-trade rhetoric increases, but for now we like EM debt due to economic green shoots and investor appetite for income in a world starved for yield. Read more market insights in my Weekly Commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

Terry Simpson, CFA, a multi-asset strategist for the BlackRock Investment Institute and a regular contributor to The Blog, contributed to this post.

 

Investing involves risks, including possible loss of principal. International investing involves special risks including, but not limited to political risks, currency fluctuations, illiquidity and volatility.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.