But there is reason to believe that this historical
relationship has broken down of late. One possible culprit is the Fed’s overt
goal of inflating asset prices in hopes of having investors acting out those ostentatious
December to Remember car commercials;
the so-called wealth effect. Another cause for caution is that, scarred by the
recession, fewer investors are participating in the market’s ascent. Combine
these two and we have the possibility that the worn-out cliché of Wall Street vs. Main Street may adequately
capture present conditions in the country. Those still in the market are
benefiting from the Fed’s largesse while for everyone else it still feels like
mid-2009. This migraine is a consequence of another goal of the Fed’s attempt
to pump up of share prices…enticing corporations to ramp up capital expenditure
and hire workers who then rush out and spend spend spend, thus creating a
virtuous circle…has fallen flat on its face. Furthermore, any increase in shares based on
sound fundamentals may be a result of U.S. corporations’ foreign earnings
(roughly 46% of sales) rather than reflecting strong prospects at home. In this
case, equities investors may indeed feel wealthy enough to spring for that luxury
car (complete with big red bow on the hood……I hope no one has ever done that),
but the 7.9% (14.6% using a broader measure) of Americans out of work and
shelling out north of three bucks for a gallon of gasoline won’t likely
practice such magnanimity over the holiday season.
Stop Me if You’ve
Heard This One Before
Not to completely plagiarize the posting that followed the
Q2 earnings season, but the narrative has changed little. At that time,
year-on-year growth in quarterly profits had slowed to a snail’s pace compared
to the periods immediately succeeding the recession. With nearly all S&P
500 members reporting, the rate for Q3 has turned negative, compared to the
same period in 2011 ($24.30 vs. $25.39, or a 3.6% decline). Perhaps more alarming
is the consistent downward revision of future earnings forecasts. Over the past
year, EPS forecasts for the current quarter (Oct-Dec) have been dialed back 14%
to $25.68. Since March, full-year 2013 earnings forecasts have dipped nearly 4%
to $113.38. Should….important word…that
target be hit, it would represent a 14% increase over full-year 2012 estimates,
which far outstrips the paltry 3% growth expected between this year and last. Hope
springs eternal.
Higher Sales to the
Rescue of Lean-Running Firms?
For much of the post-recessionary period, earnings gains
have far outpaced top-line sales figures. While it is laudable for management
to constantly streamline operations in order to cut expenses, too much of a
good thing means firms will be ill-equipped to handle an increase in business,
should that day ever come. If they are cutting because they foresee little
possibility of increasing operations in the near term, well then, that’s a
whole other cup of tea….a very bitter one. And if trimming expenses takes place
solely to drive EPS gains and satisfy Wall Street, that game has a short life.
Investors are well aware of the paramount need for firms to increase revenues
at a solid pace. As seen in the chart below, sales growth has tapered off over
the past five quarters to critically low levels (under 2% for the past two periods).
Proving our point that expenses can only be cut so much, YoY earnings gains
have shrunk from over 17% to this quarter’s negative reading. In order to hit
next year’s earnings targets, firms will need to increase top-line growth; a challenging
task in a consumer-driven economy suffering from chronically high joblessness.
With earnings forecasts consistently being revised down and Q3 revenue and EPS lousy, what has driven the near 10% rally in equities since early June? Here we refer once again to the Three “E”s of equities; earnings, economics and emotions. We covered earnings. Paltry. The economic outlook, especially when accounting for some form of higher taxation in 2013, will likely remain subdued. So that leaves emotion. Perhaps investors simply view stocks as sufficiently cheap and have jumped back into the market. In June, the forward P/E was around 12.5. The current figure based on the next for quarters of earnings has inched up to 13, still relatively cheap compared to historical valuations. But shares likely have lagged historical levels for good reasons, such as the aforementioned tepid earnings growth and economic headwinds. When looking at P/E ratios based on GAAP earnings, which take into account extraordinary items, valuations are slightly higher, though still below the long-term average.
Investors in U.S. equities are fortunate that such a large
percentage of sales is generated abroad. But this has dipped over the past
three years as Europe fights its crisis and emerging market buyers of
American-made capital goods face their own economic slowdown. Domestically,
while there have been no outlines of a potential deal to avert the fiscal cliff,
one can expect certain taxes, like those on dividends and capital gains to
revert to higher levels. Short-term, such an outcome may be partly responsible
for the post-election rally as investors take advantage of current tax policy.
Long-term, higher rates would likely serve as a disincentive to invest in
equities. Such tax policy would be yet another distorting force on investor behavior. As with any distortion, it would further clutter the efficacy of financial markets in executing its historical role of allocating capital to its most productive use. The result: the prospects of Wall Street and Main Street would continue to diverge, undermining what has historically been a mutually beneficial relationship.
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