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Beware the ides of 2020

The market is telling us that US earnings expectations are way too high.

According to Benjamin Graham “in the short-run, the market is a voting machine but in the long-run it is a weighing machine”. Put another way, the market is never wrong for long, but investors often are.

Currently, the S&P 500 Index is at an all-time high and according to most valuation metrics – such as historic or forecast price-to-earnings (PE) as well as the Shiller cyclically-adjusted PE ratios – the market is ‘very expensive’.

But does this mean the market will correct this year? We believe these metrics are never a sufficient enough argument to estimate expected market returns. At best, PE ratios might help us over cycles of five years or longer, which is not good enough to keep our reputations and track records in place if we get it wrong.

The market is constantly forecasting earnings per share (EPS) growth for us, but is anybody listening?

The key problem in using PE ratios is that they require somebody to assume what the ‘fair’ or realistic price-earnings level should be right now. In addition, PE ratios suffer from substantial problems and ‘dimensional biases’.

For example, stock prices change every day, whereas EPS is only reported twice or four times a year. Prices are far more volatile than EPS, so the contribution of price changes to the PE ratios by far dominates any contribution made by EPS changes. Mathematically it is accurate to state that a PE ratio is actually just the price with a tiny ‘earnings limp’.

Also, simple ratios like the PE can easily hide vital information.

If the PE of the market moves from 20 times to 22 times, this could either be due to prices rising or EPS falling and each means something very different.

What doesn’t matter … and what does

As a result, we have developed an indicator that can remove a lot of this subjectivity. We base our analysis on the old economist’s adage that using the ‘level’ of a variable like PE ratios actually never matters, whereas measuring ‘changes at the margin’ to these levels does.

We prefer using a type of ‘deconstructed’ PE ratio where the ‘rate of change’ in prices (in other words, how the market is reacting to new information at the margin) is compared with the ‘rate of change’ in EPS or earnings growth.

For example, if the market prices are rising by 15% per annum but earnings are only rising by 5% per annum, that is telling us something. Rationally, that is not sustainable.

Sometimes, in extreme cases, market prices may even be rising while earnings growth is falling. This demonstrates a clear market conflict, irrespective of what the current PE levels are.

Figure 1: S&P 500 EPS momentum vs price momentum (both year-on-year%)

Source: RMB Global Markets

We have therefore discovered that the rate of change of prices is a remarkably reliable predictor of future EPS growth – far more reliable than consensus EPS growth forecasts.

It is like the market itself is constantly and effectively estimating what future EPS growth is.

In the chart above, we see the rolling 12-month change in the S&P 500 excess return above US Treasury bills together with the 12-month change in the earnings of the S&P 500. Instead of combining price and EPS into a PE ratio, we realised that price momentum and earnings momentum don’t deviate too much from each other for too long.

Prices cannot rise sustainably without EPS growth eventually materialising.

For example, during the period 1997-2000, year-on-year price momentum was sustainably higher than EPS momentum. When the EPS growth did not materialise, the price momentum collapsed, resulting in the dot-com crash.

As Benjamin Graham stated, the ‘collective market machine’ is indeed a clever instrument that can more reliably ‘weigh’ what future EPS growth is going to be.

Figure 2: S&P 500 price momentum reliably leads EPS growth by six months (both yoy%)

Source: RMB Global Markets

This chart shows that if we lead the S&P 500 Index price momentum by six months we get a much better ‘fit’ than the same time series in Figure 1.

This indicates the market does to some extent effectively ‘forecast’ EPS growth.

So how do we use this information in the case of the US and the S&P 500 Index right now?

The interesting result of our analysis is that if EPS growth follows price momentum, as our research observes, then the market itself is currently expecting EPS growth to move from 4% year-on-year and to balloon to 18% over the coming months.

The market doesn’t care what you think

In conclusion, as we stand in January 2020, the market itself already ‘priced in’ during the 2019 market rally a rapid and extreme spike in EPS growth for 2020.

This can only resolve itself in two ways:

  • Either the US equity market delivers abnormally high EPS growth in order to justify the run-up in prices, or
  • Prices correct when S&P 500 corporates fail to deliver this very extreme EPS growth expectation.

We therefore conclude, without having to rely on current PE levels or using EPS forecasts from the experts, that investors can expect a pull-back in the US stock market in the first half of 2020 as the most likely outcome.

This isn’t our view or forecast – it is the market itself that has got itself into a knot. Price momentum has simply run ahead too fast from its own earnings momentum and generally this is not a good signal for positive equity returns over coming months.

Remember that the market is self-correcting and therefore is never wrong for long and it certainly doesn’t care what current PEs are, or what you or I think.

Roland Rousseau is responsible for equity structuring and portfolio strategy at RMB Global Markets.

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The movement in the balance sheet of the Fed is the single most valuable predictor of longer-term movements in share prices. All other metrics are derived from it, and have to conform to it. Liquidity, not value, drives share prices in the short term and liquidity determines value in the long term.

If the FED’s balance sheet (+ ECB + JCB) drives everything going forward, can it grow indefinitely ?

well, you can answer that question yourself by looking at the average annual growth rate since 1971.

Agree 100%. The stock market tend to go to extremes and will eventually self-correct and because of the massive amount of cheap money in US, it will get ugly VERY quickly, the exit door will burst because of all the speculators trying to get out, especially those who tried to chase the market at the end of the rally. This will create a great buying opportunity for the patient investor. Looking forward to the correction!

Rocky, if your chart is a “remarkably reliable predictor of future EPS growth”, then surely the more LIKELY outcome would be a positive earnings surprise, not a market pull-back as you expect. If you are just going to overrule this predictive tool with your personal view, then what is it’s value?

Also, stock prices don’t just reference earnings or cash flows, but also interest rates. Prices can increase when the risk-free rate is seen to compress, even without a commensurate increase in EPS growth. We saw that between 2013 and 2015, and this may well be happening again.

100% correct!

It basically comes down to this – it is mathematically impossible for a share index to crash in terms of a currency, if the purchasing power of that currency is intenionally being devalued by a Reserve Bank with the aim of supporting the value of the share index! The patriot act legalised this act.

Benjamin Graham is irrelevant now because the Jerome Powell took his place. Benjamin Graham published his book in 1949, under the gold standard. Since then we had the Nixon shock and 9/11 and QE to infinity.

The world has changed. Investing has become much easier. The Fed gives us a put option for free.

It does makes the central bank look awfully like a central planning committee, though.

Barque, you are spot on with that comment. That is why the investment business is so simple these days. Much easier than before 1971.

What is the valuation of the US markets excl FANGS or even just tech in general?

Reporting has not helped us. Too many journal entries.

What is the multiple of cashflow from operations per share over time? That will tell you whether the Market is expensive.

Add in more than a thousand unlisted companies with a value over a billion. About 5 trillion in twelve year old startups with no operating cashflow forecast.

I’m mostly cash except for one share

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