The current bull market has lasted 2,407 days, the third longest in history behind the run from 1949-1956 (2,607 days) and 1987-2000 (4,494 days). This continued move, in my view, has conditioned the beliefs of market participants that prices move in one direction, as it is all we have seen for the past six and a half years, in turn leading to justifications for why the market will move higher. Here are some examples:
- Equities are cheap relative to bonds. Where am I going to put my money? It’s the only game in town.
- Bears have been saying we are going to have a crash for years and have been wrong.
- The market trades at a 16-17x multiple, fairly in-line with historical valuations.
- Ex energy, ex dollar.
Trends are subject to negative tests that either reinforce or weaken participants’ perceptions. Since 2009, each pullback has been bought and the market has moved higher, in turn reinforcing the inherent trend. At some point though, the divergence between market prices and reality becomes so far removed that participants realize a misconception is involved and doubt grows, but the prevailing trend is continued through inertia, referred to by Soros as a twilight period.
In my opinion, we’re currently in that period and are on the verge of a significant re pricing of the S&P as the market begins to look at the underlying fundamentals and domestic economic data continue to deteriorate. This will likely lead to:
- The Fed putting an indefinite hold on rate hikes, and possibly experimenting with negative rates / embarking on another round of quantitative easing.
- A bid for bonds, sending yields lower and possibly negative.
- Capital that has been forced into stocks moving into gold, as minimal yield exists elsewhere and there is “nowhere else to put your money.”
I outline this thesis below.
The aftermath of the financial crisis led the Federal Reserve to embark on the most accommodative monetary policy in its 102 year history, as it purchased bonds and moved the fed funds rate to zero. For reference, the Fed has never set the federal funds rate at zero or purchased bonds, so in turning to history as a guide of the future, there is no reference point. While the initial move stabilized markets, the Fed continued easing through the majority of 2014 and still holds its zero interest rate policy today. Through these cumulative programs, $3.5 trillion was injected into the financial system, which found its way into the equity market illustrated below by DoubleLine Capital.
It is my view that prices currently fail to reflect market fundamentals due to excess liquidity provided by the Fed and the hope for more, evidenced over most of the past year by poor economic data sending the market higher. While this seemed to change following the Fed’s decision in September to hold rates at zero (market sold off), it re manifested last week as the market rallied 6%+ off the lows following September’s brutal non-farm payrolls miss and August’s downward revision, illustrating the market’s appetite for more.
The Fed’s liquidity injection has created an artificial bid for equities. Below Morgan Stanley outlines cumulative maximum drawdowns from 2009 to 2015. As you can see, periods without QE resulted in healthy drawdowns; however, during periods of QE, the drawdowns were significantly less, which to me indicates the market’s willingness to take on additional risk with the backing of the Fed. Given that QE is now on hold, the lack of Fed support subjects the market to significant drawdowns, as we saw on August 24th. This to me was a very significant event, as it shocked participants and led them to start questioning their current perceptions.
While QE sent capital into the market, the Federal Reserve’s prolonged zero interest rate policy pushed participants’ farther out on the risk curve in search for yield, leading to aggressive market behavior. This has been evident in speculative biotechs, momentum plays such as GoPro, and cloud based players like Netsuite, for example. Company earnings have taken the back seat to growth as liquidity flooded the market and participants found ways to justify prices or cared not to.
This changed recently, as market leaders such as the SPDR XBI biotech index fell ~28% from highs, momentum names such as GoPro and Shake Shack touched or closed near 52-week lows, and cloud/internet security highfliers like Netsuite, FireEye, and Barracuda networks continue to fade. By no means is this an indication that momentum is dead (NFLX, CRM, AMZN all still strong) however, it is a signal to me that participant’s perceptions are changing and the trend has significantly weakened – indicative of the aforementioned twilight period.
Personally, I think the Fed has lost all credibility. The failure to hike rates over the preceding few years after seemingly strong economic data, and September’s no hike is concerning. They are clearly seeing something that the market isn’t, or failing to see what the market is, leading me to believe they will NOT raise rates this year or in 2016. In my mind, the odds favor further quantitative easing or experimentation with negative rates (recently in Fed officials’ commentary). Here is why.
The Fed has stated in normalizing policy it is looking for inflation to return to its 2% objective and for the economy to return to full employment, which at 5.1% is consistent with their view. My question is if we are moving closer to raising rates, why are inflation expectations moving farther from the Fed’s 2% target (shown below)?
Meeting this target will be increasingly difficult due to China’s slowing growth weighing on commodities and technology’s deflationary nature. In addition, how is it that we are at or near full employment with the labor force participation rate (employed or actively looking for work) at levels not seen since 1977 and falling? Note: the 5.1% unemployment rate fails to capture those who leave the workforce. All things equal, discouraged workers leaving the labor force reduce the unemployment rate, illustrating why the participation rate is preferable gage of the labor market.
September’s non-farm payrolls miss and August’s downward revision showed that the labor force may be losing steam and proved the Fed missed its window to hike. While these are only two data points, the 59k (+43% MOM) announced layoffs in September according to Challenger, Gray & Christmas, will put additional pressure on forward numbers.
This year, there has been 493k planned layoffs, up 36% YOY. Challenger stated that,” job cuts have already surpassed last year’s total and are on track to end the year as the highest annual total since 2009, when nearly 1.3 million layoffs were announced at the tail-end of the recession.” That doesn’t sound like “labor market conditions continue to improve.”
If that wasn’t bad enough, recent ISM and regional survey data showed further deterioration, and if history is any indication, GDP will likely be next.
In my view, the Fed’s recent decision to hold off on rate hikes and the subsequent verbiage from Chair Yellen and committee members significantly reduces the Fed’s credibility. Chair Yellen’s September 17th FOMC press conference comments regarding global economic and financial developments weighing on its decision to hike were this:
“While we still expect that the downward pressure on inflation from these factors will fade over time, recent global economic and financial developments are likely to put further downward pressure on inflation in the near term. These developments may also restrain U.S. activity somewhat but have not led at this point to a significant change in the Committee’s outlook for the U.S. economy.”
Chair Yellen addresses that international developments have led to a change on the Committee’s outlook for the economy, albeit insignificant. Two weeks later during a speech at UMASS Amherst, Chair Yellen stated:
“… we do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy.”
They just did.
In addition, if international developments put further downward pressure on inflation how will that not have a significant effect on the path of policy if the Fed targets 2% inflation? What emerged in the following weeks that changed the Chair’s tone? Well the market sold off 6%+.
During this two week period, multiple committee members voiced how September’s decision was a close call, but September’s minutes released following these comments showed the call was not very close at all. So that leads to question, is the Fed being driven by the markets? Well the odds of a rate hike sure seem to be, shown below.
Looking at historical tightening cycles further illustrates how difficult it will be to raise rates in 2015 and 2016. As you can see below, the only data point that is higher than previous cycles is the unemployment rate, which is likely more of a function of discouraged workers leaving the workforce than new hiring. This chart was taken from Valuewalk.com.
It is my view, that the current (and changing) perception of participants is blinding them of the underlying fundamentals, as well as what things will look like 1-3 years down the road. I think QE illustrates this well, i.e. participants have the Fed’s backing so valuations take the back seat and buying shifts into third. However, as previously stated there comes a point where prices become so far removed from reality that the misconception is acknowledged by participants and doubts grow. I believe we are currently in that period, as earnings continue to deteriorate.
The S&P currently trades at 15.9x forward estimates according to Factset, versus the market’s 10 year average multiple of 14.1x. While the multiple does not seem far off from its historical average, it is subject to the forecasts of Wall Street analysts who are inherently bullish and report earnings estimates on non-GAAP basis. (note: many participants point to the previous point as a reason for buying equities).
According to Factset, earnings for the third quarter will be down by as much as 5.5%, following a decline in Q2, shown below. The company notes that this, “will mark the first time the index has reported two consecutive quarters of year-over-year declines in earnings since Q2 2009 and Q3 2009.” I believe this will be a key reason for why participants begin to question their assumptions, as they typically look at what’s right in front of them rather than a few miles out.
The significant earnings increases through FY16 are interesting. While not impossible, I have a tough time getting my head around such growth given the underlying trends we are seeing today. What will be interesting to look at going forward is the composition of earnings, as companies have unquestionably become cleverer in reporting them.
The Analyst’s Accounting Observer (AAO) recently wrote a fascinating piece of GAAP vs Non-GAAP earnings (GAAP: generally accepted accounting principles). Currently, earnings estimates for the S&P are based off of non-GAAP numbers which is permitted by the SEC as long as a reconciliation to net income is include. AAO notes that companies typically use non-GAAP earnings (NGE) for three reasons:
- So companies can match their guidance
- Earnings look more appealing on a NGE basis
- Once a company within an industry starts presenting numbers on a NGE basis, others follow so they do not look weaker than their competition
The number of companies reporting on a NGE basis in 2009 was 232. This resulted in $60.2B non-GAAP add backs or ~19% of 2009’s earnings. In 2014, this grew to 334 companies (+44%), with add backs totaling $132.1B, or ~18% of FY14 earnings. Below are the line items companies add back to their net income to arrive at non-GAAP earnings.
The chart below represents both GAAP and NGE from 2009-2014. As you can see, the difference between GAAP and NGE earnings is the highest since 2009 at 22.2%. Digging into these numbers you will see that while NGE grew ~12.3% between FY14 and FY13, GAAP earnings were essentially flat with 1% growth. This should be concerning to participants referencing earnings growth as the reason for why the market should move higher, as the evidence proves otherwise.
Taking into consideration FactSets recent comments that earnings will be flat for FY15, and using the S&P’s market cap at month end, the GAAP multiple of the market is 29.9x. If we assign the currently assumed 15.9x multiple to $594.5B in earnings for FY15, we arrive at $9.452B for the S&P, or roughly a 47% discount to where it traded at months end. FY16 earnings would need to grow by roughly 98% YOY to justify the S&P’s current valuation.
The market’s historical overvaluation is as apparent on multiple other valuation metrics as well. Looking back over the past decade (below), you will see that we currently sit at the some highest price to cash flow multiples across multiple industries. This is supportive of faux earnings as cash flow is harder to manipulate.
Source: Gavekal Capital Blog
The same thing is true for price to sales, which is nearly impossible to manipulate.
Source: Gavekal Capital Blog
And finally price to book.
Source: Gavekal Capital Blog
For multiples to come back in-line with historical valuations, earnings would need to increase significantly. This will be increasingly difficult as companies have invested billions of dollars to buy back their stock at 16-17x (30x GAAP) earnings rather than invest it in growth opportunities. That would mean earnings would need to grow 17% (30% GAAP) YOY to justify the investment. Given this low probability, US corporations just invested billions of capital that will potentially have a negative return, adversely affecting future earnings. This is the same thing we saw in 2008.
Below is a chart from Societe Generale outlining debt issuance, share buybacks, and funding deficits. As you can see the last time we were at these levels was in 2008. So not only are earnings at extremely elevated levels, U.S. corporations are levered up to levels not seen since 1999.
Looking at history to try to get an idea of what will happen in the future, I turned to the 2001 market top. The charts are eerily similar and multiple parallels can be drawn between the two periods; 80% of IPOs have no earnings, corporate leverage (shown above), utter disregard for earnings.
From the chart below, you will see that the market moved higher from the “you are here” pointer (created a few weeks ago), as we saw over the past few weeks. The next leg is clearly lower, with ~45% downside based on the market bottom in late 2002. This drawdown is in-line with the markets valuation based on the previously mentioned earnings multiple of 15.9x being applied to FY15 earnings.
It is my view that participants are realizing there is a discrepancy between their perception and the underlying fundamentals of the market. While the upward movement in the market has been slow and steady, the downward movement will be violent, as bubbles are typically asymmetrical in shape. This sharp downward movement will likely cause capital to rotate from the equity market to the bond market, lowering yields, and making gold significantly more attractive. This move alone, in absence of any economic job and inflation data, will put the Fed on hold, as they are seemingly now driven by the market. This will alleviate rate hike concerns that have been putting downward pressure on gold, and possibly lead to additional QE, as well as negative interest rates given that it is the only tool in the shed.
They say keep dancing until the music stops. Well I’m not hearing anything.