Last year, despite slowing profit growth, U.S. equities experienced a “valuation levitation” because they were too cheap compared to bonds and cash. Why own a bond yielding 3-5% when you could own a stock with a 3% dividend yield, 8% EPS growth and 10% DPS growth? But late last year, after stocks had run up and many strategists boosted price targets, I flagged a worrisome “whiff of complacency.” The broad stock market did indeed take a breather in the first four months of 2014, but aggressive traders pushed “momentum stocks” to ridiculous valuations by the end of February, when the average PE on 2014 EPS of Tesla, FaceBook, LinkedIn and Twitter was 511x (or a mere 132x excluding Twitter).
Six Bricks of the New Wall of Worry
For stocks to make meaningful new highs from here, complacency and greed needed to be replaced by perplexity and fear. The proverbial “Wall of Worry,” which loomed large at the beginning of 2013, needs to be rebuilt. That is in fact happening as traders confront:
- The painful collapse of many “momentum” stocks, partly due to forced liquidation by hedge funds.
- This year small cap stocks (Russell 2000) have lagged the S&P 500 by nearly 600 bps.
- Those two trends have led to what is, for many market technicians, a disturbing “divergence” between small caps and the S&P 500. Quite a few commentators on CNBC have argued that the S&P 500 will follow the Russell 2000 lower.
- Supposedly stock market “fundamentals” have been disappointing. When stocks were soaring near the end of 2013, some investors talked themselves into believing this presaged a strengthening global economy. That view was mostly wrong; things have improved a little but not a lot. U.S. GDP was flat in Q1, much of Europe is stagnant, Japan is fairly weak, and China’s real estate bust is proceeding on schedule. Much needed “structural” reform in all these regions is mostly talk not action. Political turmoil in Ukraine, Thailand, Egypt, Libya, etc. does not help. Neither does the Obama Administration’s continued regulatory onslaught.
- These allegedly deflationary macro pressures seem to be confirmed by the surprising strength of bond markets, with the 10-year Treasury yielding just 2.54%. The bond market is said to have a higher IQ than the stock market. Hmmm. That would be the same bond market that was priced for low inflation in 1972 (10-year Treasury at 6.21%) and hyper-inflation in 1981 (10-year at 13.92%).
- Putting these macro factor together with A) uninspiring Q1 earnings and B) profit margins already at record highs, bears conclude that over the next few quarters weak revenue growth will produce major earnings disappointments.
But This Wall Looks Scalable
Those six bricks comprise the Wall of Worry that stocks need to scale over the next year, producing attractive relative returns. I think stocks can do it because:
- It is bullish, not bearish, that dumb speculation in momentum stocks ended with a thud, before it got out of hand as in the 1990s.
- Divergence between the S&P 500 and the Russell 2000? Even if you drink the technicians’ Kool-Aid, it all depends on your time frame. You could argue the divergence happened last year, when the Russell 2000 vastly outperformed SPX, and now the two indices are coming back into sync. Year to date the Russell has lagged the S&P 500 by 594 bps, but over the past two years both indices have appreciated 42-44%. Looks to me like convergence, not divergence.
- The Fed is still dovish, as worried about deflation as inflation. Ultimately this could prove to be a mistake, but not yet. For now, loose monetary policy in Washington, Frankfurt, and Tokyo is keeping bond yields low.
- The global macro picture may be worse than bulls expected, but nevertheless it is improving slightly, to about 3% global GDP growth this year from 2.5% last year. Europe, by far the most important foreign market for U.S. multinationals, is growing modestly rather than shrinking.
- Despite bad weather which hit some industries hard, Q1 earnings were not too bad. Strategists continue to look for $117-$120 in S&P 500 earnings this year, and a 5-8% gain next year. The media do a poor job of assessing profits. They forget that U.S. nominal GDP is an imperfect proxy for revenue and EPS growth. Large companies can pull many levers to grow EPS, including organic revenue growth globally (not just domestically), acquisitions, restructuring / cost-cutting, and share buy-backs.
- A big Republican victory in the November U.S. elections, which is looking more likely following the VA scandal and constructive primaries, would be bullish for stocks.
I admit stocks are no longer cheap. Using $118 in 2014 SPX EPS, the S&P 500 trades at a multiple of 16.2x, versus a 2004-2006 average PE on trailing pro forma EPS of 16.9x. But rates are much lower now. You have the choice of zero return on cash, modest return on overpriced bonds, or blue chip stocks that can deliver a high single digit total return comprised of 2% dividend yield and 5-8% EPS growth. And dividend growth will exceed earnings growth over the next two or three years. So stocks should be able to scale the new wall of worry. Some investors worry when stocks hit record highs, but don’t forget that earnings are also at record highs; this year S&P 500 EPS will be 109% higher than in 2000.
Copyright Thomas Doerflinger 2014. All Rights Reserved.