The Coming Market Correction?

In mid-May I wrote a piece in the blog entitled, “A Slowing Economy and a Wall of Worry”. I cited worries about the lack of strength in retail sales, softer than expected consumer confidence numbers, the abysmal Atlanta Fed GDP forecasts and the declining Citigroup U.S. Economic Surprise Index as evidence that there may be significant cracks starting to show in the economy.

Of course I stopped short of trying to make a market call at that time as I don’t have the luxury of such clairvoyance. I pointed these items out as an adjustment to risk management in one’s portfolio. “There is always the treat of a correction or bear market on the horizon but it is truly impossible to forecast when it will happen. In the cases of market “bubbles”, market sentiment has much more influence on asset prices than intrinsic values. Attempting to time market tops and bottoms is a futile and unprofitable strategy in my opinion. Understanding the fallacy of the Efficient Market Hypothesis and the Efficient Frontier and embracing the influence investor behavior can have on market valuations is one of the hardest parts of investing. We have written in the past about our concerns about the market valuation but have an equally sound concern about missing potential market gains by ignoring the power of investor sentiment. The proper use of portfolio risk management while maintaining equity exposure is the most prudent option right now, in our opinion.”

Fast-forward to the beginning of July

I received a call from my good friend Joseph the other day and we had one of our ever-insightful conversations about the current state of the economy and the markets. Joseph has a unique perspective on the economy as he is on the front line of two of the most economically sensitive sectors, transportation and construction. His knowledge of these two industries is a derivative of the type of business that he runs – moving construction and demolition debris by rail. He made a comment that business is very strong – the strongest he’s seen in years and that the “economy is doing fine”.

Indeed rail traffic and the recent move in lumber prices certainly confirm his thoughts.

 

 

 

 

 

 

The Federal Reserve Bank of Atlanta’s GDPNow – which nailed it with their 1Q15 GDP projections has shown marked improvement from May. “The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2015 was 2.3 percent on July 7, up from 2.2 percent on July 1. Following this morning's international trade release from the U.S. Census Bureau, the nowcast for the contribution of net exports to second-quarter real GDP growth increased from -0.2 percentage points to 0.1 percentage point.”

 

The Citigroup U.S. Economic Surprise Index is also starting to trend higher as economists’ projections and actual economic performance move further in line.

 

 

Market Correction

There has been a slew of analysis saying our equity market is in bubble territory and that it is way overdue for a correction of sorts. I not only agree with that synopsis but welcome a correction as it will allow for portfolio adjustment and the opportunity for increased alpha. Based on Bloomberg data, the companies that comprise of the S&P 500 are expected to show $125.71 in earnings per share over the coming twelve months and have a current earnings yield of 6.1%. Book value per share for the index is $736.68 with a BV yield of 35.4% and cash flow per share of $180.23 for a CF yield of 8.8%. If we weight each valuation measure according to accuracy in predicting future price movements our blended fair value for the S&P 500 is $1702 or about 18% overvalued.

 

I am on board with the market overvaluation camp but not the imminent correction folks. The question that I have is what will be the catalyst that sparks the correction. So assuming the economy is still growing, albeit at a subdued pace and that growth shows little signs of trailing off at this time we will rule out a recession as the cause for correction. Tightening monetary policy comes to mind, but given the length of time with a ZIRP in place, even a September increase by the Federal Reserve can still be considered nothing less than accommodative.

Perhaps the correction will manifest itself through a non-U.S. event. I agree with John Mauldin when he writes, “For some time now, I’ve been saying that the US economy should bump along in the Muddle Through range of about 2% GDP growth. The risk to that forecast is not from something internal to the United States but from what economists call an exogenous shock, that is, one from outside the US. In particular I have said that a crisis in both Europe and China at the same time would be very negative for both US and global growth. We now see potential crises in both regions. It would be convenient if they could arrange not to have them at the same time. But those who are paying attention to global markets are certainly experiencing a bit of market heartburn as they watch both China and Europe manifest the volatility that they have over the last few weeks. I will become far less sanguine about the US economy if full-blown crises develop in those two regions.” Indeed we recently pointed out on this blog space that the events unfolding in China offer the greatest risks to the U.S. bull market in our view – even if temporarily.

Earnings Drought

Perhaps the genesis of the market decline will be rooted in the deterioration on corporate fundamentals, i.e. revenues and earnings. There are a fair share of financial engineering skeptics in the world of finance and admittedly all bring up excellent points. I read post from Wolf Street this weekend. He writes, “Now the bad news. Currently the S&P 500 companies are projected to report a year-over-year decline in earnings of 4.4% for the second quarter, on a revenue decline of 4.2%. Of the companies in the index, 24 have already reported, which nudged up the estimates at the beginning of Q2, when the earnings decline was pegged at 4.5%... If this estimated earnings decline of 4.4% is the final number for Q2, it will be the first decline since Q3 2012, when earnings dropped 1%, and it will be the largest decline since Q3 2009, when earnings plunged 15.5%. If the revenue decline of 4.2% is the final number for Q2, it would be the first such decline since Q3 2009. These are not exactly hot numbers. Don’t despair. Companies will beat these numbers with plenty of positive “earnings surprises” in the weeks to come, given all the expert financial engineering that goes into these numbers. But they might not be able to beat them by enough to get them into the green. Over the last four years, actual earnings were on average 2.9 percentage points higher than estimates at the beginning of the quarter. If it works out this way for Q2, earnings would still decline by 1.6%, which would still be the worst earnings debacle since the Financial Crisis. However the final outcome, what’s striking are the trends of earnings estimates at the end of the quarter and of actual earnings “growth” – both of which have been heading south for over a year and are now, despite all expert financial engineering, turning negative”

 

I agree that there has been a decrease in the quality of earnings of late. It takes quarters and years of deterioration to impact the market in a major way and yes this bull market is long in the tooth. One item that concerns me is corporate profit margins. Looking at the figures below, one can see that trailing twelve month revenues and earnings have been leveling off as have profit margins. Prior to the dot.com bust in 2000, corporate margins for the S&P 500 peaked at around 8%. Remember, earnings didn’t matter in the late 90’s so one wouldn’t expect excessive margin expansion for that time. But looking prior to the 2008 crash, margins peaked near 10% before retreating in a big way. We are leveling off at nearly 10% net margins today and I’m curious as to how we will get increased margin expansion from this this point. Ultimately I’m a believer in mean reversion and believe margins will contract over time. I’m just not sure if it’s going to happen sooner rather than later.

There are compelling views that I have read that justify current profit margins as a function of secular shifts in corporate America. A “new normal” if you will (I truly dislike that term). This post from Philosophical Economic entitled Profit Margins in a “Winner Take All” Economy is an interesting read. They write, “With yet another quarter now on the books in which profit margins have remained steady at record highs, it’s becoming increasingly difficult for open-minded investors to reject the possibility that “this time is different”–i.e., the possibility that the observed profit margin increase relative to past averages is secular in nature, and that the much-awaited mean reversion isn’t going to happen.” The theory behind the secular shift in margins has to do with a limited concentration of businesses within a certain sector, i.e. higher barriers to entry and specialization. “Barriers to entry keep competition out.  As they get stronger, the players protected by them are able to successfully operate at increased levels of profitability, free from the threat of competition. This brings us to the “Winner Take All” economy.  The point is difficult to quantify or conclusively prove, but it seems that the dramatic technological changes of the last 20 years have made credible competition in certain key sectors of our economy more difficult, and have allowed dominant best-in-breed companies–the $AAPLs, $GOOGs, $MSFTs, $FBs, and so on of the world–to command sustainably higher profit margins. The current U.S. economy seems to have more genuine monopolies than the economies of old–more companies that face little to no competition. The increase in monopoly businesses and monopoly products seems be due, at least in part, to the massive distributional, network-creative and network-protective power of the internet, and also the shift towards the production of non-physical things.  A first-mover with a strong intangible product can distribute that product to the entire world at little cost, protect it as intellectual property, and build a profitable user network around it that other corporations will have an exceedingly difficult time competing with.”

The author goes on to prove this hypothesis. “Now, there is a clever way to test the hypothesis, which brings us to the theme of this piece.  If a “Winner Take All” economy, where increased barriers to entry–first-mover barriers, network barriers, patent barriers, size barriers, tax-advantage barriers, regulatory barriers, and so on–have allowed an increasingly concentrated group of dominant companies to earn substantially higher profit margins and push up on the aggregate profit margin, is the main driver of the aggregate profit margin increase, then we should expect the following.  If we separate the market into different tiers of profit margins, we should expect the higher tiers to have seen larger increases in their profit margins in recent decades than the lower tiers.  Increases in the profit margins of the higher tiers–at the expense of the lower tiers–would represent the “Winner” gradually “Taking All.””

The results were as the author expected and those specialized, high barrier to entry tiers had seen sustained increases in the profit margins. It’s a fascinating study and I believe it will be relevant on mitigating margin erosion for the markets on the whole, but I was never a fan of the “this time it’s different” mantra (another term not to my liking).

 

Given the margin analysis it’s also beneficial to look at the quality of earnings that are produced within the S&P 500. I like to track the index net operating income less its cash flow from operating and investing activities. One can then scale it by total index assets for easier cross index comparisons but for simplicity the chart below is shown as a z-score or where it lies on the bell curve. Knowing how much of reported earnings is supported by cash received versus accrued is key when using financial ratios and attaching a multiple to determine fair value.

When the earnings quality line is falling, then earnings quality is deteriorating. When it’s rising then it an earnings quality improvement. Notice both the market tops in 1999 - 2000 and 2007 – 2008 correlated with a -4 reading in the EQ chart. While earnings quality currently is deteriorating, it is nowhere near the dangerous levels of the previous two bear markets. For all the talk about sinister financial engineering used to goose profits, it appears to me that there is still some wiggle room to continue down this road for a while longer.

 

To Summarize

Do I think the U.S. stock market is overvalued by nearly 20% – YES.

Do I think we are in need of a correction to realign our portfolio for better alpha generating opportunities – YES.

What will be the catalyst that sparks the correction – I have no idea but will be prepared when it does happen.

Will an economic slowdown/recession be the cause of the correction – NO, not at this time.

Will an earnings recession and a breakdown in profit margins be the cause of the correction – NO, not at this time.

Will a China/Greece financial crisis be the cause of the correction – It’s possible.

Bottom Line: We continue to take a cautionary stance towards the market but remain invested. As we stated in previous writings, “We wrote a few weeks ago that we agreed with the general consensus that the market appears overvalued. That said, the market is a function of intrinsic value AND market sentiment. We have a cautious outlook but understand that market sentiment can be a powerful force. The trend is up and will most likely continue until there is a catalyst that changes that direction.”

In fact, given the recent turn of events we are getting slightly more bullish on equities for the second half of the year. More on that to follow.

Joseph S. Kalinowski, CFA

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