Thursday, January 24, 2013

Corporate Revenues Fail to Keep Pace with Tiring Market Rally

According to Comstock Partners, The Market Rally Is Based On Four Dubious Assumptions
These assumptions are as follows:
1) Since almost every central bank in the world is aggressively easing, the market cannot go down.
2) Although the U.S. is facing a fight in Washington over the debt limit, the sequester and the expiration of the annual federal appropriation, various political threats over the last two years have passed without substantial market damage, and the same will happen this time.
3) S&P 500 earnings will rise to $108 in 2013, resulting in a current P/E multiple of only 13.7.
4) The economic recovery will kick into full gear once the problems in Washington are solved or again "kicked down the road."
I won’t deny that the ongoing strength and length of the current bull market has caught me by surprise. Large government budget deficits were initially very supportive of corporate profits, however those effects are waning just as profit margins are peaking. Meanwhile, weak economies at home and abroad have severely limited corporate revenue growth. The following chart looks at the percentage change in the S&P 500 sales per share, earnings per share, and operating earnings per share since the recession began in December 2007:
S&P 500 Sales Per Share Chart

Considering the meager growth in GDP, one might have expected that sales per share would be effectively flat over this period. What may be surprising, is that minimal revenue growth has not prevented an astonishing rise in earnings per share. Regarding earnings per share, it’s worth pointing out the noticeable difference in volatility between the two separate measures. While I am no expert in accounting, there are countless ways in which companies can “manage” their earnings across time. With an increasing prevalence and usage of such (generally legal) measures, I suspect the magnitude of changes in earnings per share will continue to grow in both directions.

Out of curiosity, I decided to add the S&P 500 index to the chart above:

S&P 500 Sales Per Share Chart

Despite the widespread focus on earnings and their supposedly fundamental value to stock valuations, prices have more closely tracked the cumulative change in revenues since the recession began. If profit margins are truly mean reverting and earnings are increasingly manipulated, than it is possible sales now provide a better metric of corporate profitability over the course of a business cycle. That being said, it’s equally plausible (perhaps more so) that this data merely represents an anomaly.

Regardless of whether the above graphs prove useful for forecasting, trend growth of earnings has been slowing rapidly. With interest rates practically at the zero lower bound (ZLB) and central bank balance sheet expansion already set in place, potential drivers of further multiple expansion appear limited. In the near-term I expect that current momentum will drag markets higher, possibly to new all-time highs (for the Dow and S&P 500). However, looking further out on the horizon (3-5 years) I believe the present cyclical bull market is tiring and that the secular bear market will re-exert itself, leading to tests of the 2009 lows.   


  1. Woj, I'm no expert either. With growth being barely above anemic, how does one account for such rapid growth in the value of the S&P500? This seems to be the making of a bubble getting ready to burst. When is the question, not if. I had been considering moving some funds into an S&P index fund and out of my total bond market index fund. Now I'm not so sure. I think I'm more willing to take a small hit on my bond fund as opposed to a bigger risk and larger hit when the S&P corrects. 2-3yrs out? That seems overly optimistic.

    1. Hey nanute. Despite my bearish tone, I do recognize there are many reasons to be bullish: strong earnings, low interest rates, momentum, etc. As I pointed out in the post, I think earnings are being overstated and separately, interest rates/QE have less of an impact on future nominal earnings than many suspect. I don't expect those views to change but think people are overlooking declining margins, slow earnings growth and bottoming interest rates.

      So yes, I think we will see a bear market within the next 2-3 years that brings the S&P 500 back into triple digits. History is also on our side since few bull markets have lasted more than 4 years (where we are now). All that being said, I would be careful where in the bond market you try to hide out. Junk bonds look more bubblicious than stocks. My best guess is mid-to-long term Treasuries, agency-MBS, and high-grade corporates remain decent bets.