Stocks Are Sounding the Alarm on Earnings

The U.S. stock market is warning investors about earnings, and it’s time to pay attention.

The S&P 500 Index slipped into a correction on Dec. 7. It ended the day down 10.2 percent from its recent peak on Sep. 20, breaching the 10 percent decline that customarily marks a correction. The index is little changed this week through midday Friday.

Investors are comforting themselves, as they have all year, with reassurances about strong fundamentals. According to estimates compiled by Bloomberg, Wall Street analysts expect earnings for the S&P 500 to grow by 12 percent in 2018 and by an additional 9 percent in 2019. That’s well above the average growth rate of 4 percent a year since 1871, according to numbers compiled by Yale professor Robert Shiller.

It’s false comfort, however. As I pointed out in May, declines in the stock market most often precede slumps in earnings rather than the other way around. And this would be a particularly bad time for earnings to disappoint. Stock prices have rarely been as vulnerable to a downturn in earnings as they are today. If the market decides that the earnings outlook is too rosy, the recent sell-off could get a lot worse.

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Surge of Inflation Isn’t a Guaranteed Portfolio Wrecker

Alan Greenspan, chairman of the Federal Reserve from 1987 to 2006, sent a shiver through investors last week.

In an interview on “The David Rubenstein Show: Peer-to-Peer Conversations” on Bloomberg TV, Greenspan warned that the U.S. may be poised for a period of stagflation, a rare combination of high inflation and high unemployment.

The U.S. last experienced such an episode in the 1970s and early 1980s, and the memory still haunts those who lived through it. The annual inflation rate jumped to 9.8 percent in 1980 from 2.9 percent in 1972, according to the core PCE price index, a measure of personal consumption expenditures excluding food and energy and the Fed’s preferred inflation gauge. Meanwhile, the unemployment rate swelled to 10.8 percent in 1982 from 3.5 percent in 1969, according to the Bureau of Labor Statistics.

For members of Generation X — which includes me — and subsequent generations, stagflation is ancient history. Annual inflation hasn’t topped 3 percent since 1993 and has averaged just 1.8 percent since then. And the current unemployment rate of 3.7 percent is the lowest since 1969.

Still, the implications for investors of skyrocketing inflation and unemployment come quickly to mind. According to lore, a surge in inflation would lift interest rates, causing bond prices to decline and thereby wrecking bond portfolios. Higher interest rates would also thump stock prices because future corporate earnings would be worth less when discounted at higher rates. And all of that would come when many investors would lean on their savings to offset higher living costs and possible bouts of unemployment.

It’s not clear, however, how much of that received wisdom is reliable. Yes, when inflation creeps up, interest rates tend to follow. The correlation between annual inflation and the yield on 10-year Treasuries has been strongly positive (0.76) since 1959, the first year for which numbers are available for the core CPE price index. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)

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A Bull Market Quandary: Your Clients or Your Convictions

The U.S. stock market is dominating again this year, and money managers may soon face some unpalatable choices.  

It’s not even close. The S&P 500 Index is up 9.9 percent in the eight months through August, including dividends. Meanwhile, overseas stocks, as measuredby the MSCI ACWI ex-USA Index, are down 3.2 percent. U.S. bonds, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, are down 1 percent. And hedge funds, as tracked by the HFRI Fund Weighted Composite Index, are up a modest 1.7 percent.

It’s too soon to know how private assets, such as venture capital, private equity and real estate, have done because their results are generally reported on a multi-month lag. But it’s not likely to matter. Even the most ardent admirers of private assets, such as elite university endowments, allocate only a portion of their portfolios to them. So the results, however good, are unlikely to make up for the drag from other assets.

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What Does the Longest Bull Market Mean? A Debate

There’s lots of disagreement about whether the current bull market in stocks is now the longest in history. Bloomberg Opinion columnists Nir Kaissar and Barry Ritholtz recently met online to debate its longevity, whether it matters and if anyone should care. They previously discussed passive versus active investing and global equity valuations

Nir Kaissar: The U.S. bull market became the longest on record yesterday. It’s been 3,453 days since the market hit bottom in March 2009, surpassing the run that began in October 1990 and ended when the dot-com bubble burst in March 2000.

Or did it? According to Yardeni Research Inc., the bull market that ended with the dot-com bust began in December 1987 — not October 1990 — and lasted 4,494 days. By that count, the current bull market won’t steal the record for another three years. And that assumes this bull run began in March 2009, a claim that Barry will undoubtedly contest.

It’s tempting to wave this away as frivolous banter among market historians. But that’s a mistake because this debate is about the future, not the past. By asking whether this bull market is the longest in history, investors are really asking whether it’s near an end.

It’s an unavoidable question. Underlying most portfolios are so-called capital market assumptions — estimates of how various investments will perform in the future. Those assumptions have a big impact on how the portfolio is constructed.

Which inevitably raises more questions: Does the length of a bull market say anything useful about the future? And are there more reliable ways to forecast what’s ahead?

Barry Ritholtz: I am fascinated by this topic! Over the years I have spent a lot of time thinking and writing about it (see this).

I have found the conventional wisdom on determining the age of bull markets to be mostly wrong. No, bull markets do not begin from bear market lows. If this bull began in March 2009, then did the postwar rally from 1946 to 1966 actually begin in 1932? Did the 1982-2000 bull market start at the bear-market lows in 1974? Of course not — but that’s where the claim this bull market began in March 2009 leads to.

When did this bull market actually start? There are many ways to measure a bull market, but the most reasonable way is from when it makes new all-time highs. In this case, that means the start of this bull market was March 2013. The recovery from the financial-crisis lows, retracing the plunge from October 2007 to March 2009 is not, in my opinion, part of the bull market.

So no, bull markets don’t start at bear-market lows.

There are other ways we can debate the issue of whether or not this is the longest bull market ever, but perhaps we should discuss an even more important question: Does it really matter?

Bull markets do not simply die of old age; they don’t reach a certain length, and then keel over. What kills them are things that hurt corporate revenue and profits: high credit costs that makes borrowing costly, or inflation that makes input costs like natural resources, energy and labor more expensive. Or just a good old-fashioned recession — and even those don’t always kill the bull.

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Elon Musk Isn’t Wrong About the Public Markets

If Elon Musk takes his electric car company and goes home, investors will be poorer for it.

Tesla Inc.’s colorful co-founder and CEO tweeted on Tuesday that he’s considering taking it private after complaining for years about life atop a public company. As Bloomberg News recalled on Tuesday, Musk expressed “his frustrations with having taken Tesla public” in an interview in January 2015 and has carped about the market several times since then.

Hours after the tweet, Musk laid out his beef with public markets in an email to Tesla employees. The gist is that 1) the volatility of Tesla’s stock is a distraction; 2) the scrutiny around quarterly earnings creates pressure to focus on short-term results at the expense of longer-term ones; and 3) short-sellers, or those who bet against the company, have an incentive to attack it.

My colleague Matt Levine rightly points out that Musk, “who is constantly tweeting attacks on journalists and jokes about bankruptcy, who is also busy running two other companies,” isn’t the best-suited critic of the market’s shortcomings. But don’t confuse the message with the messenger. Regardless of your opinion of Musk or the wisdom of taking Tesla private, with the number of companies listed on U.S. stock exchanges down to roughly 3,600 at the end of 2017 from more than 7,600 in 1997, it’s a good time to ask whether public markets are working the way they should.

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Bitcoin Isn’t an Investment Until Buyers Sweat the Fees

If you want to know where cryptocurrencies are in their development, keep an eye on fees.

When a new “investment” comes along, investors are often too busy counting their anticipated bounty to care about cost. Shrewd purveyors predictably seize the opportunity to charge excessive fees. But reality inevitably falls short of investors’ expectations, and the focus eventually turns to how much they’re paying to invest.

That’s a short history of stock investing. Investors had little access to stock market data a century ago. They didn’t have the luxury of knowing, for example, that the S&P 500 Index would generate a real return of 7.1 percent annually from 1926 to 2017, including dividends. Or that the index’s real return would fall short of that long-term average 52 percent of the time over rolling 10-year periods.

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Ray Dalio’s Short-Bet Puzzle Is Missing Some Pieces

Hedge fund titan Ray Dalio is famously enigmatic, but his latest wager may be the most puzzling yet.

Bloomberg News reported on Thursday that the fund Dalio founded, Bridgewater Associates, has made a $22 billion bet that many of Europe’s biggest companies in the blue-chip Euro Stoxx 50 Index are poised to decline.

Bridgewater didn’t respond to Bloomberg’s request for comment, so Dalio’s motivation is not entirely clear. But according to Bloomberg News’ Brandon Kochkodin, Dalio “has a checklist to identify the best time to sell stocks: a strong economy, close to full employment and rising interest rates.”

It’s an old idea. Economic fortunes are reliably cyclical, even if no one can precisely predict the turns. Booms tend to be followed by busts, and vice versa, and stock prices often go along for the ride.

By that measure, it seems like a precarious time for U.S. stocks. The U.S.’s real GDP has grown for eight consecutive years, by 2.2 percent annually from 2010 to 2017. Unemployment has declined to 4.1 percent from 10 percent in late 2009. And the yield on the 10-year U.S. Treasury is up to 2.9 percent from 2.1 percent in September — an increase of nearly 40 percent.

The problem with Dalio’s checklist, however, is that stock prices take their cue from companies’ fundamentals, not the economy. Yes, companies’ collective fortunes often reflect those of the broader economy, but not always. And when the two diverge, the relationship between economic results and stock prices breaks down, too.

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Millennials, Born Under Sign of the Bull, Should Embrace the Bear

Remember, millennials: Red is good.

Millennials are probably tired of hearing that they’re not doing as well as their baby-boomer parents. But with every 1,000-point drop in the Dow Jones Industrial Average, their fortunes are brightening.

If they doubt it, millennials need look no further than mom and dad. The baby boomers entered the workforce from roughly 1966 to 1984. They couldn’t have timed it better because U.S. stocks were in an epic funk during those 19 years. The S&P 500 Index gained just 3.2 percent annually while inflation grew by 6.5 percent, which means the real value of U.S. stocks declined by a stunning 3.3 percent a year for nearly two decades.

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On Goldman’s Rosy Market Outlook

For anyone suffering whiplash after following the markets in recent months, Goldman Sachs’s well-known strategist, Abby Joseph Cohen, recently offered a soothing forecast: She pegged the S&P 500’s fair value at 2,100. As of this writing, the S&P 500 is trading at about 1,896.

Cohen didn’t show how she arrived at her valuation, but the calculation is straightforward: you use earnings per share multiplied by the fair value, price-to-earnings ratio. Et voila.

Problems arise and predictions vary, however, because neither EPS nor the fair value P/E is obvious — and the resulting fair value can vary wildly depending on the assumptions used for each of those measures.

To see the effect of EPS on fair value, let’s assume that the fair value P/E for the S&P 500 is 16.5. Looking at S&P’s earnings data, the forward operating EPS of $126 yields a fair value for the S&P 500 of 2,079. The forward, as reported EPS of $119 yields a fair value of 1,964. The trailing operating EPS of $106 yields a fair value of 1,749. The trailing as reported EPS of $95 yields a fair value of 1,568. (Operating EPS excludes non-recurring items; as reported EPS doesn’t exclude non-recurring items.)

By using the most conservative of those valuations, we’ve already shed 25 percent from Goldman’s estimate of fair value – a real life decline that would make investors weep – and we haven’t even normalized earnings yet.

If we then cyclically adjust earnings using a ten-year trailing average, the normalized operating EPS of $88 yields a fair value of 1,452. The normalized as reported EPS of $76 yields a –- gasp –- fair value of just 1,254.

The fair value P/E is as elusive as EPS. A common proxy for fair value P/E is the historical average P/E, and reliable U.S. stock data is compiled by Nobel laureate Robert Shiller going back to 1871. But which historical period should we use? From 1871 to 1945, the U.S. was effectively an emerging market. Soon thereafter, the U.S. joined an elite club of developed countries and eventually became the most creditworthy country in the world.

Investors appropriately priced the U.S. more richly in the “developed” period than in the “emerging” period. To see the effect of fair value P/E on the resulting fair value, let’s assume that EPS for the S&P 500 is $126. The average one-year trailing P/E since 1946 is 16.8, which yields a fair value for the S&P 500 of 2,117. But the average one-year trailing P/E since 1871 is 15.4, which yields a fair value of 1,940 – nearly a 10 percent haircut from the post-1946 figure.

One way around the problem of deciding which set of historical data to use is to build a fair value P/E from the bottom up (as I recently did for China) by using the sum of inflation, real productivity growth, and dividend yield.

The IMF estimates that U.S. inflation over the next five years will be 2.2 percent annually, and that real productivity growth will be 1.7 percent annually. The current dividend yield for the S&P 500 is 2.3 percent. The sum of these three variables is 6.2 percent, the inverse of which implies a fair value P/E of 16.1.

By these lights, Goldman’s fair value for the S&P 500 of 2,100 is aggressive. In order to get there, one has to assume the most optimistic earnings results for 2016 – a forward operating EPS of $126 – and a generous fair value P/E of 16.7.

Cohen may be right, of course, but investors would be wise to think critically about her assumptions. Cohen is no stranger to bullish calls. Near the peak of the tech bubble in late 1999, she believed that the market was near fair value. (Cohen says that in March 2000 she suggested that clients sell stocks.) In January 2008, Cohen predicted that the S&P 500 would close the year at 1,675. Spoiler alert: It didn’t.

My Bloomberg colleagues reported last week that the U.S. is showing worrisome signs of decline, including weakening retail sales, manufacturing, and wholesale prices. The S&P 500’s brutal selloff so far this year appears to echo those concerns, and 2,100 seems to be increasingly farther way, in my estimation.

So I’m inclined to use a more cautious valuation when looking at the S&P 500. I’ll take the normalized operating EPS of $88 and the fair value P/E of 16.1, and peg the index’s fair value at 1,417.

But investors need not accept Goldman’s or my estimation of fair value. Given how readily available good data is these days, every investor can form his or her own judgment about EPS, fair value P/E, and the resulting fair value for the S&P 500.

What’s your number?

Source: Bloomberg Gadfly, https://bloom.bg/2yX7uL7

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Stop Freaking Out About China

With China in the midst of what appears to be a significant economic slowdown, investors are questioning their faith in one of the new century’s great growth stories. They shouldn’t abandon China just yet.

First, some perspective. China was never going to string together an uninterrupted record of astounding annual growth. Despite all the hyperbole in recent years about China’s prowess and coming global dominance, not even China is exempt from the business cycle. But the current contraction will be followed by another expansion, unless you believe that China is going out of business — and no one who is a serious student of the country and its economy believes that. 

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