Stocks Still A Bubble

The level of equity bullishness has been high since the election. From my perspective, it doesn’t matter how long it lasts; it’s still a bubble. Optimism is an emotion and tone of the market which can change. However, it doesn’t have to change after a specific length of time, so we could be waiting awhile. If you are impatient because you under performed over the past few weeks because you had too much cash, then you must determine what your approach should be. If your strategy is to try to be aggressive every year to make as much money as possible as quickly as possible, then you should buy high beta stocks and ignore any warning signs. I don’t think blindly being bullish and holding high beta stocks makes sense every year. This strategy has been working for 8 years, but when it doesn’t work very high losses can occur.

If your strategy is to pick your spots and go against the grain when excesses occur, then maintaining a high level of cash would be a good idea. Where you pick your spots is critical. You can use the 1990s tech bubble as an example. If you are more conservative, you would have sold stocks in the mid-1990s. If you are more aggressive, you would have sold in the late 1990s. According to many valuation metrics such as price to sales, the market is at those late 1990s valuations. If you are aggressive or conservative and pick your spots, now would be a good time to avoid equities.

The chart below shows the recent cross-asset fund flows from the election to last Friday. There has been nearly $70 billion of fund flow into U.S. equities as investors have chased performance. Money has come out of conservative areas like muni bonds, gold, investment grade bonds, and government treasuries. High yield bonds and financials have also received funds as well. This is a textbook ‘risk on’ trade as the time period where stocks had almost zero returns for two years has been forgotten. If you are bullish because you think an entire cycle has skipped over the deleveraging period, then you must recognize that you are in the majority of market participants. This means upside is limited even if you are correct.

Making the claim that the cross-asset fund flows can correct is an easy point to make because it is showing a duration of only a few weeks. The chart below shows a much tougher point. The reason it is tough is because its conclusion provides evidence for a level of patience that’s difficult to practice. The chart shows that the bottoms up S&P 500 EPS consensus for Q4 dropping 2.2%, while the market has rallied to new all-time highs. This is surprisingly a great performance compared to the recent past. The past year, the EPS estimate fell 4.7% on average. It fell 4.3% in the past 5 years and 5.6% in the past 10 years. This entire bull market run has occurred in a period where in most quarters’ earnings expectations fell. That’s a tough pill to swallow because it means earnings haven’t mattered for years. This makes the question of when you should sell more difficult. To be clear, when I say earnings haven’t mattered, I’m not saying stocks shouldn’t have gone up at all; earnings have increased. I’m saying that the market hasn’t moderated its pace of increase even when estimates have fallen.

I consider 2017 a make or break year in terms of the way future earnings estimates vary from reality because stocks have accelerated their rally on the back of earnings estimates being especially high. It’s disingenuous for stocks to rally on higher earnings after they haven’t fallen on weak numbers, but that’s the reality we live in. According to FactSet, analysts are projecting 11.5% earnings growth in 2017. We’ll know if that estimate will be hit early in the year because Q1 profit growth is supposed to be 11%. Usually lower estimates haven’t been hit in the past few years, yet this time we are expected to believe higher expectations are more realistic. Because expectations are particularly high, I think the market will not have a great year if earnings only grow in the mid-single digits. This perspective has not worked in the past few years, but with interest rates rising, it may finally work out.

The chart below gives an example of why earnings growth won’t be able to meet these high expectations. As you can see, corporate profit margins have historically followed the unemployment rate lower because when the labor market gets tight, employment costs increase. Corporate profit margins have already peaked, yet analysts ignore the cycle and expect margins to stop falling. Revenue growth for 2017 is expected to only be 5.9%. With 11% profit growth, analysts are implying a rebound in margins even though unemployment is about as low as it can get.

The only way wages and profits can grow is if productivity accelerates. Productivity growth has been non-existent recently. I think Trump can spark productivity growth, but it will be masked by the end of the credit cycle. While businesses are optimistic, I don’t expect regulatory cuts and tax cuts to boost productivity right away because the web is difficult to untangle.

While the Trump administration is untangling the web of regulations, with health care being a principle focus, the credit growth has the potential to unwind before his policies have any positive effects on the economy. As you can see from the chart below, when nominal rates have risen in the past, bank lending growth was stymied. Lending growth has been shown signs of peaking recently. If it does follow the same correlation to nominal rates, it has further to fall, thus putting a damper on economic growth.

Conclusion

            The new normal has been profit expectations falling while stocks rise. 2017 is expected to be an exit of the new normal as profit growth meets estimates while stocks rise. I’m expecting the new normal to exit in the opposite direction as estimates aren’t met while stocks fall. Bank loan growth and corporate profit margins decreasing would be negative catalysts for this to happen. There’s also a possibility that those who gave up looking for a job, start looking again because of the relatively strong labor market. This could damper wage growth and help profit margins.