We Suggest Looking This Gift Horse in the Mouth. This So-Called Gift or Beast of a Market in 2019 Looks Healthy to Us…We Remain Positive
“I’m not looking for the best players; I’m looking for the right players.”
-Herb Brooks, hockey coach… as portrayed by actor Kurt Russell in the 2004 hit movie, “Miracle,” about the amazing success of the winning 1980 gold medal American Olympic hockey team.
The phrase, “Don’t look a gift horse in the mouth,” implies that it is impolite to closely inspect a gift one has received. This phrase harkens back to the 15th century when folks were known to study the health of a horse by examining its teeth — the longer the teeth, the older the horse. Thus, it could it be considered rude to look a gift horse in the mouth to determine if the horse met the receiver’s age and quality standards. Substituting the market for the horse in this analogy, we have no problem with studying the market closely or with what we see when we do…the robust return so far this year in stocks is not an undeserved “gift” to investors, unlike the assertions of many financial commentators, and it looks healthy to us.
The Data Tells a Positive Story
Let’s take a closer look at the data. The year-to-date S&P 500 Index return of over 20 percent through the end of July, is not, in our view, simply a sugar high emanating from policy “gifts” such as an accommodative Federal Reserve1. We believe these results are well deserved and have the right combination of solid fundamental economic and earnings data, attractive valuation levels and healthy technical metrics…the F’s, V’s, and T’s, as we refer to them. In fact, we expected this outcome in 2019 as we outlined in our Crystal Ball outlook for the year.
These important F’s, V’s and T’s continue to be constructive in a manner that inspired us to channel the late, well-known hockey coach, Herb Brooks, regarding his assessment that he selected the right players rather than the perceived best players to beat the Soviet Union and miraculously win the 1980 Olympic gold medal in hockey. Herb was heavily criticized by the advisory committee to the American Olympic hockey team in the early stages of this road to gold, when he made unilateral decisions in selecting his final roster rather than seeking the broader committee’s advice. They frankly and loudly told him that he was missing some of the best college players in the country…the so-called All-Stars. But Herb was unfazed and smartly retorted that he wasn’t looking for the best players who surface based on the siloed way of thinking they were employing. He cited the recent huge defeats of the NHL All Star team at the hands of the Soviet skaters as case-in-point examples that superstar teams don’t necessarily correlate with winning.
Instead, he was looking for that right blend of talent, whose skill sets and emotional make-up/commitment complimented one another and could actually lead to victory. And that’s what we believe we have here today in U.S. equities…a very nice combination of catalysts and data. None of it is overly robust or superstar in nature, nor is it alarmingly weak. That’s what makes it work. It’s a very nice blend in our view.
Economic and earnings growth is positive, but not so robust that folks fear surging inflation and rates that tend to end recoveries. Nor is it weak enough to signal recession is around the corner. It’s a mix of economic and earnings growth, interest rate levels and credit conditions, and inflation expectations that generally lead to rising stock prices. In our view, it is similar to conditions that led to attractive returns in decades such as the 1950s and 1980s2. We say this while headlines still warn of the late stage of this cycle and potential recession. This negative sentiment only increases our conviction to stay the course and remain grounded in our disciplined research in this environment. We’ll adjust our view when supported by a change in the data.
The “Wash-Rinse-Repeat Cycle”
While the S&P 500 has advanced over 20 percent this year through July, it hasn’t been a straight line up. The index has caused significant angst at times, and monthly returns have been a roller coaster during the last eight months. The S&P 500 corrected by almost 20 percent intra-month in December resulting in headlines of “Worst December Since 1931.3” After the best first four months in a calendar year since 1987, we then experienced the worst May since the 1960s and this was quickly followed by the best June since 1955. All told, this topsy-turvy return pattern did conclude with the best first-half of a year for the S&P 500 in 22 years. The second-half is off to a nice start as well, with almost a 3 percent return in the S&P 500 during July1.
What we have observed from the momentum shifts in monthly returns is a news reporting and market return pattern that we refer to as the “Wash-Rinse-Repeat Cycle.” The sell-offs we’ve seen have appeared primarily psychological in nature and have centered on speculation about potential failures on the policy front. Investors have CHOSEN to assume worst-case outcomes regarding the Fed’s rate decisions.
Trade discussions with China have speculated that this would result in economic recession and declining earnings by S&P 500 companies. All the while, both the economic and the earnings data have remained healthy — not necessarily robust, but positive and significantly better than feared. So much so that the press has begun promoting a new acronym this earnings and economic reporting season, “BTF” (Better-Than-Feared). U.S. gross domestic product growth was 3.1 percent in Q1 and 2.1 percent in Q22. These outcomes were far better than feared, hence the phrase.
S&P 500 earnings growth was projected to be a negative 3 percent in Q1 and turned out to be a positive 3 percent4. Q2 looks like it will come in at roughly the same level. The consumer maintains record levels of net worth as of June 30, is employed and confident, as expressed in attitudinal surveys and a personal consumption spending growth of more than 4 percent. This is a BTF picture and simply not recessionary, in our opinion. We think it’s pretty darn good, “PDG,” in our own “technical” terms!
The “Wash-Rinse-Repeat Cycle” pattern is one in which negative headlines appear to be about policy risks and potential recession. These concerns can cause a significant, temporary sell-off, such as what we saw in late November and most of December. In other words, psychology and stock prices trend sharply negative temporarily due to fears about possible policy mistakes. We refer to this as the Wash Cycle. This is followed by release of the facts — solid earnings and economic data — and the market surges, a la last the week of December and the first four months of 2019. Headlines and tweets resurface, scaring investors and making them think that policy risks have spiked again and will lead to recession, which we saw in May. Then new economic and earnings data is released that shows all is well, and the market recovers handsomely as was the case in June and July.
The challenge in managing clients’ wealth, at moments of head-spinning monthly swings in investor psychology and equity returns, is to make sure we stay grounded in the data. It takes discipline to focus on the solid data amidst negative psychology to help ensure we don’t make harmful adjustments to a client’s portfolio, such as selling or reducing equities amidst the headline-induced sell-off, which could cause our client to miss out on the rapid recovery. This is called whiplash and it is not helpful. Ergo, our mantra in environments like this is: at Mariner Wealth Advisors, we strive not to confuse activity with progress! Given that the market is up roughly 10 percent during the last 12 months1, staying the course has appeared to be the correct path.
It’s all P/E Expansion rather than Good Old Earnings Growth — Not True
I’ve lost count of how many times I’ve heard someone say that stock market returns, for some time, have been driven not by earnings growth, but by investors simply bidding up stock prices by paying higher and higher P/E multiples for them. This is not accurate from our perspective.
The chart below illustrates that roughly 70 percent of the price appreciation in the S&P 500, since the recovery began in 2009, was driven by earnings growth and less than one-third by P/E expansion. Yes, the 2019 returns paint a different picture. More than 90 percent of the advance in the S&P 500 this year is indeed driven by P/E expansion, but doesn’t that make sense? In 2018, we saw great earnings growth, but the market declined as P/E multiples imploded from 19 times to 14 times and earnings grew nicely. At such levels, the market was priced for anticipated recession. Therefore, it’s logical to us that multiples would expand this year back to more average levels when the economy proved resilient and not recessionary as feared.
Source: Goldman Sachs Investment Research, Factset
The second chart below breaks out the contribution to stock returns, earnings growth versus P/E expansion, and shows that dominance of one of these factors versus the other varies significantly year-to-year. What we’re seeing is not unusual on this score.
Multiple Expansion vs. Earnings Growth Impact – Variable from Year to Year
Valuation—Contrary to Popular Opinion, Stocks Do Not Look Expensive
Much of what you hear in the general media is that the market is expensive and most often the P/E multiple is cited as the basis for this conclusion. Valuation analysis includes looking at more than just P/E levels. Valuation is an art and must be evaluated on a number of key metrics in a mosaic fashion, not on a “one number and done” basis. Sticking with P/E’s for a moment, the S&P 500 is currently priced at just over 17 times the next 12 months earnings figure.4 This isn’t the cheapest, but it is quite normal to be at these levels for these low levels of interest rates and inflation. After all, stocks compete with bonds for investors’ attention.
On a dividend yield to bond yield basis, stocks currently look attractively valued. When the 10-year treasury yield is roughly equivalent to the dividend yield on the S&P 500, as it is today, an investor might say, “I can get the same yield on stocks as on intermediate bonds and benefit from the fact that S&P 500 dividends generally grow annually as does it’s price level. I think I want exposure to stocks.” At times, when 10-year bond yields are higher, say 5 percent rather than the 2 percent figure today, bonds might compete better for an investor’s attention, but that is not currently the case.
Source: Ed Yardini Research
On an earnings yield to bond yield basis, stocks are simply not expensive. S&P 500 earnings as a percentage of the S&P 500 price level is 6 percent versus the bond yield of 2 percent. Normally that gap is far tighter as you can see in the adjacent chart. P/E’s would have to rise significantly (or rates to spike, which we think is unlikely) for this gap to fall to more normal levels, so stocks look very cheap based on this measure. Another measure that shows that stocks are priced attractively for today’s low unemployment/low interest rate environment also appears below.
Source: Ed Yardini Research
Look at the P/E level, historically, when the misery index (unemployment rate plus inflation) is as low at it is today. On this measure, we believe the P/E level looks appropriate.
Source: Ed Yardini Research
We think the trend in stock prices is still upward for the next 12 months. Short- term, we are biased to increase our current top end S&P 500 price target for the 2019 calendar year up to the 3200 to 3300 level, but will refrain from doing so until we complete our review of Q2 S&P 500 earnings releases and get an additional news flow on the economy and policy over the next month or so — stay tuned. We’ll continue to call it as we see it when it comes to reading the data, remaining grounded in our current constructive outlook.
2CNBC, July 26 article: GDP slows to 2.1% in second quarter but beats expectations thanks to strong consumer
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation. Investors cannot invest directly in an index.
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