Why is the Market Hitting All-Time Highs?
by Mitch Zacks, Senior Portfolio Manager
Okay, we have Google and Microsoft missing earnings estimates, Detroit potentially filing for bankruptcy, and housing starts as well as retail sale coming in weaker than expected. Yet, the S&P 500 actually went up 15 basis points on Friday and is hovering around its all-time highs. A disconnect is very clearly developing between the economy and the market.
The consensus view by economists is that second quarter GDP growth is going to come in around 1.2%. I am becoming more and more convinced we are going to see actual GDP growth for the second quarter materialize around 0.7% to 0.9%, weaker than expectations. I think that the Federal Reserve’s recent dovish statements are a direct result of the growing perception that the second quarter is going to be weaker than expected.
I am also becoming concerned about corporate earnings. Roughly 20% of the companies in the S&P 500 have reported earnings and although it is early in the earnings reporting season, only 62% of the companies reporting have beaten earnings expectations. This is slightly below the 67% level that I like to see in terms of positive earnings surprises (companies that beat earnings expectations) which are necessary for a strong quarter for earnings. The tech sector is extraordinarily weak and based on the technology companies that reported earnings, the tech sector in aggregate is actually seeing earnings decline on a year-over-year basis. There is however some good news on the earnings front with GE reporting stellar numbers and the finance sector is exhibiting unprecedented strength.
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I generally do not like finance stocks due to the opaqueness of their earnings, but most likely the Federal Reserve’s actions are going to keep the yield curve relatively upward sloping which should help bank profits. I would not be running out to buy any mortgage REITS and prefer small-cap plain vanilla banks in the current environment versus the major multi-national banks.
If you want to understand why the market is hitting new highs, you only have to look as far as earnings. Despite the relatively weak quarterly reports, earnings in aggregate for the companies in the S&P 500 are likely to hit an all-time high this quarter and rise to a hair over $1 trillion dollars in fiscal year 2013. Effectively, the aggregate earnings of the companies within the S&P 500 are very likely to hit an all-time new high this quarter and the Fed’s stimulus caused the P/E multiple to expand. When you combine these two effects, it helps explain why a new all-time high was recently hit for the S&P 500. The problem is that without further P/E expansion, or growing earnings, the market will have a hard time continuing to go higher. Most likely we are due for a pull-back until the market realizes that third quarter GDP growth is going to be stronger than anticipated. Although 62% of the companies reporting earnings have beaten earnings expectations, only 38% have beaten revenue estimates. Top-line revenue growth appears to be stalling out. U.S. corporations are unfortunately beginning to look more and more like a wet rag whose earnings have been squeezed out through cost cutting. While I do not buy into the doomsday scenario that profit margins will revert to historical levels causing earnings to plummet over the cliff, I do think the market will be under pressure until the economy starts to re-accelerate in the third quarter of this year. While margins are unlikely to substantially contract, I do not see any way they can expand. Revenue needs to accelerate for the market to head higher. Despite my expectations that the second quarter is going to be weak, I fully expect GDP growth to accelerate in the rest of the year. I anticipate 2.5% GDP growth in the third quarter of 2013 and eventually 3% growth in 2014. Ultimately this economic growth will surprise to the market to the upside and help contribute to gains for the remainder of the year. The growling bear scenario is dependent on profit margins reverting to the historical levels they were at over the past decade. I think this is very unlikely for the simple reason that the historical profit margins are unduly depressed due to the effects of the ’08 recession. Essentially, I don’t see profit margins collapsing because although we absolutely will have a recession some-time in the next few years, it will likely not be the same magnitude as the most recent one. The 2008 recession was not par for the course, it was an outlier, and investors should not anticipate that profit margins will revert to the levels seen during the flood. Sampling profit margins based on the recent past, as a result, will likely not give a good estimate of what profit margins are going to be over the next few years. However, I firmly believe that additional gains in the market are going to be hard to come by unless we start to see revenue grow. There can be limited P/E expansion unless corporations in the S&P 500 begin to see their revenue increase. At the end of the day, corporate earnings must grow if the market is to advance. Thus the bullish case for the market is dependent on the economic recovery continuing to proceed. The Federal Reserve realizes the economy is not strong enough to handle a recession and, as a result, they will likely err on the side of too much stimulus as opposed to too little, which is beneficial to the market in the short term. Most of the gains in the market since the end of June are due far more to changes in expectations regarding the Federal Reserve’s quantitative easing policy than stellar earnings reports. The economic recovery will continue and, as a result, interest rates are going to be rising. Inflation is going to start to materialize as well, and is likely to come on much faster and harder than investors are currently anticipating. If you look at historical inflation levels over the past eighty years and compare them to inflation expectations as implied by TIPs pricing, it is very clear that investors are likely to be surprised. Ultimately the low inflation environment of the past few years is not the norm and fixed income investors are almost certainly not going to do as well over the next decade as they did over the past decade. In terms of the immediate future, the data seems to indicate that small-caps will continue to outperform large cap stocks. Research we have done at Zacks Investment Management indicates that price momentum works relatively well when trying to determine whether to over or under weight small-cap stocks relative to large-cap stocks. Looking at the results of 3, 6, 9 and 12-month momentum tests, it is likely that small-caps will continue to outperform large-cap stocks in the immediate future. While the momentum effects are clearly favoring small-cap stocks, other fundamental signals such as widening credit spreads (the difference in yield between junk bonds and treasuries) and valuation levels seem to give preference to large-cap stocks. However, short-term interest rates (3-month treasury bills) seem to be falling over the past quarter which bodes well for small-cap stocks. Small-cap stocks generally do better when interest rates are lower because they are more exposed to credit availability. If credit is hard to come by it effects small-cap stocks which tend to be more dependent on bank financing than large-cap stocks which tend to access capital markets for growth capital. I believe the economy is going to continue its recovery, the momentum effects will trump the valuation factors, and small-cap stocks will continue to outperform large-caps. Ultimately, with the emerging market looking more and more like a slow motion train wreck, earnings growth is likely going to be more narrowly focused in the U.S. Now is not the time to bet on companies dependent on overseas revenue and, as a result, small-cap stocks seem like the better choice over the next few months. For the most part, the potential Detroit bankruptcy should be ignored. As evident by how the city’s bonds were trading, the news is not a surprise. Municipal bond investors should not freak out, municipal debt remains the safest type of debt issued with historically the lowest chance of default. Additionally, the likelihood of another municipal bankruptcy the size of Detroit remains remote. I would be far more concerned about the potential of rising interest rates than by credit quality in the bond markets. As long as the economic recovery remains on track, stocks should continue to appreciate, just at a slower pace than they have in the first half of the year. On a valuation basis, the market remains neither cheap nor expensive. P/E expansion can materialize if we can see some top-line revenue growth. Not to sound like a broken record, but the best course of action is to remain invested and keep your asset allocation consistent with your risk level. I am a big believer that asset allocation changes should not be based on beliefs about future asset class performance, but rather based on changes in individual risk levels. The history of equity investing is that slow and steady wins the race. If you want to know how to double your money in the stock market it is very simple – buy equities and then ignore everything that occurs over the next ten years. The market will melt-up and will at some point correct and perhaps even crash, but I am confident that ten years later, if dividends are reinvested, your investment will be almost double its initial size due to compounding. Under no circumstances should you time the market, as passé as it sounds the best course of action when dealing with equities is to buy and hold. About Mitch Zacks Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A. in Analytic Finance from the University of Chicago. Mitch also is a Portfolio Manager for the Zacks Small Cap Core Fund ( ZSCCX ). |
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