Month: August 2020

In my previous three posts, I examined the pricing fundamentals of the US stock market. In this post I will look at possible explanations for the pricing.

1. Don’t fight the Fed

The argument here is that the Fed is active in monetary policy to offset the negative effects of the recession. In the recessions of 2001 and 2008, interest rates were around 6% and could be slashed giving a huge boost to the economy. In addition, in 2008, the Fed began its expansion of its balance sheet and continued it with QE in 2010.

In the recession of 2020, the Fed’s tools are more limited but it is fair to say they are using them as aggressively as they can and have managed to get long term interest rates to fall despite the vast surge in government debt issuance. The question remains of why the Fed will be so much more effective now than in previous recessions as the forecasts and pricing suggest.

The argument that yields have fallen and so the yield on all assets should follow is decent and intuitive but doesn’t explain why pricing is so much more optimistic than in previous recessions. In the other recessions of 2001 and 2008, we also saw sharp falls in interest rates but the impact of the drop in growth and thus earnings vastly overwhelmed this. The argument to justify the current situation would have to be rather different, that earnings will not drop very much (unlike previous recessions) and that Fed intervention will be huge and long-lasting, despite a rapid recovery of the economy.

It is true that Fed intervention this time around is truly monumental, the increase in the size of their balance sheet is over $3trn in the past quarter alone. If you can remember as far back as the Global Financial Crisis, the increase of $1trn in the balance sheet was seen by many as dangerous and would inevitably lead to hyperinflation. It may indeed be true that this huge intervention has flowed through to other asset markets, driving this stock market rally, but I do not expect the rise to be permanent. I do not expect the Fed to keep buying $3trn a quarter in financial assets to support the markets, particularly if the analysts are correct in expecting profits to immediately bounce back.

2. Private investors

This is an argument I find rather appealing. Fiscal transfers from the US government, in response to Covid, have been massive but poorly targeted. For example, the PPP (Payroll Protection Programme) came in the form of forgivable loans which did not have to be fully spent on payroll. Much of $500bn PPP has been in effect gifts to affluent people who do not need it to support spending.

Overall transfers from the government have been over $1trn, whilst spending has fallen by nearly $400bn. This leaves a lot of extra cash sitting in the bank accounts of affluent people and since they are not spending it, they are investing it. I would suggest in equities and putting that much money into the US market in a short time is going to have a large impact on the price.

Looking more closely at the typical small investor in the US, there has been a recent move to choosing their own stocks. They will tend to pick stocks they have heard of, that has been rising rapidly, that is sexy. They buy tech stocks like Amazon, Apple, Google, and Facebook. They even buy Tesla because Elon Musk is so often in the headlines and he makes it sound like a tech stock.

This is a classic bubble environment. A rapid influx of new money causes a spike in prices, whether it is art, vintage cars, fine wines, or stock markets. Tesla is now worth more than all the other car manufacturers in the world combined while producing less than 1% of the cars. It takes a lot of effort to find a fundamental rationale for that.

In the last two posts, I examined the fundamental basis for earnings of the US stock market. In this post, I will look at pricing and to what extent the market is discounting any of the risks highlighted.

Given that we have been looking at earnings already, all we need to get to the index price is to multiply by the Price-Earnings (PE) ratio from the chart below.

It is clear from the chart that PE ratios have been rising as confidence in the durability of profit growth has cemented. The current pricing levels are such, that even if earnings do return to record levels in late 2021, we would still have a PE ratio at the highs of the last decade.

This suggests that far from pricing any risk that NIPA data might be correct, or that the earnings drop might resemble previous recessions, the market is currently fully pricing a return to record profitability and excellent growth in profitability to continue from there.

I would rate stock market optimism as extremely high.

In the previous post, I examined the relationship between the economy and corporate earnings and showed that we should be sceptical about the numbers reported by companies as “earnings”. Profits, as measured by the national accounts data, not only suggest profits might be 30% lower than companies represent them to be but that they have also been declining for the past few years, rather than ever rising to record highs in the earnings series.

In this post, I will leave aside scepticism on historic reported earnings, and instead examine the impact of the recession on earnings and what we should make of current earnings forecasts. The chart below shows GAAP earnings as a percentage of sales, including the current forecasts to 2021.

Looking at the last two recessions, we see what we would normally expect. Profits and profitability hit hard, taking about 4 years to return to the levels before the recession. The depth of these earnings recessions corresponds to the depth of the economic recessions, with 2008 being much deeper than the recession of 2001.

If we look at the current recession, the market professionals who forecast earnings and the economy are expecting a completely different outcome. Despite this economic recession being far deeper than that of 2008, in fact the deepest since the Great Depression of a century ago, earnings are not expected to fall far. In addition, they are not just expected to quickly recover to the historic average of around 8%, but back up record high levels of profitability of over 10% before the end of 2021.

Have US companies disconnected from the real economy?

The chart above suggests that the drop in profits so far is entirely consistent with what we would expect in a recession. However the forecasts for profits to return to previous highs within 2 years do not tie up with examining previous recessions. These suggest a much longer recovery of 4 years but also that the current fall in profits may not be over.

The first thing is to look at the relationship between corporate revenues and the broader economy and to see if it has altered over time. In the following chart, I look at the ratio of:

• Aggregated sales for the S&P 500 (Sales)
• Personal Consumption Expenditure (PCE) from the GDP data

The relationship has not changed in the past 20 years. Revenues of US companies look tied to the spending of the US consumer in exactly the way we would expect. Further, this relationship is why we can look to the performance of the broader economy to predict the overall financial performance of companies.

How about profits/earnings?

The next step is to look at the relationship between corporate sales and corporate profits or earnings. This becomes far murkier, mainly relating to deciding which data you trust on what corporate earnings actually are.

The first issue is to choose which of the many earnings that companies report to use.
Generally Accepted Accounting Principles (GAAP) are a uniform set of accounting and reporting standards to which US companies are required to produce accounts complying to.
You may imagine these would be the earnings that people refer to when calculating the PE ratio (price/earnings) for example, but strangely instead the most commonly talked about earnings are where they “correct” the GAAP for temporary “non-recurring” items. Funnily enough this measure, normally called operating earnings (Op earnings) is always higher than GAAP, with this difference growing to over $20 i.e. over 15% of reported earnings. Here I chart the difference:

GAAP would be clearly a better number to use, as it reduces the discretion allowed to companies to massage their numbers to make them look better to investors. The chart above strongly suggests that at least some of the recent exuberance in the growth of profits is pure cheerleading and manipulation of earnings data. I will further strengthen this argument below.

How do corporate profits relate to the real economy?

The big story of the rising stock market of the past few years has been rising earnings, amid a large rise in the profitability is US companies. Here I look at GAAP earnings versus the Sales series from the first chart.

If we ignore the recessions which play havoc with profits, during the previous good years of 2003-2007 profits averaged around 8% of sales. This was also true from 2010 to 2016. But in the past 3 years we have seen a rise to record levels of profitability. Here I’m even using GAAP earnings which are far lower and more conservative than the operating earnings companies prefer to talk about.

Did this really happen?

There is another way to measure corporate profits which is via the National Income and Product Accounts (NIPA) data, which is the data used in compiliing GDP and looks at the numbers reported by companies in their tax filings. GAAP data has the advantage in that we have it for each company, whilst NIPA data is only reported for the US economy as a whole. The advantage of NIPA data is that it provides much even less discretion to the companies in how they calculate it and so is far less susceptible to manipulation or “optimisation”.

If we redo the previous chart and instead look at the NIPA measure of profits against sales, then the picture of the past decade tells a very different story.

We can see that in good times, profits are in a tight range against sales which makes sense. In recessions (2001 & 2008) profits nearly halved before recovering again. Currently we are observing a drop in profits, which is the usual behaviour before a recession, the opposite to the previous chart which showed an acceleration in GAAP earnings versus sales. The following chart shows it even more clearly.

My real concern with this story of rising corporate profitability is that earnings data reported by companies seems out of line with not only sales but also NIPA data, both of which seem to have much less flexibility in reporting compared to GAAP.

Has this ever happened before?

Yes but it’s a more recent phenomenon. NIPA and GAAP earnings up until the mid-80s had a correlation of 0.9. Since then as GAAP rules have changed, they diverged in the same way in the previous two economic cycles.

The chart above shows a profit cycle which is broadly the same as the economic cycle. In white NIPA profitsover PCE (our GDP proxy as before), in yellow GAAP earnings over PCE.

Profits rise in boom times and do extremely poorly in recessions. The striking difference is that the NIPA earnings are a leading indicator of economic recessions, and GAAP earnings are a lagging indicator. This means clear divergence in the 2 measures cycle peaks, the circles drawn.

In the first green circle, we can see NIPA profits peaking in 1997 whilst GAAP earnings continued to rise until 2000. This was the dot com bubble and we discovered that the euphoria built upon ever rising profits believed to be due to the tech revolution was fundamentally misplaced.

In the second green circle, we see the same thing happening before the Financial crisis. NIPA profits peaked in 2006, but the wonderful results posted by financial firms continued well into 2007, before being exposed as completely fabricated.

Note that these profits reported in 2000 and 2007 were not lies. They were in line with GAAP reporting standards. It is just that late in the cycle, firms get quite good at making sure their earnings numbers keep rising. As I mentioned GAAP reporting leaves a lot more discretion than NIPA.

More recently we saw a small earnings recession in 2014/15 in both the NIPA and GAAP numbers. Since 2016, this is where we have seen the divergence, shown in the red circle. The NIPA data shows a typical late cycle deterioration in profit margins. The GAAP data shows a surge to record levels of profitability and the current set of forecasts expect us to reach even greater heights as early as next year.

Have US companies disconnected from the real economy?

It is clear from NIPA data and sales data that corporations are behaving entirely normally late in the cycle amid falling profit margins. It is clear from all the earnings numbers produced by companies themselves that corporations are still exuberant, having an entirely different relationship with the economy with earnings growing far more rapidly than their sales.

Stock market pricing has risen far more rapidly than the broader economy in the past few years. This seems to fully believe these reported earnings which is why it looks so disconnected from the underlying economy.