Michael Santoli

A 'Second Wind' for Earnings Could Quiet the Bears' Huffing

Michael Santoli
A Wall Street sign is seen in front of the New York Stock Exchange in New York's financial district
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A Wall Street sign is seen in front of the New York Stock Exchange in New York's financial district, March 4, 2013. REUTERS/Brendan McDermid

The Great Phony Bubble Scare of November 2013 is blowing over, but further corporate-profit growth is necessary to support the market near record highs. Even a gentle “second wind” for earnings growth, which we could see, would better support the indexes and keep further gains from being spun dangerously on hopes and risk-seeking cash alone.

You’ve heard the talk that stocks are now in or will soon enter a bubble, with warnings of varying urgency coming from Carl Icahn, Jeremy Grantham and Doug Kass. In a Bloomberg Global Poll this week, 65% of respondents said they see global equities as being either in or near a bubbly state. Central banks’ purchase of $7.5 trillion in assets the past four years must have resulted in an unsustainable, overinflated balloon by now, right?

Right?

Well, as Barry Ritholtz of Ritholtz Wealth Management and others have correctly noted, bubbles thrive amid mass delusion and a refusal to focus on growing investment risks. Because so much worry has been aired, the chance we’re in a bubble is inherently diminished. And market valuation isn’t quite as stretched as at the 2007 top (which was more credit than equity bubble), let alone the drunken-cliff-diving action at the 2000 peak.

In the past couple of weeks, as bubble talk was percolating, the indexes paused briefly, adrenaline-juiced cult growth stocks backed off hard and small-investor sentiment cooled considerably. All to the good.

An ambiguous state

In a way, it would be easier if the stock market were undeniably a bubble, rather than in its present ambiguous state – neither cheap nor outlandishly expensive, at a record high but not far above where it was six and 13 years ago. If one sees an all-out bubble, the simple choices are to sit it out and wait for the pop, or play it knowing it’ll keep growing as “greater fools” pile in.

With the Standard & Poor’s 500 index up 26% this year and 166% from the 2009 low, it’s important to recognize equities can get pricier than average relative to company profits long before they get ridiculous. Stocks can become popular again on Main Street well ahead of reaching mass greed and infatuation. The tape can stay in a sturdy uptrend for months, rarely stumbling badly along the way, as all the while it compresses returns available over the next decade.

This, it seems, is where we are as 2014 approaches. And, simplistic as it sounds, the swing factor that should determine whether this market is acutely vulnerable to a substantial downturn is the path forward for corporate profits.

From 2010 through 2012, earnings for S&P 500 companies grew far faster than stock prices rose. Beginning a year ago, as crisis-relapse risk receded and liquidity remained abundant, stocks raced ahead of profit gains. The S&P’s climb this year has come on 4.9% per-share earnings growth. Without heavy stock buybacks reducing share counts, profit growth would have been just 3.7%, according to Strategas Group.

Even so, the current bull market has been fueled far more by better corporate profitability than simply a higher price being paid for each dollar of earnings. Earnings growth since March 2009 has been 106%, while the price-earnings multiple is up 59%. Among prior postwar bull cycles, P/E expansion kicked in twice as much of the upside energy as profit growth.

A core element

A core element of the idea of a near-bubble in stocks is that corporate profit margins have remained at the top of their historical range, and thus must soon regress. Corporate profits as a proportion of U.S. GDP has approached 10% this year, well above the 6.5% long-term average.

It's true companies are “over-earning” relative to the past, in part due to cost-cutting, under-investment in their business and ultra-low debt costs. But as CFA Alan Hartley details here,  Corporate America's “pretax operating profit” of 15% recently is right near the 14.3% 30-year average. What has made bottom-line profit margins so much fatter is mostly lower taxes (likely due to more foreign earnings) and low, locked-in interest rates. Which of those is set to change quickly?

Profit growth in the third quarter came in handily above beaten-down forecasts, sales increased a bit more than anticipated. Crucially, for most of 2013 the rest of the world was a drag on multinationals’ bottom lines. As the year turns, activity in the emerging markets and Europe appears to be picking up. Strategas figures non-U.S. revenue growth should accelerate to 4% from 2.4%, with a greater impact on profits thanks to those fat margins.

Strategist Barry Knapp of Barclays Capital has noted the past quarter was the first in more than two years when industries geared to global activity (such as industrials and technology) had better earnings growth than U.S.-centric companies.

One virtue of this year’s market has been how sectors have taken turns carrying the indexes. Retail and housing stocks have flagged in recent months, but financials and transportation names have accelerated. Early in the year, stable dividend-yield plays were the rage. Deep cyclicals were weak through mid-year but have firmed since. The lucky scenario now would be for big companies exposed to rejuvenating global industrial production and trade to shine.

At this stage of the cycle, with liquidity abundant and investors belatedly throwing cash into equities, steady to slightly higher profits are probably enough to support share prices. Barclays notes stocks are more highly valued now and profit growth slower than in the past two “mid-cycle” periods a decade or two ago, suggesting P/E expansion from here should be muted. Similarly, Goldman Sachs strategist David Kostin figures earnings growth of 8% in 2014, pushing the S&P 500 up just 6%.

Some, such as Adam Parker of Morgan Stanley, think rising real interest rates should foster still-more multiple expansions after a Fed policy downshift, as “management hubris” at companies builds over the next year or two, spurring more deals and leverage and growth investments. That’s the “upside-risk” scenario.

When this market is  finally ready to pull back hard, it won't lack for handy excuses, including nasty fiscal politics, the coming inflection point in Fed policy, cracks in overconfident credit markets and emerging-markets capital flight. For several reasons, it’s likely the “easiest year” of the bull market is ending.

And if current trends continue, with easy-money policies persisting as financial markets grow ever more expensive and confident, this is probably all headed, eventually, for a frothy end game.