James Bevan: The US and where we’re heading

Equities will continue stronger but only by understanding what’s underlying the current bull market.

Patterns of behaviour in markets are important and in the current extended bull market, the latest sell-off in the stock market seems to have been yet another panic attack followed by yet another relief rally.

To gauge what has happened and may likely lie ahead, we need to focus on the US as the world’s biggest economy and largest stock market, and leader in both market behaviour and possible central bank tightening.

Looking back, the previous bear market was traumatic, making investors especially skittish during the current bull market about “endgame” scenarios – no surprise given that the S&P500 fell 56.8% during the previous bear market, which lasted 510 days from 7^th October 2007 to 9^th March 2009 – and this prolonged period of genuine pain affected the thinking and behaviours of investors, business managers, and central bankers, turning out to be very bullish for stocks.

The facts really speak for themselves – the current bull market has had five 10%-plus corrections so far and there have also been four minor, but unnerving, panic attacks, with the S&P 500 down between 5.8% and 7.7% along the way.

During the previous bull market, there was only one full-fledged correction and there were three during the bull market of the 1990s and history shows that corrections tend to occur infrequently during bull markets. The previous correction-prone bull market occurred during the 1970s, and also followed a wicked bear market during 1973-1974, with the S&P 500 down 48.2% over 622 days.

China’s hard landing & optimism

This summer’s correction seemed to be triggered by fears of a hard landing in China with stock prices tumbling over there and commodity prices falling hard, with prices affected by what  was actually an ETF-led flash crash.

We concluded in the late summer that the bottom of the correction might have been made on Tuesday, 25^th August, when the S&P500 closed at 1867.61. So far so good, although it looked like we were going to be proven wrong when the S&P500 dipped to 1881.77 on 28^th September.

Our optimism has been rooted in our analysis of S&P 500 forward earnings. It has stalled in record-high territory over the past year as a result of the plunge in the energy sector’s earnings.

However, excluding this sector, forward earnings remains on an upward course in record-high territory despite the additional drag from the strong dollar.

We are also encouraged to see that forward revenues for the overall S&P500 has been recovering since the spring – and late in October, it was actually at record highs for the S&P 400 MidCaps and S&P 600 SmallCaps.

Nervous breakdown

Clearly, industry analysts aren’t suffering from the worries that afflict others, at least based on their forward earnings and forward revenue projections.

Rather, it might have been investors who had a bit of a nervous breakdown during the latest correction, as evidenced by the plunge in forward P/E multiples for the S&P 500/400/600, and the rally since 25^th August demonstrates that there have plenty of investors who came to view the markdown as a buying opportunity.

In terms of the real economy, thus far, the economic expansion has lasted 77 months, whilst the average length of the previous 11 expansions was 58 months.

Based on the historical norm, we are clearly very late in the cycle. In the past, profit margins would start to decline during the late stage of the expansion. That’s because expansions tended to culminate in booms when business managers over-hire and build excess capacity. Their irrational exuberance about the sustainability of their booming sales leads to eh ramping up of costs and output in excess of what can justified.

In this way, booms given way to busts, and central banks respond to the resulting inflationary pressures by tightening credit conditions.

Excesses avoided

It’s dangerous to say this, but this time it is different. As a result of the trauma of 2008, company managers seem obsessed with maintaining or even expanding profit margins even at this late stage of the business cycle, and they are avoiding the hiring and spending excesses that would normally cause margins to shrink. This implies that the business cycle expansion can last much longer.

Importantly, there has been an inverse relationship between corporate profit margins (as measured in the National Income and Product Accounts) and the sum of compensation of employees and private fixed investment as a percentage of nominal GDP.

The margin is high (low) when business costs are relatively low (high). In terms of where we are now, during Q3, labour and capital costs were 66.3% of GDP and that’s below the previous three cyclical troughs! No wonder the profit margin has been in record-high territory in recent years.

As for central bankers, much of the bull market has been driven by their actions and policies and it’s apparent that their ultra-easy monetary policies may actually be counter-productive. Thus, instead of stimulating self-sustaining economic growth and stable 2% inflation, central bank policies seem mostly to be driving up asset prices without even much of a positive wealth effect on real growth and inflation.

No retreat

In terms of the agenda, since the financial crisis of 2008, central bankers have said that they will do whatever it takes to avert another crisis, and have lowered their official interest rates to close to zero, to zero itself and in some cases to even slightly below zero.

They’ve also purchased lots of bonds through quantitative easing programmes and remain nervous, with the likelihood therefore that they will continue with ultra-easy monetary policies, which should continue to boost asset prices.

Against this backcloth, consumers seem to have become increasingly confident. That may be because since 2008 lots of individual investors bailed out of stocks and have never returned. Their confidence has been rising as jobs markets have improved and has been relatively immune to the panic attacks in the stock market.

This confidence may also help to revive stock prices from their occasional panic attacks – importantly, there’s an observable strong inverse correlation between the S&P 500 forward P/E and the Misery Index, which is the sum of the core consumer inflation rate and the unemployment rate. The latter was down to 6.4% during September, the lowest since May 2007.

There is also a strong correlation between the S&P 500 forward P/E and the weekly Consumer Comfort Index – and both have been fluctuating at cyclical highs all year.

On the corporate earnings front, with 74% of S&P500 companies having reported Q3 2015 results, earnings data are mostly better than at the comparable point in Q2, but the revenue numbers are worse. The revenue data are disappointing, but the earnings figures are positive – the problem here is that the numbers are helped by financial engineering.

The conclusion we can draw is that equities can continue stronger – but we should be focused on companies that are of high quality, with decent and sustainable growth and strong balance sheets. This is not the time to think cyclical or to retreat to cash and bonds.

Wall Street Bull photo (cropped): Sam Valadi, Flickr.