August 13, 2013

The confluence of fundamentals and valuations: Are we at a fork in the road?


The second-quarter earnings season is coming to a close, and the results have not been spectacular. Earnings grew year over year but showed a slowing trend, and revenue growth (top line) was somewhat disappointing, yet the market moved up.

Markets often take good news too far. Conversely, they can take bad news and drive it into the ground. Right now, we think the market needs to see more solid strength ahead before it can make another major leap forward.

Economic recovery and broadly better GDP results have supported and driven this story. The current US business cycle just had its fourth birthday. There were no celebrations to mark this birthday, nor, for that matter, were there any at the end of the last recession. That recession was painful, broke many records and was compared to the Great Depression of the 1930s. No one wants to relive the harrowing days of 2008 and 2009 — bank failures, credit market collapses, massive stock market losses.

The trail back from disaster has been a bright one, though not perfect. Since those days, a recapitalization of the banks has occurred, the US Federal Reserve has injected hundreds of billions of dollars into the system and recovery has turned into expansion as the United States became one of the few OECD countries to have its GDP rise above its previous high-water mark. The US growth rate was moderate, though subaverage compared with other recoveries, but all the while the private sector grew at a faster pace. Companies thrived, labor markets grew cautiously and the US gained in its share of world manufacturing.

All of this led to a robust profits recovery, and this fundamental trend led US stocks up to new heights from the lows of 2009. I have previously made the point that this market recovery and expansion has been entirely supported by the base fundamentals. Up until now, that has held. But I have also said that the day would come when easy money conditions and optimism could take the market beyond its fundamental support point. Let’s examine if that has happened now in light of a modest earnings season.

The S&P 500 Stock Index has gained nearly 150% since its March 2009 low mark of 666. Since then, economic fundamentals in the market have turned positive and strong earnings and cash flow have led the financial markets up. In addition to record free cash flows from S&P 500 companies, lower debt burdens, high profit margins and high cash balances have all characterized and justified the market’s strength and upward momentum.

But nonfundamentals, such as valuations, are important as well. They tell us if the market could be paying too much or too little for those fundamentals. On the nonfundamental side of this cycle, there are supports to this market that amplify the fundamental story. These are flourishing share buybacks, which shrink the overall share count and increase earnings per share, and an ever-increasing dividend stream, which returns cash to share owners. All of this has led to higher price-to-earnings multiples.

What is different now is that valuations (multiples), after trailing the fundamental improvements in corporate America since 2008 – 2009, have now overtaken the fundamentals. By this, I mean that the market’s trailing price-to-earnings ratio has risen sharply. In the last year, the market’s overall P/E has risen from 14.5 times earnings to more than 16 times earnings. In the last 12 months alone, the S&P 500 has risen 22%. While the fundamentals have not disintegrated, the rate of fundamental improvement has slowed as the market has zoomed ahead. This is a yellow flag, not a green flag.

There are several historical justifications for the re-rating of the US stock market, and multiples may deserve their current level. First, low interest rates support a higher market multiple than average. Second, the Fed is supplying liquidity to the marketplace and seems ready to act to prevent a lapse in US growth. This tends to give the market some justifiable confidence. Also, there have been some modest whiffs of future inflation, and a bit of higher inflation is also historically tied to higher valuations of the US stock market.

Bull markets can have a life of their own, but it is always safer to stay with a market that is growing in parallel to the fundamentals rather than ahead of them. The markets look ahead, and perhaps they are seeing a recovery in Europe as well as China and other developing countries. This is an important part of the S&P 500, which is now almost 40% dependent on sales from outside the United States. I don’t see enough data or trends yet to prove this point.

I don’t think that the market is overvalued relative to fundamentals, but the fundamentals will have to show strong improvement before year-end for us to state that this market is on solid ground. In other words, the first shots have been heard in the war between valuations — the price of the market and its expectations — and the fundamentals of the market — the underlying strength of earnings and cash flow. Investors remain on alert.



No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

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