Thursday, 25 July 2013

What do we care about today? (25 July 2013)

Overnight comment, The long term verses the short term, earnings season, China bullishness

Overnight, US stocks retreated from their record peak in what was one of the busiest days so far in the earnings season. A pair of downbeat reports from Caterpillar and AT&T weighed on the Dow while Broadcom fell -15% for the biggest decline in the S&P500 after issuing forecasts that trailed analyst estimates. Apple gained +5.1% following last night’s small beat (on beaten down expectations). Volume, as it invariably is on sell-offs lately, was the highest in 3 weeks.

In eco data, new home sales surged in June to +8.3% m/m (vs. +1.7% expected) while US PMI came in at 53.2, up from 51.9 the prior month. This sort of data is likely to continue to fuel “taper on” sentiment in the market and thus result in negative price action. The yield on 10yr Treasuries rose 8bps to 2.59% - the worst day in 3 weeks for USTs/

The long term: With the S&P500 at ALL-TIME highs, a lot of effort is being made to explain how “cheap” US stocks are still. The most popular valuation metric is the good old PE ratio. The chart below shows the current PE for the S&P500 is around 16x, which incidentally is pretty much smack on the average since 1954 (which is as far back as my Bloomberg data goes):

So using a very popular and widely understood – if simplified – valuation metric, US stocks appear fair value against history.

Now for a little thought experiment:

What if analyst earnings estimates for 2015 are right? The "Street" estimate for EPS for the S&P500 in 2015 is 135.32. 

Furthermore, what if stocks in 2015 are trading on an earnings multiple of…let’s say 20x (approx. 1 standard deviation above the average earnings multiple of 16x). Such multiple expansion could be the continuation of the trend we have seen since 2009, resulting inter alia from a lack of other attractive investment alternatives in a zero interest rate world.

Well…we would then get an S&P500 target for 2015 (and I can hardly believe I’m writing this) of 2,706, i.e. ~1,000 index points higher than where we are now.

So if you are looking for a reason to be bullish US equities longer term - see above!

DISCALIMER: This thought experiment should make you realise just how nutty trying to pick forward stock or index prices is. Trying to guess forecast earnings is one thing. But bear in mind that an earnings multiple is a reflection of people’s feelings about the future. So in forecasting guessing a future earnings multiple, we are trying to guess how people will be feeling about the future in the future! If someone said to you “I think people will be in a 20% better mood about the future in 2015” you would think they that were crazy. But when someone does the same thing in projecting future stock/index target prices, we have the good manners to call it analysis!

And now for the short term:

Not only has the S&P500 risen +8.5% since 24th June (that’s +178% annualized!), it has risen 16 of the past 21 trading days – including 12 of the past 14 trading days. I dislike using the term “overbought” but in this case I’m prepared to make an exception: Price action, technical indicators, volume patterns, a collapsing VIX and bullish sentiment surveys all lead me to conclude that "overbought" is where stocks are in the short term. Expect a pullback.

The 2Q earnings season so far has been pretty good. As I foreshadowed a couple of weeks ago, low expectations for this earnings season were likely to be the market’s saviour.

As of the end of last week, with 108 companies having reported, 71.2% have beaten street profit estimates while 53.2% have beaten revenue estimates. The earnings beat % is impressive indeed compared with quarterly earnings seasons back to 2002…

...the revenue beat % is decidedly less so…

The concern being – with operating margins skirting all-time highs, how much juice does the cost cutting/margin expansion story have left in it?

Large cap financials (e.g. GS, Bank of America, Citi), healthcare (e.g. Baxter, JNJ) and industrials (e.g. Lockheed Martin, GE) have been the positive standouts so far this reporting season. Big tech has had a bumpy ride with disappointments from Microsoft, Google and Intel…fortunately Apple managed a small beat on sales and earnings.

In Asia, stocks have risen to two month highs following a declaration from Premier Li Keqiang that 7% growth is seen as a bottom line for tolerance of an economic slowdown. Scepticism around Chinese GDP figures aside, Chinese equities have probably now reached valuation levels where bad news can be absorbed and any good news at all is an excuse for a rally. Remember that chart at the top of this email showing the PE for the S&P500? Here’s how the same chart for the PE ratio of the Shanghai Composite looks:

And here’s a staggering statistic for you to consider: The Shanghai Comp is lingering near four year lows, just 42% above 1992 highs, despite an incredible 1,768% rise in Chinese GDP over the past 21 years!

This statistic is strong evidence that:
-          The stock market ≠ the economy. In other words, don’t just blindly buy the equity market of country XYZ just because you are bullish on the prospects for country XYZ’s economy
-          Valuation, while virtually meaningless in the short term, is probably the most important determinant of long-term investment returns

And the valuation argument for Chinese equities is starting to look compelling.