Friday, July 1, 2016

Brexit: Breaking Bullish or Bearish?

During my visits with our accounts at the beginning of this week, I didn’t sense as much anxiety about the selloff in equities during Friday of last week and this past Monday as I detected among our accounts during the correction at the start of the year. Perhaps we are all getting inured to the recurring panic attacks of this bull market. Bears have argued that there is too much complacency. So they were happy to growl “we told you so” earlier this week, though the remarkable rebound from Tuesday through Thursday should be disturbing them.

The S&P 500 hit a record high on May 21, 2015. Despite the latest relief rally following the two-day Brexit panic attack, it has been over 400 days since the S&P 500’s last record high. I remain in the secular bull camp. I expect a resumption of the current bull market. I think that could start to happen after the November elections. I am still targeting 2200-2300 by mid-2017 for the S&P 500.

The Brexit vote didn’t change my secular bullish stance. That’s because I don’t believe it will cause a recession in the US. I expect that earnings growth will resume during the second half of this year and that interest rates will remain as low as they are now for the foreseeable future. Let’s have a closer look at the latest relevant data:

(1) Aggregate revenues should grow 4% next year. On an aggregate basis (rather than per-share), S&P 500 revenues fell 1.0% y/y during Q1. These comps have been negative since Q1-2015 as a result of the plunge in the Energy sector’s earnings. Excluding them from the S&P 500 shows that the growth rate has remained just above zero over this same period and was 2.2% during Q1 of this year.

(2) Revenues per share should grow 5%-6% next year. On a per-share basis, S&P 500 revenues rose 0.5% y/y during Q1 as corporations reduced their share count through buybacks. (I can’t do the same comparison excluding Energy on a per-share basis.) Buybacks and acquisitions could add 1-2 percentage points to revenues growth on a per-share basis next year.

(3) Business sales data are highly correlated with S&P 500 revenues. The growth rates in aggregate S&P 500 revenues with and without Energy are highly correlated with the growth rates in total manufacturing and trade sales with and without petroleum products. During April, business sales fell 1.3% y/y, but rose 0.8% excluding petroleum products.

(4) Here’s my bottom line on the top line. So I expect aggregate revenues growth to rebound to about 4% next year. On a per-share basis, it could be closer to 5%-6% as a result of buybacks, which I’ve discussed many times before. I am assuming that oil prices will stabilize around current levels.

(5) The recent strength in the dollar doesn’t concern me all that much. Historically, there has been a decent correlation between aggregate S&P 500 revenues growth and the inverse of the y/y percentage change in the trade-weighted dollar. A weak (strong) dollar tends to boost (depress) revenues. Given the plunge in oil prices, it’s worth looking at this relationship excluding Energy from aggregate revenues.

When I do so, my conclusion is that the soaring dollar, which was up as much as 21.3% on a y/y basis on July 20, 2015, doesn’t seem to have weighed as much on revenues as it might have in the past. That may be because a strong dollar not only depresses demand for US exports and reduces the dollar value of earnings from abroad but also lowers input costs priced in dollars.

(6) Margins should remain high. The S&P 500 profit margin edged up to 8.7% during Q1-2016 from 8.0% during the previous quarter, which was the lowest since Q4-2009. However, excluding Energy, the margin was 9.7% during the first quarter. It has been hovering around 10.0% since Q1-2013. These numbers are based on operating earnings data compiled by S&P, which tend to be closer to GAAP earnings than Thomson Reuters (TR) data. I prefer the latter data but have to use the S&P data instead when calculating metrics with and without Energy.

The TR data show that the profit margin peaked at a record high of 10.7% during Q2-2015. It fell to 9.8% during Q1, which still exceeded the previous cyclical peak of 9.5% in Q2-2007. I can also derive a broader profit margin using after-tax corporate profits from current production in the National Income & Product Accounts and dividing it by GDP. That shows that the margin was 7.7% during Q1, up slightly from the previous quarter but down from the 10.1% record high during Q4-2011.

My bottom line on the profit margin is that it should remain around current cyclical highs for the foreseeable future.

(7) Earnings growth should match revenues growth. If my outlook for the profit margin is correct, then earnings-per-share growth should be the same as revenues-per-share growth, which I reckon will be 5%-6% next year.

(8) Valuation is high, but record-low yields are supportive. While stock valuation multiples are historically high, they aren’t excessively so given how low bond yields are currently. However, I don’t want to push my luck and argue that valuations are attractive given the low interest rates, which reflect a tough environment for earnings growth.

In my most likely scenario, with a 60% subjective probability, earnings grow at the same pace as revenues and stock prices appreciate at that same pace, i.e., 5%-6%. I can’t rule out a Melt-Up scenario, to which I continue to assign a 30% probability, given that the 10-year Treasury is now under 1.50%. The remaining 10% would be a Meltdown scenario, which has been a recurring scare during the current bull market. So far, every panic attack has been a buying opportunity. I suspect that will hold true for the Brexit panic of recent days as well.

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