A Memorable Earnings Season

Q1 revenues, earnings, and margins are now available for the S&P 500. Revenues per share dropped 2.7% q/q during Q1. Earnings per share, based on Thomson Reuters I/B/E/S (TR) data, fell 1.3% q/q. So in what sense was the Q1 reporting season “memorable,” as stated in the title of today’s commentary?

For starters, the S&P 500 rose to a new record high of 2415.82 on May 26. The S&P 400 and S&P 600 stock price indexes continued to mark time at their recent record highs. Industry analysts remained upbeat about earnings for this year and next year, as reflected by the record highs in the S&P 500/400/600 forward earnings.

This all happened despite a growing realization that President Trump’s economic agenda is likely to be slowed by Washington’s swampy ways. I came to that epiphany on May 18 and adjusted my earnings estimates accordingly, pushing the corporate tax cut into 2018 from 2017. Without a tax cut, I estimate that S&P 500 earnings per share will be $130.00 this year and $136.75 next year. With the tax cut in 2018, my estimate for next year gets raised to $150.00. Let’s have a closer look at the results of the latest reporting season:

(1) Good growth. Of course, the apparent weakness in Q1’s revenues and earnings on a q/q basis is mostly seasonal in nature. The first quarter of the year tends to be the weakest one of the year. On a y/y basis, revenues per share rose 6.9%, the fastest since Q4-2011. Earnings per share rose 14.5% y/y, the best growth since Q3-2011.

I argued that the S&P 500 revenues recession during 2015—when y/y growth rates were down each quarter—was mostly attributable to the plunge in the revenues of the energy sector. The revenue growth rates, which turned slightly positive during Q1-2016, have been increasing since then. It was last summer that I declared the end of the earnings recession. The y/y growth rate of earnings turned positive during Q3-2016 at 4.2%, rose to 5.9% during Q4-2016, and chalked up 14.5% at the start of this year.

(2) High & stable margin. The profit margin of the S&P 500, based on TR data, rebounded sharply from a record low of 2.4% during Q4-2008 back to its previous cyclical peak of 9.6% during Q3-2011. There was lots of growling by the perma-bears that it would soon revert to its mean. Instead, it continued to rise to a new record high of 10.7% during Q3-2016. It has remained around there since then, registering 10.5% during Q1.

I argued that following the Trauma of 2008, company managements would do whatever they could to raise and maintain their profit margins by remaining conservative in their spending plans despite record profits. I’m not saying that the profit margin will never revert again. It will do so come the next recession. But that downturn may not come for a while because companies are being conservative.

In the past, the profit margin would often peak before recessions as companies went on hiring and capacity expansion sprees. The resulting boom would create the borrowing and inflationary excesses that set the stage for the inevitable bust. This time, the economy isn’t booming the way it often has at this late stage of an expansion. No boom, no boost … at least not in the foreseeable future.

(3) Correlations. I’m not surprised by the solid rebound in S&P 500 revenues because its y/y growth rate tends to be nearly the same as the comparable growth rate for manufacturing and trade sales, even though this series is limited to goods and does not include services. Aggregate (not per-share) revenues was up 5.2% y/y during Q1, while business sales rose 6.4% through March. Revenues per share on a y/y basis tends to lag the US M-PMI. The latter remains relatively high and consistent with revenue growth around 5%. Not surprisingly, there is a decent correlation between the y/y growth rate in nominal GDP and aggregate S&P 500 revenues.

Valuation: A Less Miserable Measure

Almost all valuation multiples are flashing that stocks are dangerously overvalued. Are there any valuation models suggesting that the danger signals might be false alarms? There is one. It shows the inverse relationship since 1979 between the S&P 500 forward P/E and the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate. Let’s have a look at it and compare it to a few of the other valuation indicators:

(1) Misery Index very bullish. During April, the Misery Index was down to 6.6%, near previous cyclical lows. That’s down 6.3ppts from its most recent cyclical peak of 12.9% during September 2011. Over this same period, the forward P/E has risen from roughly 10 to 17, well above its average of 13.8 since September 1978.

The theory is that less misery should justify a higher P/E. A low unemployment rate should be bullish for stocks unless it is accompanied by rising inflation, which could cause the Fed to tighten to the point of triggering a recession and driving the jobless rate higher. Nirvana should be a low unemployment rate with low inflation, which seems to be the current situation. In this happy state, a recession is nowhere to be seen, which should justify a higher valuation multiple.

I construct a “misery-adjusted” P/E simply by summing the S&P 500 forward P/E and the misery index. It has been trendless and highly cyclical since September 1978, with an average of 23.9. Its low was 18.5 during November 2008, and its high was 33.0 during March 2000. During April, it was 24.3, in line with its average. That’s somewhat comforting.

(2) Rule of 20 no longer a buy signal. Less comforting is the Rule of 20, which tracks the sum of the S&P forward P/E plus the CPI inflation rate. So it is the same as the misery-adjusted P/E less the unemployment rate. I moved to CJ Lawrence in 1991. My mentor there was Jim Moltz, who devised the Rule of 20, which states that the stock market is fairly valued when the sum of the P/E and the inflation rate equal 20. Above that level, stocks are overvalued; below it, they are undervalued.

The rule was bearish just prior to the bear market at the start of the 1980s. It was wildly bullish for stocks in the first half of the 1980s. It turned very bearish in the late 1990s and bullish again a couple of years later in mid-2002. Those were all good calls. However, like most other valuation models, it didn’t signal the bear market that lasted from October 9, 2007 through March 9, 2009. At the end of 2008, the Rule of 20 was as bullish as it was in the early 1980s. That was another very good call. By early 2017, it was signaling that stocks were slightly overvalued for the first time since May 2002.

(3) Buffett ratio sees no bargains. Another valuation gauge I follow is the price-to-sales (P/S). The S&P 500 stock price index can be divided by forward revenues instead of forward earnings. However, the forward P/S ratio is very highly correlated with the forward P/E ratio. So it doesn’t add much to the assessment of valuation.

A variant of the P/S ratio is one that Warren Buffett said he favors. It is the ratio of the value of all stocks traded in the US to nominal GDP. The data for the numerator is included in the Fed’s quarterly Financial Accounts of the United States and lags behind the GDP report, which is available a couple of weeks after the end of a quarter on a preliminary basis. Needless to say, it isn’t exactly timely data.

However, the forward P/S ratio, which is available weekly, has been tracking Buffett’s ratio very closely. In an interview he did with Fortune in December 2001, Buffett said, “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.” That’s sage advice from the Sage of Omaha. His ratio was at 1.69 during Q4, while the P/S was 1.90 in mid-May, suggesting that we are playing with fire.

On the other hand, a year ago in a 5/2 CNBC interview, Buffett said, “If you had zero interest rates and you knew you were going to have them forever, stocks should sell at, you know, 100 times earnings or 200 times earnings.” He was speaking hypothetically, of course. More recently, this year in a 2/27 CNBC interview, Buffett said that US stock prices are “on the cheap side,” and added, “We are not in a bubble territory.” He also announced at the time that he had more than doubled his stake in Apple since the new year and before the tech giant reported earnings on January 31.

(4) Fed model still bullish. To round out the discussion, I should mention that the Fed’s Stock Valuation Model showed that the S&P 500 was undervalued during April by 61.9% using the US Treasury 10-year bond yield and 24.9% using a corporate bond yield composite. This confirms Buffett’s assessment that stocks are relatively cheap compared to bonds. If more investors conclude that economic growth (with low unemployment) and inflation may remain subdued for a long while, then they should conclude that economic growth and inflation may remain historically low. That’s a Nirvana scenario for stocks, and would be consistent with valuation multiples remaining high.

Death by Amazon

An anchor store is one of the larger stores in a shopping mall, usually a department store or a major retail chain. Shopping malls were first developed in the 1950s. Their developers signed up large department stores to draw retail traffic that would result in visits to the smaller stores in the mall as well. The anchors usually paid heavily discounted rents.

Amazon is a river in South America. It is the largest one in the world by discharge of water and the longest in length. A piranha is a freshwater fish with sharp teeth and a powerful jaw that inhabits South American rivers, including the Amazon. If you happen to fall off a riverboat steaming down the Amazon, the piranhas will pick your bones clean.

Amazon is also a piranha-like corporation that eats up retailers, particularly the anchor stores, and doesn’t even leave the bones. I have been picking apart this story for a while. For example, see our 3/30 Morning Briefing titled “Jeff Bezos, The Terminator.” I was quoted in a 5/12 IBD article on the subject as follows:

"Amazon is killing lots of businesses. In the process, it may also be killing inflation," Ed Yardeni, noted economist and president of Yardeni Research, said in a recent report. Using Chief Executive Jeff Bezos’ playbook, Amazon has pummeled rivals with price cuts enabled by its smart logistics and relentless drive toward efficiency. Labor-displacing warehouse robotics give Amazon a cost advantage, and it aims to one day deploy delivery drones to extend its edge all the way to the customer’s doorstep. Amazon’s casualty list already is formidable. Over the years, Amazon has left consumer-facing retailers such as Borders, Circuit City and Sports Authority in the dust. Department chains have been closing stores, unable to answer the e-commerce challenge.

The IBD article reported that Amazon’s piranhas are about to chew up other businesses. Consider the following:

(1) Big-box retailers & grocers. Amazon is going after big-box retailers like Wal-Mart and Costco by leaning on their consumer staples vendors to sell their products, which are packaged in big boxes, to consumers directly through Amazon’s distribution system. The $1.3 trillion US grocery market could be Amazon’s biggest potential source of revenue upside. IBD noted, “Amazon hopes to eliminate store cashiers at Amazon Go convenience stores now being tested. Amazon Go stores use sensors to track items as shoppers put them into baskets. The shopper’s Amazon account gets automatically charged.”

(2) B2B. Yardeni Research already has received mailings inviting us to set up an Amazon Business account for our office needs. IBD observed: “The online sales channel for business customers is sending prices down for industrial products, pressuring companies like W.W. Grainger.”

(3) Entertainment. Amazon is also going head-to-head with Netflix and all of Hollywood, by producing and distributing movies. The CEO of the entertainment provider Liberty Media, Greg Maffei, called Amazon a “ridiculously scary” rival at a financial conference on May 9. He presciently explained that Amazon’s competitive advantage is that it “has an ability, because of its scale, to invest at incredibly low or negative rates of return—because they can cross-subsidize, and the market is willing to suspend disbelief in future profitability.”

(4) On-demand & logistics. IBD reported: “Amazon recently was granted a patent for automated, ‘on-demand apparel manufacturing.’ The patent highlights plans to go beyond clothing into other fabric-based products, such as footwear, bedding and home goods. … Amazon is also bringing more of its logistics and delivery operations in-house.” This means that it is aiming to compete with, and eventually chew up, the airfreight, trucking, and home delivery industries.

(5) Cloud. In March 2006, Amazon officially launched Amazon Web Services (AWS). We signed up in 2008 for this fantastic cloud service, which has been remarkably reliable and very cost effective for us. IBD reported:

As corporate America outsources more computing work to AWS and other highly automated cloud services, companies buy less hardware and software for internal data centers and cut back on IT staffing. In the March quarter, IBM’s (IBM) hardware business fell nearly 17% to $2.5 billion year-over-year, reflecting the impact of cloud adoption. How do the likes of IBM, Cisco Systems (CSCO) and Hewlett Packard Enterprises (HPE) fight back? By cutting prices. ‘Cloud is deflationary and collapses markets,’ said a Citigroup report in April. "Labor, with 85% deflation in the cloud, has the most significant disruption from cloud economics," says the Citi report. It says 15 IT staffers in a public, shared cloud service can replace 100 in a private data center.

According to Citigroup, AWS will rake in some $37.5 billion in revenue by 2020, up from $17 billion this year. IBD quoted me as follows:

“Perhaps most importantly, AWS’ juicy operating profit margin of more than 25% gives Amazon a way to fund its new ventures and a retail business that has notoriously skinny margins. The cash and financial flexibility AWS provides ensure that Amazon will be a lethal competitor in the retailing industry for many years to come.”

In other words, “Death by Amazon” is a plague that will continue to afflict more and more businesses and industries. We can keep track of the mounting body count with a few economic indicators and by reading the business obituary page.

In March, online shopping rose to a record 29.7% of all online and in-store sales of GAFO, i.e., general merchandise, apparel and accessories, furniture, and other sales. That’s up from just above 5.0% in 1994, when Jeff Bezos founded Amazon on July 5 that year. Over this same period, department stores’ share of GAFO plummeted from 34.3% to 12.5% currently. The box retailers saw their share rise from about 7.0% in 1992 to peak at 27.2% during January 2014, and ease back down to 25.3% currently.

In a 5/4 CNBC interview, Warren Buffett said he sold off about a third of his company’s 81 million shares of IBM since the start of the year. “I would say what they’ve run into is some pretty tough competitors,” Buffett said. “IBM is a big strong company, but they’ve got big strong competitors too.” In a 5/8 CNBC interview, Buffett was asked why he didn’t own any Amazon shares. He had a simple one-word answer: “Stupidity.”

Buffett explained, “I was impressed with Jeff [Bezos] early. I never expected he could pull off what he did ... on the scale that it happened.” He added, “At the same time he’s shaking up the whole retail world, he’s also shaking up the IT world simultaneously.”

In the nominal GDP data, I see that capital spending on software and on information processing equipment both rose to record highs during Q1-2017 of $346.2 billion (saar) and $334.3 billion. Computers and peripheral equipment, which is included in the latter category, has been virtually flat in both current and inflation-adjusted dollars since Q4-2010 at around $82 billion (saar). This flattening out after rapidly increasing since the early 1980s coincides with Amazon leading the expansion of the cloud business since 2006. Companies don’t need to buy computers when they can sign up for the computing power and storage they need on the cloud, which uses the available hardware much more efficiently.

Earnings: Small Is Beautiful

The money keeps pouring into equity ETFs. The latest data from the Investment Company Institute shows that they attracted $38.1 billion during March, $98.6 billion during Q1, and $198.7 billion since November, when Donald Trump was elected president. Over the past 12 months through March, equity ETFs attracted a record $295 billion. No wonder the S&P 500 is up 7.1% ytd through Tuesday’s close and is just 0.1% below Monday’s record high. It is up 12.0% since Election Day.

Just as impressive, the S&P 400 MidCaps and S&P 600 SmallCaps stock price indexes are up 14.2% and 16.7% since Election Day. The stock market rally since then has been attributable to a combination of higher forward P/Es and increases to record highs in the forward earnings of the S&P 500/400/600. The current bull market has been especially good for MidCap and SmallCap investors. Consider the following:

(1) Performance & earnings derby. The S&P 500/400/600 price indexes are up 254.7%, 329.7%, and 368.3% since March 9, 2009. That’s because the forward earnings of the three composites are up 107.2%, 132.8%, and 161.4% over that same period.

(2) Valuation derbies. All three started the bull market with forward P/Es just above 10.0, specifically at 10.3, 10.1, and 11.1, respectively. These valuation multiples for the S&P 500/400/600 are currently 17.5, 18.3, and 19.4.

(3) Earnings in 2017 & 2018. Analysts’ consensus expectations in early May showed earnings growth for the S&P 500/400/600 of 11.4%, 10.5%, and 9.8% this year. Next year, they expect estimate growth rates will be 11.9%, 13.6%, and 19.8%. Interestingly, their expectations for 2018 have been remarkably stable since late last year for the LargeCaps and SmallCaps, while their MidCap consensus forecast has been rising.

(4) Q1 upside hooks. Now that the Q1 earnings season is almost complete, we see upside hooks in the results relative to expectations at the start of the season for all three composites. The S&P 500/400/600 Q1 actual/blended numbers now show y/y gains of 13.9%, 10.5%, and 6.3%. In other words, LargeCap investors have something to brag about for now. (By the way, at the beginning of the current earnings season, the estimates were 9.2%, 6.7%, and 2.1%.)

(5) Alpha & beta. The reason that small companies grow faster than large companies is that if they survive, they tend to grow into bigger companies, while the large ones may have hit their critical mass many years ago. There is more alpha in small companies, and more beta in large companies. “Alpha” refers to company-specific developments, while “beta” refers to economy-wide ones that impact all companies. Of course, this can be a curse during recessions when both alpha and beta fall apart for many small companies, while large companies mostly take a beta hit.

Currently, the big problem for all companies is a shortage of workers. This hits smaller companies harder because they need to increase their payrolls to grow more so than large ones. The NFIB survey of small business owners released yesterday for April showed that 31.7% are not able to fill open positions, using the three-month average to reduce m/m volatility in this series. That’s the highest since February 2001. On the other hand, 17.5% of them are saying that government regulation is their number-one problem, down from a recent peak of 22.2% during May 2015. SmallCaps and MidCaps are likely to benefit more than LargeCaps from President Trump’s economic agenda to reduce regulations and cut corporate taxes.

Seinfeld Market: Nothing Bad Happening

"The Pitch” is the 43rd episode of the TV sitcom Seinfeld. It is the third episode of the fourth season. It aired on September 16, 1992. In it, NBC executives ask Jerry Seinfeld to pitch them an idea for a TV series. His friend George Costanza decides he can be a sitcom writer and comes up with the idea of “a show about nothing.”

The bull market in stocks since March 2009 has had a fairly simple script too. As a result of the Trauma of 2008, investors have been prone to recurring panic attacks. They feared that something bad was about to happen again, so they sold stocks. When their fears weren’t realized, the selloffs were followed by relief rallies to new cyclical highs and to new record highs since March 28, 2013. Their jitters are understandable given that the S&P 500 plunged 56.8% from October 9, 2007 through March 9, 2009.

From 2009 through 2016, there were four major corrections and several significant scares. I kept track of them and the main events that seemed to cause them. By my count, there were 57 panic attacks from 2009 through 2016, with 2012 being especially anxiety-prone with 12 attacks. (See our S&P 500 Panic Attacks Since 2009.)

From 2010 through 2012, there were recurring fears that the Eurozone might disintegrate. There were Greek debt crises and concerns about bad loans in the Italian banking sector. Investors were greatly relieved when ECB President Mario Draghi pledged during the summer of 2012 to do whatever it takes to defend the Eurozone. China also popped up from time to time as concerns mounted about real estate bubbles, slowing growth, and capital outflows over there. At the end of 2012, fear of a “fiscal cliff” in the US evaporated when a budget deal was struck at the start of 2013 between Democrats and Republicans. I expected it, though I certainly had no idea that it would be worked out between Vice President Joe Biden and Senate Minority Leader Mitch McConnell. In a November 9, 2013 Barron’s interview titled “Lifting the Odds for a Market Melt-Up,” I observed:

I have met a lot of institutional investors I call "fully invested bears" who all agree this is going to end badly. Now, they are a bit more relaxed, thinking it won’t end badly anytime soon. Investors have anxiety fatigue. I think it’s because we didn’t go over the fiscal cliff. We haven’t had a significant correction since June of last year. We had the fiscal cliff; they raised taxes; then there was the sequester, and then the latest fiscal impasse. And yet the market is at a record high. Investors have learned that any time you get a sell-off, you want to be a buyer. The trick to this bull market has been to avoid getting thrown off.

There was another nasty selloff at the start of 2016 as two Fed officials warned that the FOMC was likely to follow 2015’s one rate hike at the end of that year with four hikes in 2016. I had predicted “one-and-done” for 2015 and again for 2016. Contributing to the selloff in early 2016 was the plunge in the price of oil, which had started on June 20, 2014. That triggered a significant widening in the yield spread between high-yield corporate bonds and the US Treasury 10-year bond yield from 2014’s low of 253 basis points on June 23 to a high of 844 basis points on February 11, 2016. The widening was led by soaring yields of junk bonds issued by oil companies. There were widespread fears that all this could lead to a recession. In addition, the Chinese currency was depreciating amid signs of accelerating capital outflows from China.

I remained bullish. In a February 6, 2016 Barron’s interview titled “Yardeni: No U.S. Recession in Sight,” I reiterated my opinions that the Fed was unlikely to hike the federal funds rate more than once and that the secular bull market remained intact. I argued on Monday, January 25 that “it may be too late to panic” and that the previous “Wednesday’s action might have made capitulation lows in both the stock and oil markets.” Sure enough, the price of a barrel of Brent crude oil did bottom on Wednesday, January 20. The S&P 500 bottomed on February 11, the same day that the high-yield spread peaked. The S&P 500 Energy sector dropped 47.3% from its high on June 23, 2014 to bottom on January 20, 2016. During the summer of 2016, I perceived the end of the energy-led earnings recession and projected that the bull would resume his charge.

Following the surprising Brexit vote that summer, the stock market declined for just two days despite lots of gloomy predictions. Just prior to the presidential election, I argued that the rebound in earnings, following the recession in the energy industry, would likely push stock prices higher no matter who won. After Donald Trump did so, I raised my outlook for the S&P 500, expecting that a combination of deregulation and tax cuts would boost earnings. The latest bull market was still going strong in early 2017.

I was interviewed again in the February 4, 2017 issue of Barron’s saying:

It would be a mistake to bet against what President Trump might accomplish on the policy side. I’m giving him the benefit of the doubt, hoping good policies get implemented and bad ones forgotten. We could get substantial tax cuts. All his proposals don’t need to be implemented for the Trump rally to be validated. If you get $1 trillion to $2 trillion coming back from overseas because of a lower tax on repatriated corporate earnings, that would be very powerful in terms of keeping the market up.

So far, investors are relieved that the bad outcomes predicted by the naysayers about Trump in the White House haven’t happened. The anticipated bullish outcomes are also still mostly on-the-come. Nothing really terrible or wonderful is happening other than that earnings are rising in record-high territory again.

By the way, in case you missed it, you might be relieved to know that Greece and its international creditors on Tuesday reached a preliminary deal allowing the country to receive yet another round of bailout payments in exchange for promises to raise taxes and to further cut pensions and social spending. Chinese stocks seem to be stabilizing this week, having dropped sharply during the second half of April after officials slammed what they called short-term speculators. This past Sunday evening, congressional leaders reached an agreement on a spending deal that would fund the government through the end of September and avoid a looming shutdown. This weekend, the French are likely to elect a President who is all for the EU and euro. These developments should all be a relief, though no one really worried much about any of them this time. Nothing bad is happening, which is good news for stocks.