Eurozone Stocks Hit Air Pocket (excerpt)

This may very well be the week for a deal, or for no deal. The question is who will blink first in this dangerous game of chicken between Greece and its creditors. Global stock investors started to blink on April 13, when the EMU MSCI (in euros) hit the year’s high with a gain of 22.9% ytd. On Monday, it was down 9.4% from that peak and still up 11.3% ytd. So it continues to outperform the US, UK, and EM MSCIs. Interestingly, the latest selloff in the EMU MSCI has been remarkably widespread among the 10 sectors comprising the index.

The good news is that the forward earnings of the EMU MSCI has been recovering nicely over the 14 weeks through June 4. In addition, the region’s Net Earnings Revisions Index jumped to 4.0% during May, the highest since September 2010. Obviously, industry analysts either aren’t counting on a Grexit, or don’t expect it will matter much to their companies. The index remains relatively cheap, with the forward P/E at 15.1.

While numerous economic indicators show that the Eurozone’s economy is on an upswing, it’s a very anemic one based on the region’s measures of industrial production. Here is the y/y performance derby for the region and its four biggest economies: Spain (2.2%), Germany (1.3), Italy (0.1), and France (-0.1). That’s not much to get excited about. It’s not much better in some of the other European economies: Sweden (1.5), UK (1.2), and the Netherlands (-4.2).

Yesterday, one of our accounts asked me if Europe’s economy is strong enough to absorb the shock of a Grexit. I think so, but I wouldn’t bet the ranch on it. Keep in mind that the Eurozone’s recovery is weak despite the fact that the following six cylinders have all been firing: near-zero interest rates, QE, a weak euro, rising bank lending, soaring stock prices, and lower oil prices.

Today's Morning Briefing: Dead Reckoning.(1) Deduced reckoning. (2) Are investors in the same boat with Nicole Kidman? (3) Is the Greek play a tragedy or comedy? (4) In praise of kicking the can down the road. (5) Angela vs. Wolfgang. (6) Earnings finally recovering in Eurozone. (7) No wind in the sails of commodity, currency, and S&P 500 traders. (8) Eurozone’s economic recovery remains uninspiring. (9) China’s economy continues to struggle with excess capacity and PPI deflation. (10) Focus on market-weight-rated S&P 500 IT industries. (More for subscribers.)

Varieties of Valuation (excerpt)

In my ongoing research on valuation, I constructed a quarterly P/E series for the S&P 500 based on reported earnings from Q4-1935 through Q3-1988, and operating earnings since then. Its average is exactly 15.0. It was 18.5 during Q1-2015. It has been this high before and sometimes gone higher. A reversion-to-the-mean valuation model is bearish based on this measure of the P/E since it is currently higher than its mean.

Over 30 years ago, Jim Moltz, my mentor at CJ Lawrence during the 1990s, devised the Rule of 20. It states that for equities to be fairly valued, the P/E ratio plus the inflation rate has to be around 20. In April, the CPI inflation rate was minus 0.2% y/y, implying that the fair-value P/E should be 20.2, well above the trailing P/E. On the other hand, the core CPI was up 1.8% y/y, suggesting that 18.2 is the right valuation number.

Greg Donaldson, the chief investment officer of Donaldson Capital Management and a subscriber and friend of Yardeni Research, offers an interesting inflation-based analysis of the P/E in a 5/16 Seeking Alpha article titled “The Great P/E Debate: Are Stocks Overvalued?” Greg writes: “We do not find strong relationships between any of the widely followed indicators such as interest rates, GDP growth or earnings growth. We have found that inflation is the best predictor of P/E ratios at any given point in time.” He ran a regression of inflation (using the core PCED) on the earnings yield (E/P). He used it to calculate that the current P/E should be about 21 based on his model.

In addition to tracking the trailing P/E, I also monitor market-capitalization-to-sales and price-to-sales ratios. During Q1, the Fed’s Financial Accounts showed that the ratio of the market capitalization of all equities traded in the US (excluding foreign issues) to nominal GDP rose to 1.69, the highest since Q3-2000. The comparable ratio for the S&P 500 rose to 1.87 during Q1, also the highest since Q3-2000. The ratio of the S&P 500 to its forward revenues per share rose to a cyclical high of 1.82 in early June. Stocks are seriously overvalued according to these measures.

Today's Morning Briefing: Slice & Dice. (1) The valuation question again. (2) Waiting for the answer while stocks meander. (3) Earnings-led target of 2300 for the S&P 500 next year. (4) Reversion-to-the-mean model is bearish. (5) A 20 P/E isn’t irrational according to inflation models. (6) Fed model says either stocks are too cheap or bonds are too expensive. (7) Does revenues growth matter to valuation? (8) Price-to-sales models are bearish. (9) Retail sales data suggest soft patch is over. (10) Our in-house Gen Xer slices and dices generational demographics from A to Z. (11) “Love & Mercy” (+ + +). (More for subscribers.)

Abrupt Normalization in Bond Market (excerpt)

One simple model of the 10-year bond yield compares it to the growth rate of US nominal GDP on a y/y basis. While real GDP fell 0.7% (saar) during Q1 on a q/q basis, it was up 2.7% y/y, confirming that the quarterly result might have been distorted by faulty seasonal adjustments. Recent economic indicators confirm that the US economy continues to grow at a moderate pace. In any event, nominal GDP rose 3.6% y/y during Q1. That’s well above even the latest yield. In the Eurozone, real GDP rose 1.5% (saar) q/q during Q1. It was up 1.0% y/y, with nominal GDP rising 2.0%.

This suggests that the rebound in yields is an abrupt normalization relative to nominal economic activity. This happened in reaction to the ebbing of deflationary fears. Expected inflation in US 10-year TIPS is up from this year’s low of 1.54% on January 13 to 1.86% on Tuesday. In addition, growth prospects seem to be improving in the US and Eurozone. While the ECB is committed to its QE program through most of next year, the Fed is likely to respond by raising the federal funds rate later this year. Expectations that the Fed will soon start normalizing monetary policy is another explanation for the abrupt normalization of bond yields.

Today's Morning Briefing: Bond Bath. (1) Blondes vs. bonds. (2) Bonds vs. bunds. (3) Where do we go from here? (4) From abnormal to less abnormal. (5) Deflation fears ebbing. (6) A simple bond model. (7) Draghi deserves credit and blame. (8) Dudley says Fed policy is market dependent. (9) Tranquility in the commodity pits. (10) Riding the Age Wave. (More for subscribers.)

No Soft Patch for Small Business (excerpt)

The NFIB survey of small firms reports a series reflecting the net percentage of business owners saying that their earnings were higher over the past three months versus lower. It has been negative since the start of the data in January 1986. It jumped last month to -7%, the highest reading since October 2005. It’s up from the series’ record low of -47% during January 2009.

Not surprisingly, the 12-month average of the earnings series is highly correlated with the NFIB small business optimism index. When small business owners are optimistic because their earnings are improving, they tend to hire workers. Sure enough, the percentage of small companies expecting to increase employment is up to 11.6%, the highest since February 2008. The percentage of small firms with job openings is up to 25.4%, the highest since December 2001.

The latest NFIB survey noted: “Owners report that the labor market is, from an historical perspective, getting very tight. Owner complaints about ‘finding qualified workers’ are rising, job openings are near 42 year record high levels, and job creation plans remain solid. Over 80 percent of those hiring or trying to hire in May reported few nor no qualified applicants.” In an obvious dig, the report added that there’s not much the Fed can do to increase the supply of qualified workers.

Today's Morning Briefing: Small Business Is Big. (1) Jury is out on soft-patch verdict. (2) No soft patch for small business owners. (3) Businesses create jobs, not governments. (4) Small businesses lead the way. (5) Corporate profits lead employment and capital spending. (6) Hard to find qualified workers. (7) Capital spending improving, but lagging. (8) A real jolt in JOLTS. (9) SMidCaps vs. LargeCaps. (10) Falling oil prices have had bigger impact on earnings than rising dollar. (11) Margins getting squeezed among SMidCaps as they ramp up hirng. (More for subscribers.)

Trailing P/E Is On the High Side (excerpt)

As I noted recently, valuation, like beauty, is in the eye of the beholder. I think P/Es are high. Others disagree and say they can go higher given historically low inflation and interest rates.

I counter that low inflation rates are contributing to low revenues growth. Given record-high profit margins, total earnings aren’t likely to rise faster than total revenues. Low interest rates are offset by low earnings growth, in my opinion. I’ve constructed a quarterly P/E measure based on S&P 500 reported earnings from Q1-1960 through Q3-1988 and operating earnings since then when it first became available. Consider the following:

(1) Reversion to the mean. The average of this combined series is 16.2. The P/E was 18.5 during Q1, exceeding the average by 2.3 percentage points. Historically, readings of 20.0 or more have proved to be high and often followed by bear markets.

(2) Inflation and interest rates. There is a stronger inverse correlation between the CPI inflation rate and the P/E than between the 10-year Treasury bond yield and the PE. Arguably, they both justify still higher P/Es.

(3) Earnings growth. However, there is also a very good correlation between analysts’ consensus expected long-term earnings growth over the next five years for the S&P 500 and the P/E. The former suggests that the latter may be too high.

(4) Valuation and beauty. I come to the same conclusion as before: Valuation, like beauty, is in the eye of the beholder.

Today's Morning Briefing: Which Way Is the Wind Blowing? (1) Jefferson, Einstein, and Twain. (2) The weather will change. (3) Neither boom nor bust. (4) OECD paints a picture with some shades of grey. (5) China’s trade data confirm domestic weakness. (6) Eurozone on recovery road, as Greece can gets kicked down the road. (7) Japan isn’t getting much bang for all those yen. (8) Waiting for Thursday’s retail sales report. (9) Real exports are really OK. (10) Dead calm for US stocks. (11) Revenues growth outlook is neither hot nor cold. (12) Valuation vs. reversion to the mean, inflation and interest rates, and earnings growth. (More for subscribers.)