The US market’s advance is predicated on multiple expansion

By Edward Harrison On Aug 7, 2013

So the past year has been the year of earnings decline. Yet, the US stock market keeps powering to new highs. What’s going on? It’s called multiple expansion and it is the hallmark of all bull markets, cyclical or secular. The question is how long earnings will remain stagnant and whether this multiple expansion can continue in the face of stagnant earnings.

We know why multiples have expanded in the past: when interest rates go down, discount rates for future earnings go down and so those earnings are worth more. Lower rates therefore equal higher multiples, everything else equal. If you add in higher earnings that gets you a lot of share appreciation. The problem of course is that earnings have started to decline and rates have started to rise. Yet, the US equities market is still powering forward. And this has been going on all year.

Here’s how I put it in March:

“what is interesting is that the Dow has hit a new high and the S&P500 is really close despite the fact that S&P500 earnings peaked in Q1 2012. Now, we only have numbers through Q3 2012 but it seems likely that the Q4 2012 will still be below the Q1 2012 peak. What that says is that something other than earnings growth is driving the market higher. An optimistic reading of this dichotomy would be that the market is correctly forecasting continued economic growth that will translate into earnings growth. Another interpretation, that I support, says that the decrease in yields accounts for much of the increase. Low yields drive prices higher by decreasing discount rates and by increasing the desire to hold risky assets, so called private portfolio preferences. This says nothing about the aggregate market as a forecaster of earnings.”

That was before yields started to go up. I had already made the case for a major correction at the beginning of the year as one of my 10 predictions for the year based on a host of contrarian indicators. I wrote:

“right now the contrarian indicators are mostly bearish.

The Shiller P/E is 22
The VIX is 12.5
Junk bonds have broken below 6% yields
American Association of Individual Investors bullish sentiment is 44%
The S&P500 is 114% above its 4-year closing low of 683
New highs to lows for NYSE, AMEX and NASDAQ stocks is 1188/257 year-to-date

“So, here we are going into a period in which government is trying to cut its net deficit, something that translates into a net savings cut in the private sector and earnings misses as government deficits are the biggest driver of elevated corporate margins. And yet, the markets are going from strength to strength. And banks and home builders, the epicenters of the boom and bust are leading the charge. In my view, we have an unusually high level of market peaks that suggest greater risk for a sharp market reversal, especially in the context of anticipated fiscal retrenchment. I believe this sets the market up for a large correction at some point this year.”

We have yet to see this correction though and today I saw two stories pointing to multiple expansion as the driving force of continued share appreciation despite the increase in discount rates.

Here’s what Guggenheim Partners say. They are bullish:

“Winding the clock back to the fall of last year, it was clear that U.S. equities, and financial stocks in particular, were a strong buy and warranted increased allocations where appropriate. I gave a top-end target estimate of around 1720 for the S&P 500 at the time. Today, my long-term view of U.S. equities remains bullish, and U.S. equities could easily be 30-40 percent higher than today’s levels within two to three years. Having said that, for a number of reasons, now does not appear to be a favorable entry point. Depending on their time-horizons, investors, many who have large unrealized gains, may want to consider booking some of those gains and reducing their equity exposure.

Historically, markets that have rallied as aggressively as U.S. equities since November 2012 (an increase of 25 percent), pause or correct to digest their advances. Also, earnings among U.S. companies have flattened and could turn negative within two to three quarters, meaning further upside can only come from multiple expansion. Of the 19 percent rise in stocks year-to-date, 16 percent has already come from multiple expansion. Finally, it appears GDP growth could be entering a soft patch as we work through a number of short-term issues such as the headwinds in housing, reduced growth in China, the full impact of the sequester, and the budget and debt ceiling debates that will take place in Washington in the third quarter – all of which will put downward pressure on stock prices. The near-term outlook for equities makes now a good time to consider the old Wall Street adage, “Nobody ever lost money by taking a profit.” [Emphasis added]

So they make a case for a medium-term bullish ride of another 30-40% with some short-term profit-taking on the horizon. I presume the medium-term outlook is predicated on continued recovery no matter how slow. That makes sense if this is your macro view.

In an email I read today, John Mauldin noted the same multiple expansion phenomenon but has a more cautious tone:

To many investors, developed markets appear healthier and stronger than they have in years. Major equity markets are rallying to record highs; corporate credit spreads are tight versus US Treasuries and getting tighter; and broad measures of volatility continue to fall to their lowest levels since 2007.

This kind of news would normally point to prosperity across the real economy and call for a celebration – but prices do not always reflect reality. Moreover, the combination of high and rising valuations, low volatility, and a weakening trend in real earnings growth is a proven recipe for poor long-term returns and market instability.

Let’s take the S&P 500 as an example. It returned roughly 42% from September 1, 2011, through August 1, 2013, as the VIX Index fell to its lowest levels since the global financial crisis. Over that time frame, real earnings declined slightly (down about 2% through Q1 2013 earnings season), while the trailing 12-month price-to-earnings (P/E) ratio jumped 44%, from 13.5x to 19.5x. That means the majority of the recent gains in US equity markets were driven by multiple expansion in spite of negative real earnings growth. This is a clear sign that sentiment, rather than fundamentals, is driving the markets higher.

For me, the difference between Guggenheim and Mauldin is not on the potential for a near-term correction – for much the same reason I am expecting one this year. The real difference is that Guggenheim’s medium-term macro view is bullish and so they are also bullish on US shares. Mauldin sees less room for optimism over the longer-term because of the confluence of contrarian macro indicators. I am with Mauldin on this one with one caveat: the short-term (i.e. in the next year) is negative as both and Guggenheim and Mauldin assert. And I noted this in January. The long term is also a bit negative for the reasons Mauldin asserts. These are similar to the views I espoused in January as well. The caveat then is the medium-term. Whereas I began the year believing the US was ripe for recession before this year was over, I no longer believe this is the case. The US could realistically continue in slow-growth mode for another two or three years given the current policy mix. That makes Guggenheim’s prediction plausible.

But if Guggenheim are right and Mauldin is also right, it would suggest a pretty nasty bear market when the next cyclical downturn comes. Food for thought.