The four horsemen of this cyclical bull market rally

Yesterday I made up the phrase “The Cyclical Rally’s Four Horsemen ” when discussing the bull market rally with a colleague. What I was trying to get at was the unsustainable nature of a divergence between top line revenue growth and the increase in equity performance at this late stage in the business cycle. The four horsemen are multiple expansion, stock buybacks, operating leverage, and cost cutting. What follows below is my reasoning.

When analysts talk about market trends, they often focus on ratios, depicting these ratios in terms of divergence from trend or mean reversion. And the assumption here is two-fold. First, analysts assume that a ratio is meaningful in terms of cause and effect. For example, the price-earnings ratio is supposed to denote a causal relationship between the earnings per share of a company and the price of the shares. The P/E ratio is therefore a catch-all for the concept that share price follows earnings. Second, analysts assume that a relationship is relatively stable over time, meaning that the historical ratio between two variables is relevant to the present. Using the P/E ratio, the inference then is that the price-earnings relationship is relatively stable, such that a high or a low P/E ratio will revert to mean over time.

The last post by Niels Jensen gets into some of the caveats to these two assumptions that we have witnessed for the last secular bull market in equities. I highly recommend that you read Niels’ analysis (link here). Notwithstanding these caveats, the reality is that the two assumptions about meaningful and causal relationships, and about mean reversion make sense. The reason caveats exist is that there are other factors which affect longer-term trends, but this does not invalidate the meaningfulness or causality inherent in a market metric like price-earnings ratios.

Over the past six years, we have seen four trends which I would call cyclical caveats and they are multiple expansion, stock buybacks, operating leverage, and cost cutting. What these four horsemen of this cyclical bull market rally have done is allowed US company shares to rise in an outsized way despite relatively weak top line revenue growth since 2012.

Sales growth

While the S&P 500 is less and less representative of the US domestic economy due to the large proportion of overseas sales by US multinationals, the lack of top line sales growth is indicative of weak US domestic demand as much as it is of weak global demand. And the relationship I want to concentrate on here is the one between sales growth and share price appreciation because I believe we are going to see mean reversion in this relationship as this cycle turns down. And when we hit recession, we will overshoot to the downside. How much depends on which of the four horsemen caveats continue to hold.

Here’s the thinking:

  • In the short-to-medium term profit margins can rise or fall due to factors like operating leverage or cost-cutting.
  • However, over the long-term, profit margins are relatively stable and mean-reverting such that the driving force behind share performance is sales growth.
  • In terms of share price, three other factors come into play that can boost prices over the short-to-medium term. One is the business cycle, which we can see from the ebb and flow of sales growth in the chart above. The other two factors are the other two horsemen I identified, share buybacks and multiple expansion.
  • Over the long-term, the business cycle won’t matter. But share buybacks and multiple expansion can add to EPS growth and share price growth for far longer than one business cycle, as the last 35 years have demonstrated

Depending on where we are in the business cycle and how durable the longer-term trends are, we could see a significant dip in equity market valuations. Not only do we have to be concerned about sales growth that drives core valuation from a cyclical perspective, we also should be concerned about weakness in sales growth from a secular perspective due to declines in nominal GDP both in the US and elsewhere in advanced economies.

Moreover, we also have to think about the four horsemen. Multiple expansion across business cycles is likely a reflection of the decline in bond yields, discount rates, and equity premiums as investors reach for yield. How much more multiple expansion can we expect? It is not clear given how low bond yields already are.

Share buybacks are notoriously cyclical, with companies buying back shares in large numbers nearer the end of the business cycle than the beginning. The increase in share buybacks is in fact a sign of late-cycle behavior that I expect to end.

Operating leverage works like any other leverage, meaning it magnifies gains and it magnifies losses. So to the degree the cycle is turning down, we should expect operating leverage to cause EPS to dip more than expected, leading companies to cut costs simply to keep earnings up.

But this would be cost cutting after sales have dipped. Meanwhile, the cost cutting and caution in increasing headcount or capital investment during this expansion has allowed firms to increase profit margins despite declining productivity growth, something that has helped to overcome weakening sales growth.

In the end, however, you cannot grow EPS to the moon if sales growth is weak. And you cannot grow sales if wage and job growth is weak. The key to this cycle continuing and not turning down then is continued job growth and better wage growth. The four horsemen have taken us far. But the decline in S&P500 earnings this quarter for the first time in 6 years tells us that we have reached the end of the line for boosts from these sources.

At this point in the cycle, we will need to see the real economy finally take over if stocks are to go higher. If it does not, share prices will continue to stall. And at some point, this will lead to cutbacks in production and capital investment, shocks to income that will weaken the real economy and could spell recession. And recession means mean reversion for most, or potentially all, of the four horsemen characteristics and a large fall in share prices. My sense is that the next two quarters of earnings are going to be critical on this score.

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