Weekly Wrap-up: Earnings, Fair Value, and the 4-Yr Cycle
(Published on Tuesday, July 18 rather than on Sunday, July 16.)
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The 4-Year Cycle, which we have been exploring at length and in detail, has reached an important precipice, and will very likely make the choice between a benevolent 4-Yr Cycle Low (defined for our purposes as a drop down no lower than +46% on the chart below (1173-ish on the SPX)) and a more malevolent low down near +30% (1045-ish) between now and October.
As you can see on this chart, the 4 prior cycles that most closely resemble the current one show an intense "bunching" around Trading Day # 950 in the cycle (red arrow). And as July turns into August, we should see this cycle either follow the more benign examples of 1978 and 1994 or else the more malignant precedents of 1966 and 1990.
While the market has a lot of geopolitical concerns (the Israeli-Hezbollah conflict, Iran, Iraq, North Korea, as well as inflated commodities and assets like Oil and Gold, just to name some headline-catchers lately) market valuation, on its face supports the more bullish/benevolent/benign case.
The consensus Forward Operating 52-Week Earnings Estimate (F52W EPS) for the SPX has risen to yet-another all-time high of $90.44. Meanwhile both Trailing Operating EPS ($81.40) and Reported EPS ($75.55) have done likewise. The trends on these Headline numbers remain extremely positive, with F52W EPS now 44% higher than it was at its peak in 2000, but with the SPX about 20% lower.
The Rates of Growth of F52W EPS remain constructive on both Y/Y and 3-month annualized bases.
At 13.9% and 19.7% respectively, there is no indication that the consensus for EPS growth is rolling over toward the danger zone, defined for our purposes here as either declining at below +10% or else below 0% (going in either direction).
Previous periods during which Y/Y growth in F52W EPS projections have fallen into our danger zone are highlighted in yellow on the chart above, and as you can see, the market has a tendency to struggle during such periods.
Price/Earnings Ratios are at extremely low levels at present, especially when placed in the context of prevailing interest and inflation rates.
The SPX PE on F52W EPS is now at a new cyclical low of 13.7 (earnings yield of 7.32%), and is a lower PE than it has been at any point since 1994. As you can see, PE on both T52W EPS and Reported EPS are also at or near cyclical lows. Meanwhile, with a Price/Dividend Ratio of 19.8, the Yield on the 10-Yr Treasury is now at 5.06%. The difference between these yields (7.32% - 5.06%) now stands at 2.26%. We call this difference, which represents how much excess yield investors require in order to suffer the risk of investing in the equities markets, our Equity Risk Premium (ERP). The Post-9/11 median ERP is 1.95%, so, even by the extremely "scared" standard of the Post-9/11 norm, ERP is currently quite high, representing a high level of skepticism/fear in investors' hearts and minds vis-à-vis the Equities Markets.
Are there other factors that the markets fear other than Geopolitical Risk? Yes.
Let's look at a sector-by-sector chart of the Consensus Forward 52-Wk Earnings Estimate.
As you can see, the Telecom Services sector is projected to grow earnings at +26.1%. Materials are projected to grow EPS at +17.6%. Consumer Discretionary, +14.8%, Info Tech at +14.7%, and so on. And, notably, Energy is projected to grow EPS at just +3.6% going forward.
But look at what Trailing EPS growth has been...
Telecom Services stocks have grown EPS at just +1.5% on a Trailing basis. Materials, just +4.9%. Consumer Discretionary stocks, +11.2%, Tech, +10.8%, and so on...with Energy stocks' EPS have grown +41.5% on a Trailing basis.
So, what are we to believe? With the Yield Curve now inverted (which correlates strongly to a contracting PE Ratio)...
...and with economic growth projected to slow to the +3% or less, depending on which economist you want to listen to (probably none, if you ask me), are we really supposed to believe that EPS growth in Telecom, Materials, Consumer Discretionary, Tech, Financials, and Consumer Staples are going to ACCELERATE?
Are we really supposed to believe that Earnings can grow in the current environment at 11% while the economy grows at <3%? (Especially in the context of already-record-level profit margins?) Doesn't that stretch credulity? It certainly seems to, at least in the market's mind at present.
To sum up: The market is currently cheap on a headline basis, and relative to bonds (Equity Risk Premium is very high at 2.26%, as above). But the market is cheap relative to Forward Earnings projections because nobody believes that those projections will come true.
So, we'll be keeping our eye on the growth rate of the F52W Consensus Estimate as well as on sector-by-sector projections in the weeks and months ahead. And while we expect that the market will get even cheaper (SPX as low as 1173 even in a benevolent scenario, and perhaps as low as 1045 in a malevolent environment.), we continue to anticipate an extremely good buying opportunity once the 4-Yr Cycle Low is formed, most likely in the September-October time frame.
At present our Risk Adjusted Fair Value (RAFV) price for the SPX is at 1291, 45 points or more above the SPX price.
RAFV = F52W EPS / (TNX + Med ERP)
RAFV = Risk Adjusted Fair Value (1291)
F52W EPS = Forward 52-Week EPS Consensus ($90.44)
TNX = 10-Yr Treasury Yield (5.06%)
Med ERP = Median Post 9/11 Equity Risk Premium (1.95%)
1291 = $90.44 / (5.06% + 1.95%)
While our RAFV is now exerting a slightly bullish influence, we would expect that the SPX will drop somewhat farther below RAFV before the 4-Yr Cycle Low has been formed.
Have a great week!
Best regards and good trading!