Monday, June 2, 2014

June 2014: What Will Drive SPX Higher in the Next 12 Months?

Last September we asked what fundamental factors could drive SPX higher in the year ahead (post). We considered three variables: sales growth, margins and valuation. Our conclusions were the following:
  • Sales growth had been about 2% since 2011 but with better overseas growth could rise to 4% in 2014. 
  • Margins were 9.5%, at 70 year highs, and were unlikely to expand further. Labor and interest costs were likely to become headwinds. 
  • Valuations were average at 15.6x and an unlikely source of substantial upside potential.

Since then, SPX has risen about 15%. What has been the source of this growth?  The short answer is valuation.
  • 70% of the gain is due to multiple expansion, which increased to 17.2x. Without this expansion, SPX would be near 1730 instead of 1910
  • Sales accounted for only 2% growth (or 10% of the gain). 
  • Margins expanded slightly, from 9.5% to 9.7%, enough to add 3% to growth (or 20% of the gain).

The question now facing investors is what will drive the market higher from here. The short answer is sales:
  • Sales are likely pace index appreciation. The consensus of 3-5% sales growth is reasonable based on recent data.
  • Margins have already flattened. Further margin expansion seems unlikely. 
  • Valuation is now well above average. Even on generous assumptions, the market is above 'fair value' of 1900 for year end 2014 already. 

Let's take each variable in turn.

Sales growth
Sales growth continues to be the bright spot for fundamentals. Unfortunately, as we discussed in September, it has the lowest leverage on future returns of the three variables. Margins and valuations both have much higher leverage.

Trailing 12-month sales growth was 2.3% in 3Q13; that has moved up to 2.8% in 1Q14. The consensus is expecting 3.4% for FY14 and 4.3% for FY14. 3-5% growth is reasonable and also fits with recent macro data (post). Current growth is, it should be stressed, much lower than during the prior bull market and the forecast is for an acceleration during the 6th year of an expansion, which is unusual.

Margin expansion
Margins are high leverage on returns. As noted above, just a 20bp rise in margins since September generated 20% of the total returns.

Margins have been flat over the past 5 quarters. Since 1Q13, margins have been 9.8%, 9.6%, 9.5%, 9.7% and 9.8% (chart from Goldman).

The consensus expects margins to increase to 10.2% for FY14 and 10.9% for FY15. Margin expansion explains how the consensus extracts 11% EPS growth for each year out of sales growth closer to 3-4%.

This seems unlikely. Again, margins have already started to flatten in the past year. Higher input costs, especially labor and eventually interest payments, should be headwinds.

Moreover, via an excellent post by Philosophical Economics (here), we know that non-financial margins already reached 70-year highs in 2013. Further gains seem to be an unlikely driver of performance over the next 12 months.

Valuation expansion
Valuation is also high leverage on returns. Again, 70% of the appreciation in SPX since September came from valuations increasing by just 1.6x.

This highlights the biggest challenge in forecasting future returns. Investor exuberance can push valuations much higher just as fear can push valuations to unexpected lows. Nonetheless, what is reasonable?

In September, we considered current valuations to be full. Observe price/sales in the chart below. In September, price/sales was 1.6x. Throughout the entire 2003-07 bull market, this level was not exceeded. Each time it was reached, SPX stalled (green shading lower panel). Therefore, our assumption was that sales growth would pace appreciation in SPX.

This turned out to be wrong. Price/sales is now 1.7x. Going back 40 years, it has only ever been this high during the end of the tech bubble.

This brings us back to sales growth being likely to pace equity returns going forward.
  • If the consensus is right about 3.4% sales growth in FY14, and price/sales stays at 1.7x, SPX would end the year over 2000. 
  • If valuation falls back to 1.6x, the year end target would be 1900, below the current level of the market. 
  • Given that sales are growing at half the rate experienced in the 2003-07 bull market, even 1.6x is high, but the current market has shown a persistent disregard for precedence. 1.5x was the average between 2003 and 2007. If this is considered 'fair value', then SPX should end the year near 1780.

On a price/earnings basis, SPX is trading at 17.2x (TTM, i.e. trailing 12 months). This is equal to the brief valuation peaks in mid-2008 and it's much higher than average. Since 1870, P/Es have been 14.5x (median). In the last 10 years they have been 15.2x. During most of the 2003-07 bull market, P/Es ranged between 15.5x and 16.5x (red shading). Current P/Es are ~7% higher.

It's worth pointing out that the valuation peaks at 17.2x in mid-2008 were a result of earnings already falling while the index was still near its high. In other words, the market didn't know earnings were already lower. As you can see from the subsequent steep fall, the market quickly caught on. This has been true at nearly every P/E peak in the past 120 years: aside the late 1990s tech bubble, nearly every instance where P/Es exceeded current levels was started by a fall in earnings (post).

What this means is that P/Es above 17x are already at the high end.

The conclusion doesn't change if "forecast next 12-month" (FTM) earnings are used. Even using the consensus of 11% earnings growth for FY14, the current P/E (15.4x) is at the peak of the prior bull market and ~7% above normal. If you assume 5% growth, the P/E is 16.3x, about ~12% above normal.

Further appreciation in valuations is possible. The last several months have proven that. But at a ~10% premium, especially given the low rate of growth, further appreciation is not warranted. SPX should trade lower.

Botton-line: even if the valuation premium remains, sales growth should pace gains in the index over the next 12 months.

Assuming valuations (TTM) stay at 17x, margins stay at 9.7% and growth is the consensus of 3.4%, SPX would reach 1950 by year end. Coincidentally, this is Wall Street's consensus target for 2014.

Under the same margin and growth assumptions but with valuations of 16.5x, SPX would be about 1900 by year end, lower than it is today.

That would be the high end based on typical PEs of 15.5x and 16.5x during the prior bull market. Taking the mid-point (16x), which is still above the long term median, the 'fair value' for SPX by year end 2014 is about 1840.

Fair Value
As we said in September, using valuation as a timing mechanism is difficult, and exuberance can render all calculations moot.  Valuation is like brushing your teeth; you know it is important, but the risk is in the indeterminate future. This is why we list it last in our weekly market summary table.

Still, the message here is clear: easy gains in margins and valuation are not present. Growth in sales is likely to pace the indices while sales and profit growth rates converge. Valuation is the big wild card; it is clearly above what is warranted given growth, but the market doesn't care.

Objectively, fair value for the SPX by year end 2014 is 1780 to 1840, as detailed above:
  • On price/sales basis using 1.5x as typical during the prior bull market, fair value is 1780.
  • On a P/E basis using 16x (TTM) as typical during the prior bull market, fair value is 1840. 
Its hard to avoid the conclusion that SPX is unlikely to appreciate further during 2014 in the absence of exuberance. Even using high valuations (1.6x price/sales and 16.5x P/E), SPX would end 2014 at 1900, lower than today's level.

Balance Sheet Valuation
Although this analysis is based on income statements (revenues and earnings), the conclusions don't materially change if they are based on balance sheets. Looking, for example, at Tobin's Q (a measure of replacement cost of assets relative to price) gives the same picture of valuation (chart from Doug Short).

Share Buybacks
With low interest rates, companies have been aggressively buying back their own shares. This has the added benefit of increasing their earnings per share growth. It also supports executive compensation which is often tied to share price. But the influence of share repurchases is declining.

Share buybacks boosted 2013 EPS growth as the number of shares outstanding declined. However, shares outstanding is now flat year-over-year; it will no longer be a tailwind to EPS growth.

Since 2Q12, share buybacks have boosted EPS growth (TTM) by between 50-150 bp (i.e., 0.5 to 1.5 percentage points of growth). That has now peaked and should decline further over the next year. The impact should be negligible.