Fundamentals have been driving the stock market higher, not valuations: earnings during the past 1 year and 2 years have risen faster than the S&P index itself (meaning, valuations contracted). The strong growth in company profits is not due to a net share reduction (e.g., buybacks) either.
Looking ahead, expectations for 10% earnings growth in 2019 have already been revised down to 5%. This still looks too optimistic: if margins in 2019 remain at the same level as in 4Q18, then earnings growth will be 0%. Dollar appreciation and declining oil prices are additional headwinds that could cause earnings to fall this year.
Valuations are now back to their 25-year average. They are not cheap, but the excesses from early 2018 have been worked off: if investors once again become ebullient, there is room for valuations to expand. However, with earnings growth likely to negligible, the key for share price appreciation in 2019 is likely to hinge entirely on valuations expanding.
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85% of the companies in the S&P 500 have released their fourth quarter (4Q18) financial reports. The headline numbers were good, but not great. Here are the details:
Sales
Quarterly sales reached a new all-time high, growing 6% over the past year. On a trailing 12-month basis (TTM), sales are 9% higher yoy, among the best growth in 12 years (all financial data in this post is from S&P). Enlarge any image by clicking on it.
The arrows in the chart above and those that follow indicate the period from 2Q14 to 1Q16 when oil prices fell 70%. The negative affect on overall S&P sales (above) and the energy sector alone (below) is easy to spot.
The six sectors with the highest weighting in the S&P have grown an average of 8% in the past year (box in middle column) and, since the peak in oil in 2Q14, their sales have grown an average of 38%. In contrast, energy sector sales have declined 25% (far right column).
Excluding the volatile energy sector, sales for the remainder of the S&P have continued to trend higher at about the same rate over the past 8 years, with some acceleration in the past 2 years (blue line; from Yardeni).
The dollar has become a minor headwind for sales: in the past year (thru 4Q18), the dollar appreciated by 6%; this accounts for about a 3 percentage point decline in growth in corporate sales. For the current quarter (1Q19), the dollar is pacing an 8% yoy appreciation.
How does the dollar impact sales growth? Companies in the S&P derive about half of their sales from outside of the US. When the dollar rises in value, the value of sales earned abroad (in foreign currency) falls. If foreign sales grow 5% but the dollar gains 5% against other currencies, then sales growth will be zero in dollar terms. The chart below compares changes in the dollar (blue line; inverted) with growth in S&P sales (red line): a higher dollar corresponds with lower sales (from Yardeni).
Earnings and Margins
Operating EPS grew 13% over the past year on a quarterly-basis and 24% on a trailing 12-month basis (TTM). GAAP EPS was better: 32% quarterly growth yoy and 26% growth TTM. More on these differences below.
Importantly, EPS fell this quarter from its all-time high in 3Q18, the first substantial fall since the "profit recession" in 2015.
The arrows in the next chart again indicate the period when oil prices fell 70% between 2014 and 2016. The improvement in total EPS since then comes with energy sector EPS at two-thirds of its level in mid-2014.
Likewise, overall S&P profit margins peaked at 10.1% in early 2014, fell to 8% at the end of 2015 and have since rebounded to 10.9% in 4Q18. However, margins fell this quarter from a high of 12.1% in 3Q18.
Similarly, non-energy margins have dropped to 11.2% in 4Q18 from 12.6% in 3Q18.
Most of the largest sectors have done well, increasing their margins 1-2 percentage points in the past 1 year and 2 years.
An important exception is the technology sector, where margins shot up from 19% in 2016 to 23% in 2017 but have since fallen back to 21%. This is weighing on overall margins for the S&P.
There are some common misconceptions that are regularly cited with respect to corporate earnings.
First, companies have been accused of inflating their financial reports through a net reduction in shares through, for example, corporate buybacks. In reality, however, over 90% of the growth in earnings in the S&P over the past 9 years has come from better profits, not a net reduction in shares. Better profits have driven growth, not "financial engineering."
That has been true over the past 17 years, during which the net change in corporate shares has accounted for just 3% of EPS growth (from JPM).
In fact, despite record buybacks, the difference between EPS and profits has been consistently narrow.
Second, equity prices are said to have far outpaced earnings during this bull market. In fact, better profits accounts for about 85% of the appreciation in the S&P over the past 9 years. Of course valuations have also risen - that is a feature of every bull market, as investors transition from pessimism to optimism - but this has been a much smaller contributor. In comparison, 75% of the gain in the S&P between 1982-2000 was derived from a valuation increase (that data from Barry Ritholtz).
Over the past 2 years (since 4Q16), during which time the S&P has risen about 24%, earnings have risen 47%, i.e., faster than the S&P index itself thereby accounting for more than 100% of price appreciation. The same is true over the past 1 year (from JPM).
Third, financial reports based on "operating earnings" are said to be fake. This complaint has been a feature of every bull market since at least the 1990s. In truth, the trend in GAAP earnings (red line) is the same as "operating earnings" (blue line).
It's accurate to say that operating earnings somewhat overstate and smooth profits compared earnings based on GAAP, but that is not new. In fact, the difference between operating and GAAP earnings in the past 25 years has been a median of 10% and the recent history has been no different (it was 8% in the most recent quarter). Operating earnings overstated profits by much more in the 1990s and earlier in the current bull market. The biggest differences have always been during bear markets.
Outlook for 2019
Looking ahead, expectations for 10% earnings growth in 2019 have already been revised down to 5%. Sales growth is expected to also be 5%, rising to 6% in 2020 (from FactSet).
There are 5 considerations with a strong bearing on forward sales and earnings. Most of these appear likely to be a headwind in 2019.
First, as a baseline, it is reasonable to assume that corporate (non-energy) sales growth will be largely similar to the nominal economic growth rate of 4-5%, excluding currency effects. Right now, this seems achievable (from the OECD).
Second, the dollar weakened from the end of 2016 to early-2018 (a tailwind to growth) but has since appreciated 6%. That means that currency effects are now a headwind to growth. With half of corporate sales coming from abroad, even a small 4% appreciation in the dollar could cut 2 percentage points to sales growth this year (second chart from JPM).
Third, the price of oil was tracking more than a 30% yoy gain until October; the price has since fallen 30%. In other words, the energy sector had been a tailwind to overall sales and EPS growth; below $65, oil becomes a headwind in 2019.
As we have seen, the direct impact of oil prices on the energy sector is far more important than any ancillary affects on other sectors. As an example, consider this: the price of oil fell from over $100 to under $50 between mid-2013 and mid-2016 but non-energy sector operating margins were 10% in both instances. In short, lower oil prices are a net negative for sales and earnings.
But the tax cut was a one-off adjustment, applicable only to 2018, and there is not much reason to expect it to permanently raise growth rates. Why? US corporations are not capital constrained; they have abundant cash and access to low cost debt and equity. Moreover, corporations have been making fixed capital investments. Over the past 3 decades, rising corporate profitability (blue line) has had no positive affect on new investments (red line; from the FT).
Fifth: the biggest risk to earnings in 2019 is margin contraction. For earnings to grow as fast as sales, margins have to be maintained. But after trending higher over the past 7 years, margins jumped 140bp in 2018. This was a massive rise and sustaining that level (let alone expanding margins further) seems highly unlikely.
In fact, average margins in 2018 were 11.5% but fell to 10.9% in 4Q18. If that level is maintained throughout 2019, earnings growth will be 0%. If the dollar continues to appreciate, that growth could to -2%. If oil remains under $65/barrel, earnings will fall further.
Valuation
At the end of 2018, the combination of ~25% earnings growth and a 6% fall in equity prices left valuations at 14.4x, the same level as in 2010 and well below their 25-year average. The continued rally since then has brought valuations right back to the average (from JPM).
Valuations are not cheap, but if investors once again become ebullient, there is room for valuations to expand. Why? When investors become bullish (blue line), valuations rise (red line). Investors had been pessimistic in early 2016 and then became far too optimistic at the market peak in January 2018. Importantly, that was greatly reset by the end of December 2018 (from Yardeni).
It's hard to believe that investors have already reached peak bullishness. Fund flows into equity mutual funds and ETFs was strong before both the 2000-02 and 2007-09 bear markets, and even before the 2015-16 mini-bear market (blue circles). In comparison, fund flows have been negative for 4 of the past 6 quarters (red circle; from JPM).
Valuations are influenced by more than investor psychology. Part of the reason equities have become more expensive over time is rising corporate profitability. Margins have reached successive new highs with each economic cycle over the past 3 decades: they are now more 100bp higher than in 2007, and that peak was more than 100bp higher than in 2000. Higher profitability (and growth) is typically rewarded with higher valuation multiples (from JPM).
While it is objectively impossible to know when or at what level margins will peak for this cycle, it's a reasonable guess that the cycle peak was last quarter (3Q18).
Importantly, valuations have almost no bearing on the market's 1-year forward return (left side). But over the longer term, current valuations suggest that single digit annual returns are odds-on (right side; from JP Morgan).
In summary, corporate results in the fourth quarter were good, but not great. Sales and earnings growth were strong, but margins severely contracted. This was the first substantial fall in margins since the "profit recession" in 2015.
Looking ahead, expectations for 10% earnings growth in 2019 have already been revised down to 5%. This still looks too optimistic: if margins in 2019 remain at the same level as in 4Q18, then earnings growth will be 0%. Dollar appreciation and declining oil prices are additional headwinds that could cause earnings to fall.
Valuations are now back to their 25-year average. If investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to negligible, the key for share price appreciation in 2019 is likely to hinge entirely on valuations expanding.
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