"Life is a series of natural and spontaneous changes. Don't resist them - that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like." - Lao Tzu
The euphoria that the market experienced after the Federal Reserve announced an increase in rates seems to have evaporated as the market has woken up to reality that the Federal Reserve is no longer providing the support it requires to maintain its unsustainable upward trajectory. I would therefore not be surprised to see the market take it on the chin to such an extent that the Federal Reserve's idea of gradually raising rates in 2016 is put on ice. In fact they may even be forced into a retraction of the first increase in rates since the iPhone was introduced!
For long time readers of this blog you will know not to get sucked into thinking that this current drawdown is a buying opportunity. Keep your powder dry as there will be plenty of opportunity to buy stocks at far cheaper prices than those on offer today.
Friday, December 18, 2015
Friday, December 4, 2015
Beware of the FANGs
The quote today is from the famous cartoon scene in The Jungle Book where Baloo the bear in an effort to save his friend, a human boy named Mowgli, has grabbed Shear Khan the tiger's tail as Shear Khan is running to catch and kill Mowgli.
Buzzie (the vulture): [Flaps and Dizzy (also vultures) have just saved Mowgli] "He's safe now. You can let go, Baloo."
Baloo: "Are you kidding? There's teeth in the other end!"
To me this sums up the current state of the stock market. While the quote above refers to teeth there is a well known acronym FANG's that is used to describe the four must own stocks that are currently driving the stock market indices higher. Each letter refer to a stock and for those of you who have missed this the stocks are Facebook, Amazon, Netflix and Google (now know as Alphabet). These four stocks are masking the poor returns of the majority of the stocks that make up the S&P 500 to such an extent that if you removed their stock returns this year the market would be down considerably. All four of these stocks support P/E ratios well into the hundreds and have an average P/E of over 400 however they are still must have stocks!
At market tops there is a tendency for a very small number of stocks to control the market and unfortunately this is the exact same case today. For those of you with short memories we have had the Nifty Fifty, the SOX (just 17 stocks) and the Four Horsemen among others. Each time the market is beholden to a small group of stocks to drive the index higher things become lopsided and tend to topple over. When you add to this fact the length of the current market run, the fact that the Federal reserve in all likelihood will raise rates in a couple of weeks and global economic weakness it seems to me that 2016 will be the year of the tipping point (if we can make it through December without a massive draw down).
Looking at these four stocks one can see that they are all technology companies. Three of them produce nothing and one is completely reliant on people to remain social. Yes they are making a ton of money but so too was IBM in its heyday when Big Blue was the only stock to hold. Remember 2000 and the must have stocks of Ariba, InfoSpace, Inktomi, Verisign and Veritas Software or one of my favorites PMC Sierra? Where are these stocks and companies today? Not that I expect the current FANG stocks to disappear (IBM is still limping along a mere shell of its former self) but when you have an average P/E of over 400 and these are the only stocks holding the market up, something has to give.
In the quote above Baloo gets hit by a branch and the tiger Shear Khan, free from his grips ravages his opponent and while Baloo does not die (it is Disney after all) I expect a similar fate for this market in the not too distant future as there are FANGs on the other end!
Friday, November 27, 2015
Thanks for Nothing
"I made something out of nothing, thanks for nothing." - Lil Wayne
I have to say that one of my favorite holidays in the United States is Thanksgiving. Not only is the food delicious but it essentially marks the end of the year as the mood generally changes in preparations for the coming holidays. In the small business community in which I operate it seems that there is a general sense of relief that we made it through another year. The giving of thanks is more about another year of survival than a celebration of massive profits. Obviously this is painted with a very broad brush as some businesses had a breakout year but overall small business has still not felt the full impact of the "recovery".
While big business has had a banner fiver year stretch small businesses have continued to struggle. In another article highlighting the woes of small business it was revealed that banks have reduced their lending to small businesses this year from 58% of originated loans in 2009 to 43% this year. The majority of small businesses therefore have to look beyond the normal avenues for sources of capital and while the capital is available it comes at a price. Typically there is a spread of at least 5% over a bank loan and a private loan and often it is far higher than this. For companies that are not showing profits or assets to use to secure the loans rates can rival those of credit card debt.
This drag is having a massive impact not only on their earnings but on growth prospects. Consider a company requiring $1M that has to borrow at 12% instead of 3%. The increase in the cost of interest equals two full time employee's salaries. Assuming that the business requires the money for growth prospects there is a high probability that the goals will not be achieved as they will either have to be met in a far shorter time frame than originally intended or they will have to try to make the target with fewer employees. Neither of these prospects are encouraging and reduces significantly the chances of success. In contrast the large business with access to limitless capital in the form of loans and stock issues can not only take advantage of opportunities but also has the luxury of time to let the idea develop and flourish.
As I have mentioned repeatedly in previous blogs, until this landscape changes from completely skewed in favor of large business, GDP growth will not only stagnate but be highly prone to economic shocks from outside the United States. So while large business deals with the prospects of slowing revenue and lower profits they can at least be thankful of those whereas the small business owner sees more heavy sledding ahead with no end in sight. Little incentive to start a small business and often times too little incentive to carry on plodding. For those of you in small businesses or just starting a small business I applaud you and give thanks for your perseverance and wish you much success for 2016!
I have to say that one of my favorite holidays in the United States is Thanksgiving. Not only is the food delicious but it essentially marks the end of the year as the mood generally changes in preparations for the coming holidays. In the small business community in which I operate it seems that there is a general sense of relief that we made it through another year. The giving of thanks is more about another year of survival than a celebration of massive profits. Obviously this is painted with a very broad brush as some businesses had a breakout year but overall small business has still not felt the full impact of the "recovery".
While big business has had a banner fiver year stretch small businesses have continued to struggle. In another article highlighting the woes of small business it was revealed that banks have reduced their lending to small businesses this year from 58% of originated loans in 2009 to 43% this year. The majority of small businesses therefore have to look beyond the normal avenues for sources of capital and while the capital is available it comes at a price. Typically there is a spread of at least 5% over a bank loan and a private loan and often it is far higher than this. For companies that are not showing profits or assets to use to secure the loans rates can rival those of credit card debt.
This drag is having a massive impact not only on their earnings but on growth prospects. Consider a company requiring $1M that has to borrow at 12% instead of 3%. The increase in the cost of interest equals two full time employee's salaries. Assuming that the business requires the money for growth prospects there is a high probability that the goals will not be achieved as they will either have to be met in a far shorter time frame than originally intended or they will have to try to make the target with fewer employees. Neither of these prospects are encouraging and reduces significantly the chances of success. In contrast the large business with access to limitless capital in the form of loans and stock issues can not only take advantage of opportunities but also has the luxury of time to let the idea develop and flourish.
As I have mentioned repeatedly in previous blogs, until this landscape changes from completely skewed in favor of large business, GDP growth will not only stagnate but be highly prone to economic shocks from outside the United States. So while large business deals with the prospects of slowing revenue and lower profits they can at least be thankful of those whereas the small business owner sees more heavy sledding ahead with no end in sight. Little incentive to start a small business and often times too little incentive to carry on plodding. For those of you in small businesses or just starting a small business I applaud you and give thanks for your perseverance and wish you much success for 2016!
Friday, November 20, 2015
The Credit Cycle
In a very interesting article in the Economist Magazine the flow of debt was followed from banks to consumers to businesses and countries. Studies were highlighted showing that debt burdens on consumers has a far larger impact on growth than debt held at businesses. Furthermore it was shown that emerging economies are more prone to economic shocks due to swift changes in debt levels however these countries can be split further into those with current account deficits and low levels of foreign capital versus those with current account surpluses and large foreign reserves. The former is subject to large swings in its economic fortunes and the value of its currency versus the latter who can weather the storm. This subset can be further divided into open economies and controlled economies with the former more readily able to shed the dead wood versus controlled economies that can drag bad debt along like an anchor for years.
As an example China, a controlled economy, keeps lumping more and more debt onto poorly run and money losing state enterprises creating a drag on economic growth. The money spent could easily be used to create jobs and economic benefit elsewhere. In contrast countries such as the United States are relatively good at letting bad investments die however this will be sorely tested during the next recession as the problem of too big to fail will once put into question political stomach versus the economic merit of holding onto poorly run enterprises.
As the United States' thinks about raising interest rates this is sending shock waves through the emerging markets particularly those economies like Brazil which are prone to runs on its capital reserves. An interest rate rise should propel the dollar higher resulting in a larger burden on Brazil to pay its dollar denominated debt and making the Real fall in value. This will be exacerbated by a flow of capital out of Brazil dragging the economy into a recession.
Now back in the good old days that would not have mattered much to the first world economies but in 2015 emerging markets make up the lions share of global GDP. In fact they are approaching 60% of the world's GDP. In addition they are the engine of global growth able to produce sustained periods of growth well above 5%. This type of GDP growth has not been seen in developed economies in decades and more than likely will never be witnessed again. So if the world is to exit from the cycle of growing debt levels the only way out that I can see is for global GDP to grow at a rapid pace and the only place that this will come from is the emerging markets.
As I have mentioned before while the United States believes that it is in good enough shape to raise rates it cannot withstand a sharp slowdown in emerging economies growth rates. For this reason while the Federal Reserve may be stupid enough to raise rates next month they will not have the latitude to continue to move them higher as the repercussions of a strengthening dollar will undermine any form of global recovery forcing them to end the interest rate increases. Worse still as the debt funnels back from emerging economies to the United States the result might be that the world's debt crisis may end up right back where it all started, in the hands of the Federal Reserve and that would be worrisome!
As an example China, a controlled economy, keeps lumping more and more debt onto poorly run and money losing state enterprises creating a drag on economic growth. The money spent could easily be used to create jobs and economic benefit elsewhere. In contrast countries such as the United States are relatively good at letting bad investments die however this will be sorely tested during the next recession as the problem of too big to fail will once put into question political stomach versus the economic merit of holding onto poorly run enterprises.
As the United States' thinks about raising interest rates this is sending shock waves through the emerging markets particularly those economies like Brazil which are prone to runs on its capital reserves. An interest rate rise should propel the dollar higher resulting in a larger burden on Brazil to pay its dollar denominated debt and making the Real fall in value. This will be exacerbated by a flow of capital out of Brazil dragging the economy into a recession.
Now back in the good old days that would not have mattered much to the first world economies but in 2015 emerging markets make up the lions share of global GDP. In fact they are approaching 60% of the world's GDP. In addition they are the engine of global growth able to produce sustained periods of growth well above 5%. This type of GDP growth has not been seen in developed economies in decades and more than likely will never be witnessed again. So if the world is to exit from the cycle of growing debt levels the only way out that I can see is for global GDP to grow at a rapid pace and the only place that this will come from is the emerging markets.
As I have mentioned before while the United States believes that it is in good enough shape to raise rates it cannot withstand a sharp slowdown in emerging economies growth rates. For this reason while the Federal Reserve may be stupid enough to raise rates next month they will not have the latitude to continue to move them higher as the repercussions of a strengthening dollar will undermine any form of global recovery forcing them to end the interest rate increases. Worse still as the debt funnels back from emerging economies to the United States the result might be that the world's debt crisis may end up right back where it all started, in the hands of the Federal Reserve and that would be worrisome!
Friday, November 13, 2015
The Pulse of the Global Market
"We have to choose between a global market driven by calculations of short term profit, and one which has a human face." - Kofi Annan
"No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable." - Adam Smith
With the world seemingly getting smaller by the day and global trade having an ever larger impact on local markets and economies I thought that this week I would revisit the pulse of the global market; that is to take a look at indicators that print the health of the global economy. The three main indicators that I look at are the price of oil, the price of copper and the daily price of dry bulk shippers. All three of these indicators are global in nature; oil is obvious, copper as I have mentioned in previous blogs represents industrial growth and dry bulk shipping rates show the level of international trade. While all three prices are driven by demand and supply inputs they are more prone to demand side shocks than changes in supply making them as close to a perfect pulse on the global market as is available.
To rephrase the above comment while the number of say dry bulk ships can be reduced or not replaced, it takes years for this slow drip method to take effect. Furthermore it takes at least a year or two to build a ship so some are still coming onto the market that were ordered years ago adding to supply even as demand falls. The result is that the market slowly reduces the number of ships while demand quickly adjusts to changes in global growth or contraction. This same equation holds true of copper and oil which is why these indicators contain within their prices the pulse of the global economy.
The first chart is the daily price change in Crude Oil. As you can see crude hit a low around $39 a barrel in late August. This was touted as the bottom of the market and a recovery was imminent. Subsequently there was a trading rally but this was met with resistance around $51 a barrel and now it looks like lows are about to be broken. Certainly not an indication of global demand and resilience.
The next chart is the copper price. As you can see the price of copper, like crude tried to rally late August but not only has it rolled over it has broken below its August lows and appears to be heading lower. This is a reflection in large part of the weakness in China but it is a clear indication of global economic weakness.
The final chart is the Baltic Dry Shipping Index. This is the daily rate that dry bulk shippers can demand from their clients. As you can see there is limited demand for dry bulk shippers and this index has not come close to recovering from its 2009 highs and is once again in a clear downward trend.
Based on the above snap shot of global trade it is clear that global economic growth is anemic and should make you wonder why the market will jump from here to new highs. To me it seems obvious that earnings will remain lackluster for the foreseeable future keeping the Federal Reserve at bay in regards to interest rate hikes and could result in a significant contraction in the value of equities which have become increasingly expensive as earnings contract. Until these indicators start to show signs of life my advice would be to remain on the sidelines. As the old trading adage says, "Do not try to catch a falling knife!"
"No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable." - Adam Smith
With the world seemingly getting smaller by the day and global trade having an ever larger impact on local markets and economies I thought that this week I would revisit the pulse of the global market; that is to take a look at indicators that print the health of the global economy. The three main indicators that I look at are the price of oil, the price of copper and the daily price of dry bulk shippers. All three of these indicators are global in nature; oil is obvious, copper as I have mentioned in previous blogs represents industrial growth and dry bulk shipping rates show the level of international trade. While all three prices are driven by demand and supply inputs they are more prone to demand side shocks than changes in supply making them as close to a perfect pulse on the global market as is available.
To rephrase the above comment while the number of say dry bulk ships can be reduced or not replaced, it takes years for this slow drip method to take effect. Furthermore it takes at least a year or two to build a ship so some are still coming onto the market that were ordered years ago adding to supply even as demand falls. The result is that the market slowly reduces the number of ships while demand quickly adjusts to changes in global growth or contraction. This same equation holds true of copper and oil which is why these indicators contain within their prices the pulse of the global economy.
The first chart is the daily price change in Crude Oil. As you can see crude hit a low around $39 a barrel in late August. This was touted as the bottom of the market and a recovery was imminent. Subsequently there was a trading rally but this was met with resistance around $51 a barrel and now it looks like lows are about to be broken. Certainly not an indication of global demand and resilience.
The next chart is the copper price. As you can see the price of copper, like crude tried to rally late August but not only has it rolled over it has broken below its August lows and appears to be heading lower. This is a reflection in large part of the weakness in China but it is a clear indication of global economic weakness.
The final chart is the Baltic Dry Shipping Index. This is the daily rate that dry bulk shippers can demand from their clients. As you can see there is limited demand for dry bulk shippers and this index has not come close to recovering from its 2009 highs and is once again in a clear downward trend.
Based on the above snap shot of global trade it is clear that global economic growth is anemic and should make you wonder why the market will jump from here to new highs. To me it seems obvious that earnings will remain lackluster for the foreseeable future keeping the Federal Reserve at bay in regards to interest rate hikes and could result in a significant contraction in the value of equities which have become increasingly expensive as earnings contract. Until these indicators start to show signs of life my advice would be to remain on the sidelines. As the old trading adage says, "Do not try to catch a falling knife!"
Friday, November 6, 2015
Heterogeneity Stumps the Fed
Heterogeneity - the state of being heterogeneous; composition from dissimilar parts; disparetness.
Ceteris paribus (Latin for "with other things remaining the same") was one of the favorite terms used when I was studying economics and it appears that not only is the Federal Reserve reliant on this phrase but they are also using the other economic theory of all people acting rationally. Neither of these ever works in the real world but economists love to try theories based not on real world examples but based on ceteris paribus in an effort to prove the impact of a change in one economic variable. This is akin to data mining, digging for data that proves your point even though the two variables are often not even vaguely related, but it is becoming more and more apparent that something as simple as Heterogeneity is stumping the Federal Reserve for the simple reason that they seem to rely on ceteris paribus and rationalism.
Heterogeneity essentially says that people will act differently from one another given a set of economic variables. The Federal Reserve does not seem to consider this when making their policy decisions as if they did then I would expect their decisions to be very different. Without digging too deep into the subject let's take a look at their current policies of low interest rate and money stimulus. The idea was that if you hold interest rates low and pump trillions into the economy through the reserve banking system that individuals would not hold onto cash but would load up on debt and invest the proceeds creating businesses and jobs. All you had to do was dump enough money into the top of the funnel and it would eventually trickle down to the man on the street. Voila, simple as that and hey presto all is well. (Sorry I could not resist the kitsch phrases as to me they highlight the lunacy of the decision making process. Who knows maybe they use these words behind closed doors as how else can they hatch such a poor plan?)
Years later and trillions of dollars they are still scratching their heads as to why this ridiculous plan has not worked but it is as simple as heterogeneity. People do not act in one massive unified body and, changing one variable, interest rates, does not make another variable, high debt levels, magically vanish. The results of this massive stimulus project has been to create what is turning into another stock market bubble and one of the largest wealth divides in history with such feeble economic footing that the economy cannot even handle 1/4 of 1 percent increase in rates..
As I pointed out a few weeks ago the velocity of money is at an all time low for the simple reason that people are not spending money. As the vast majority of individuals are earning less today (in inflation adjusted numbers) than they were a decade ago and as the labor participation rate is at a 38 year low, it is no wonder that there is little to no economic benefits coming from more Fed stimulus. People act within their own personal constraints and the lower end of the labor market has not seen any economic recovery and is still struggling to recover from the last economic meltdown. Until they feel the benefit of an economic recovery throwing more stimulus at an overvalued stock market will not get the job done and raising rates will kill the supposed golden goose.
Had the Federal Reserve and the government spent their time and money looking at how to get the labor participation rate up rather than making fat Wall Street bankers fatter I would argue that the economy would be on solid footing. Simple examples to get money into the hands of the low earners would be to stimulate small business growth with tax incentives and lower reporting requirements, provide students with no interest on their student loans while sending a rebate check to those that just fell outside of this benefit and spend money on roads and infrastructure projects to name a few. Doing this would mean more jobs, resulting in more money in the hands of those that would spend the extra income, improving consumer confidence and an economy not reliant on zero interest rates. For now though their focus is on more stimulus and while their numbers seem to show success the global economy and company earnings are pointing in the opposite direction which is why my money stands on the sideline watching and waiting.
Ceteris paribus (Latin for "with other things remaining the same") was one of the favorite terms used when I was studying economics and it appears that not only is the Federal Reserve reliant on this phrase but they are also using the other economic theory of all people acting rationally. Neither of these ever works in the real world but economists love to try theories based not on real world examples but based on ceteris paribus in an effort to prove the impact of a change in one economic variable. This is akin to data mining, digging for data that proves your point even though the two variables are often not even vaguely related, but it is becoming more and more apparent that something as simple as Heterogeneity is stumping the Federal Reserve for the simple reason that they seem to rely on ceteris paribus and rationalism.
Heterogeneity essentially says that people will act differently from one another given a set of economic variables. The Federal Reserve does not seem to consider this when making their policy decisions as if they did then I would expect their decisions to be very different. Without digging too deep into the subject let's take a look at their current policies of low interest rate and money stimulus. The idea was that if you hold interest rates low and pump trillions into the economy through the reserve banking system that individuals would not hold onto cash but would load up on debt and invest the proceeds creating businesses and jobs. All you had to do was dump enough money into the top of the funnel and it would eventually trickle down to the man on the street. Voila, simple as that and hey presto all is well. (Sorry I could not resist the kitsch phrases as to me they highlight the lunacy of the decision making process. Who knows maybe they use these words behind closed doors as how else can they hatch such a poor plan?)
Years later and trillions of dollars they are still scratching their heads as to why this ridiculous plan has not worked but it is as simple as heterogeneity. People do not act in one massive unified body and, changing one variable, interest rates, does not make another variable, high debt levels, magically vanish. The results of this massive stimulus project has been to create what is turning into another stock market bubble and one of the largest wealth divides in history with such feeble economic footing that the economy cannot even handle 1/4 of 1 percent increase in rates..
As I pointed out a few weeks ago the velocity of money is at an all time low for the simple reason that people are not spending money. As the vast majority of individuals are earning less today (in inflation adjusted numbers) than they were a decade ago and as the labor participation rate is at a 38 year low, it is no wonder that there is little to no economic benefits coming from more Fed stimulus. People act within their own personal constraints and the lower end of the labor market has not seen any economic recovery and is still struggling to recover from the last economic meltdown. Until they feel the benefit of an economic recovery throwing more stimulus at an overvalued stock market will not get the job done and raising rates will kill the supposed golden goose.
Had the Federal Reserve and the government spent their time and money looking at how to get the labor participation rate up rather than making fat Wall Street bankers fatter I would argue that the economy would be on solid footing. Simple examples to get money into the hands of the low earners would be to stimulate small business growth with tax incentives and lower reporting requirements, provide students with no interest on their student loans while sending a rebate check to those that just fell outside of this benefit and spend money on roads and infrastructure projects to name a few. Doing this would mean more jobs, resulting in more money in the hands of those that would spend the extra income, improving consumer confidence and an economy not reliant on zero interest rates. For now though their focus is on more stimulus and while their numbers seem to show success the global economy and company earnings are pointing in the opposite direction which is why my money stands on the sideline watching and waiting.
Friday, October 30, 2015
Earnings Dictate the Market
"I'm living so far beyond my income that we may almost be said to be living apart." - E.E. Cummings
It is common knowledge that stock prices are based on company earnings and earnings potential. The metric often used is the P/E ratio or the Price to Earnings ratio where a stocks price is divided by the company earnings. The higher the future earnings potential the higher the stock price as investor bid up the price of shares in expectation of future earnings streams. For this reason you often witness high flying stocks with P/E ratios at 200 plus and growth rates to match while low growth stocks often only command P/E ratios in the low double digits. Mature companies that make up the S&P 500 usually hover around 15 which is considered a normal price level. Anything higher than this number shows a market that is overvalued and lower than that shows a market that might be a buying opportunity. This is all very basic and cut and dry but the market is anything but that as people's expectations of economic growth and their confidence dictate how high or low the market can go. One thing that shines through is that the earnings of companies dictate the price of the stock and this determines the direction of the market.
Looking at the earnings coming out of the S&P 500 during the past few weeks and it is clear that company earnings are slowing. With it the market is gasping for air and the oxygen is being provided by repeated Federal Reserve stimulus packages and low interest rates. It is hoped that this stimulus will keep a bull market that by any metrics is very long in the tooth afloat, but as the graph below shows this is a long shot. (The chart is provided by href
='http://www.macrotrends.net/1324/s-p-500-earnings-history'>Source: MacroTrends)
The dark line is the S&P 500 index while the light line is the S&P 500 earnings. As you can see the market moves in tandem with earnings. You may also notice that the company earnings have faltered in recent quarters and that this is the first time that this has happened since the beginning of the recovery. Admittedly earnings were incredibly low at the trough in 2009 but still to recover to new highs in such a quick time was incredible and could not be sustained.
The issue as I mentioned above is that when things are good and expected to continue, investors pay up for the promise of future growth. This translates into a P/E in excess of 15. At present and based on the current market price the S&P 500 P/E stands at roughly 22 well above its normal price. This must mean that the market expects earnings growth to continue to accelerate to new highs. Should this perception be met with continued poor earnings then the reverse will occur and the P/E will drop to below 15 plus earnings contraction will take the index even lower, the so called double whammy. Assuming that earnings contract to $90 (from $94) and the P/E ratio falls to 15 (I do not want to get overly aggressive) then the S&P 500 index would fall to 1,350 from 2,200 or 40%.
As I cannot see why earnings will resume any time soon I have to conclude that this is more than probable and that the market is being held together with Federal Reserve loose money policies and at some point these too must end!
It is common knowledge that stock prices are based on company earnings and earnings potential. The metric often used is the P/E ratio or the Price to Earnings ratio where a stocks price is divided by the company earnings. The higher the future earnings potential the higher the stock price as investor bid up the price of shares in expectation of future earnings streams. For this reason you often witness high flying stocks with P/E ratios at 200 plus and growth rates to match while low growth stocks often only command P/E ratios in the low double digits. Mature companies that make up the S&P 500 usually hover around 15 which is considered a normal price level. Anything higher than this number shows a market that is overvalued and lower than that shows a market that might be a buying opportunity. This is all very basic and cut and dry but the market is anything but that as people's expectations of economic growth and their confidence dictate how high or low the market can go. One thing that shines through is that the earnings of companies dictate the price of the stock and this determines the direction of the market.
Looking at the earnings coming out of the S&P 500 during the past few weeks and it is clear that company earnings are slowing. With it the market is gasping for air and the oxygen is being provided by repeated Federal Reserve stimulus packages and low interest rates. It is hoped that this stimulus will keep a bull market that by any metrics is very long in the tooth afloat, but as the graph below shows this is a long shot. (The chart is provided by href
='http://www.macrotrends.net/1324/s-p-500-earnings-history'>Source: MacroTrends)
The dark line is the S&P 500 index while the light line is the S&P 500 earnings. As you can see the market moves in tandem with earnings. You may also notice that the company earnings have faltered in recent quarters and that this is the first time that this has happened since the beginning of the recovery. Admittedly earnings were incredibly low at the trough in 2009 but still to recover to new highs in such a quick time was incredible and could not be sustained.
The issue as I mentioned above is that when things are good and expected to continue, investors pay up for the promise of future growth. This translates into a P/E in excess of 15. At present and based on the current market price the S&P 500 P/E stands at roughly 22 well above its normal price. This must mean that the market expects earnings growth to continue to accelerate to new highs. Should this perception be met with continued poor earnings then the reverse will occur and the P/E will drop to below 15 plus earnings contraction will take the index even lower, the so called double whammy. Assuming that earnings contract to $90 (from $94) and the P/E ratio falls to 15 (I do not want to get overly aggressive) then the S&P 500 index would fall to 1,350 from 2,200 or 40%.
As I cannot see why earnings will resume any time soon I have to conclude that this is more than probable and that the market is being held together with Federal Reserve loose money policies and at some point these too must end!
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