The S&P rallied 16% last year and tacked on another 6.6% in the first two months of this year. If one had to guess, one would likely assume economic growth has been quite strong and corporate earnings growth equally strong if not stronger. However, one would be quite wrong in that assumption. The connection between earnings growth and stock returns is loose at best in the short term and yet most analysts still point to the market’s potential earnings growth when forecasting forward returns. This is nonsense. There are a lot of things that sound like good common sense in this business that simply don’t work in practice. Sadly, there are still a lot of brokers out there selling their clients nonsense.
Last year was a challenging year for active managers, ourselves included. We entered 2012 concerned about a potential recession in the US, a nasty recession in much of Europe and a significant slowdown in China. As a result, we were conservatively positioned for the first half of 2012, choosing to own only those assets we believed would perform well in a slow growth environment. So what happened? US and European growth disappointed, as did corporate earnings, and China’s growth slowed dramatically as well. But equities rallied as central banks succeeded in reducing tail risk, with most of the year’s gains coming in the first quarter.
We wouldn’t be surprised if most of this year’s gains (and then some) were already behind us as well. Stock prices can disconnect from fundamentals in the short term, but the relationship between price and value will ultimately determine success in investing. Today, that relationship is being distorted by the world’s central bankers. It would be wise to recall the old adage that if something cannot go on forever, it won’t. The Dow is unlikely to continue making record highs every day. It is impossible to know when an overheated market will cool down, but we do know that we should be worried when others are unworried and we should be cautious when others are heedless. Consequently, we are taking some equity chips off the table today and beginning to leg back into treasuries where ten year yields have quickly climbed above two percent and sentiment is decidedly bearish. We expect that treasuries, along with JPY, will catch a strong bid as investors put the risk back in risk assets.
“It is interesting that, historically, there have never been two or more quarters of negative earnings growth outside of a recessionary context,” per ECRI’s Lakshman Acuthan. “On this chart, showing the complete history of the data, the only times we see two or more quarters of negative growth are in 1990-91, 2000-01, 2007-09 and, incidentally, in 2012.” Still, the S&P rallied 16% last year, so maybe “traditional” valuation approaches should be set aside for now. Yet, the last time we call someone making the case for alternative measures of value, they got ran over by the bear market while celebrating the millennium. History would suggest that this time is rarely different and investors should be extremely careful when questioning valuation metrics that have stood the test of time. ECRI provides some great context for the crawling economic fundamentals behind soaring valuations in a recent presentation titled, The Yo-Yo Years.
Stocks may run higher on the back of increasing retail sentiment, surging fund flows, a bullish tape and strong technicals, but none of those things change what they are worth, only what Mr. Market will pay for them. If zero interest rates were the solution to our issues and the only requirement to send stocks to infinity, shouldn’t the Nikkei be the most richly priced market in the world rather than a fraction of its former self?
That was a rhetorical question. But then again, Abe may well get it there! That is a topic for another day . . .