Despite five consecutive quarters of earnings declines and GDP growth that has fallen below 1%, the stock market recovery from February lows remains strong.
I continue to search for a catalyst in the market that will support higher valuations. Other than continued stock buybacks and low interest rates, I’m still coming up empty. The current price-to-sales ratio is over 1.8 for the S&P 500 which is a level that exceeds the tech bubble of 2000. Using GAAP earnings (vs Non-GAAP), the S&P 500 P/E is over 23X.
In other words, market valuations still remain in the top 10% historically. That said, we know they can still go higher.
If you have the mindset of a passive investor, whereby no matter the valuation of the stock market you continue to buy because you can’t “time” the market, the above is of no concern to you. To these folks, I wish you the best of luck.
If you invest in the stock market based on current business valuations and forward returns (what a business is worth now in relation to probable future returns), the consistent decline in profit margins and revenues alongside high valuations suggest this is a terrible time to be aggressively invested in stocks.
This year is starting to remind me of 1987
In 1987 as now, there was an acceptance of high debt levels, a reduction in equity shares outstanding and an increased appetite for risk as evidenced by investors’ chasing high yield bonds and excessively high stock valuations.
In 1987, very few investors were concerned that an increased acceptance of risk and higher debt levels would lead to a financial meltdown. In 1987, the FED as they have done now, had left itself with limited ways to combat its aggressive expansionary policy. In October 1987, the high debt risk bubble popped when the FED was forced to tighten because the economy was strengthening.
Institutional traders started moving in the same direction, selling stocks as fast as they could as stop loss orders were triggered. The market was unable to handle the downward slide due to new, faster moving technology and the disappearance of the vast network of specialists originally put in place to help control downward slides (the effectiveness of the specialist system can be debated). The market abruptly suffered its largest one day crash in history, dropping over 20% in value.
Today, very few expect the FED to tighten in June, much less this year even though they maintain a posture of anticipating two more rate increases this year. Keep in mind that their target thresholds for full employment levels and employee payroll inflation of 2% or higher have already been met.
We had a glimpse in January of what can happen when the FED tightens when stocks are perched at lofty valuations. Could we have another sharp correction in store if the FED tightens in June or the fall months? My position is yes.
While I’m certainly not perpetuating the idea that another flash crash could occur, the advent of high frequency trading, “fake” orders, market manipulation and high valuations do increase the risk of a negative black swan event having a huge short-term impact on the market.
Although stop breakers are now in place at the 7%, 13% and 20% levels to prevent such a one day slide, the recent flash crashes in illiquid ETF’s blamed on high frequency traders point out the limitations of circuit breakers. While they temporarily halt the slide, they do nothing to quell the fear and emotions of investors and momentum to the downside.
While this is as unpredictable market has ever, we’re keeping the following tendencies in mind. Historically, when valuations are at a high level, May is a weak month leading up to the first or second week of June. From the first to second week of June through the beginning of July there tends to be an up-tick. The biggest drops occur August to October when the right catalyst is put into place.
Now I’d like to switch to oil.
I highlighted CNX and KMI in the January issue as possible buys. I believe at this time the majority of the short-term easy money has been made in oil. I also believe for the following reasons, that it will be hard for oil to go above 45-50 in the short-term without a significant disruption to current output. As we sit today, the Dallas Fed estimates that global daily oil production still exceeds daily consumption by 1 million barrels. Analysts also expect at least 500 energy companies to go bankrupt in 2016, as meeting debt obligations becomes impossible. Ultra Petroleum was the latest large player to declare bankruptcy with 3.9 billion in debt obligations. As energy prices decline, credit lines are being reduced making it harder to raise money going forward as banks try to manage their risk level in the sector. Companies such as Chesapeake Energy are continually combatting bankruptcy rumors.
While many analysts continue to predict increased demand and predicting oil prices in the $60-$80 range by year end, I surmise that the appointment of a new Saudi Oil Minister, the expectation of the biggest IPO in history (Saudi Aramco) and slowing revenue growth tells a different story.
Last year I had warned that Chinese GDP growth was likely slower than reported based on research. When the Chinese allowed foreign investors to directly invest in Chinese stocks for the first time, I believed they had tipped their hand that growth was going to continue to slow and this was a way to inject liquidity into their markets as opposed to a great opportunity to finally buy Chinese stocks directly. So far, this has proven to be correct.
I believe the Saudi Aramoc IPO tips the Saudi’s hand in the same way. I think they’re trying to raise funds to help divest because they don’t expect a sudden increase in oil prices due to increased production in the US and abroad along with slowing global growth. Time will tell if this proves to be the case.