Wall Street ignores bad news … are valuations really that high … which bet do you want to make?
No one really wants to see the market down, but the ongoing series of up-days for the S&P 500 and the Nasdaq Composite are getting a little unsettling.
So writes our income expert and editor of Profitable Investing, Neil George.
Every morning, I turn on my trusty Bloomberg terminal to see where the stock futures markets are trading.
These days, it’s mostly green numbers on my screen. And even when there are some red numbers, they tend to turn green once the cash markets open at 9:30 …
As one example of those challenges, we could look to yesterday’s private payroll numbers.
While Wall Street was looking for an increase of one million jobs, the number came in at just 167,000.
And how did stocks respond?
Yawn.
All the major indices were in the green.
The Dow and the Russell even climbed more than 1%.
For another challenge, we need look no further than the inconsistent progress against the coronavirus.
Back to Neil:
COVID-19 cases are still running way above where we were in April and May, and new hotspots are appearing in some states.
Limitations on unlocking are rising, which while good for the populous long term are a hindrance to the economy in the short term. Despite great headlines, vaccine development by various companies, including Merck (MRK), is nowhere near deployment-ready.
Yet again, the market has shrugged this off. Instead, it focuses on anything that sniffs of good news and uses it as a catalyst for more gains.
So, is the market completely out touch? Are today’s gains driven purely by “me too!” investors wanting a piece of the gains that seem relentless?
Well, yes and no.
The answer boils down to what kind of market “bet” you’re making today.
***Reassessing where the market is
As I write, the S&P 500 is just 1.4% below its high in February.
For context, that February high was just 4.6% above where the year started.
So, the S&P is about 3% up here in 2020.
Certainly not terrible — we’ve had far worse years before.
Of course, the difference this time is what’s changed with corporate earnings due to our underlying economy.
The discrepancy between stock prices and earnings/economic fundamentals explains why so many observers are confused.
Let’s look at that.
For investors who assert that “stocks are expensive,” many are referencing a common Wall Street metric — the price-to-earnings ratio of the S&P 500.
For any readers less familiar, this ratio takes the S&P’s trailing 12-month earnings and compares them to the S&P’s current price. It answers the question, “how much are we paying today for what earnings have been in the last year?”
Today, the P/E ratio is certainly high, but nowhere near past, peak levels.
As you’ll see below, we’re at 28.6, which is 81% higher than the average P/E of 15.8. That level is still well-below more extreme levels starting around the year 2000.
Source: multpl.com
But what does the trailing-12-month P/E really tell us?
After all, everyone knows Q1 and Q2 earnings have been atrocious due to the coronavirus. But do they really represent corporate America’s profit-potential going forward today? And remember, that’s what matters to Wall Street.
What happened yesterday is already baked into your portfolio returns. What’s coming tomorrow is the real issue.
***Given this, what if we switch out trailing 12-month earnings for analysts’ estimates of forward 12-month earnings?
This is what we get when we analyze what’s called the “forward P/E.”
This ratio answers the question, “how much are we paying today for what we believe to be next year’s earnings?”
Well, here again, the ratio is high.
For those details, let’s turn to FactSet, the go-to earnings data analytics company:
The forward 12-month P/E ratio for the S&P 500 is 22.0. This P/E ratio is above the 5-year average (17.0) and above the 10-year average (15.3).
So, we’re at lofty valuations — no question about it.
But two notes …
First, we have to remember that the big tech “FAANGM” stocks (Facebook, Amazon, Apple, Netflix, Google, and Microsoft) now dominate the S&P.
If we can remove the FAANG stocks from our forward P/E calculation (and their lofty prices), will it take some pressure off the high valuation?
Yep.
Below is research from Ed Yardeni. It shows that when we remove the FAANGM stocks, the forward P/E drops from 22.4 to 19.7.
So, removing the FAANGs instantly lowers the forward P/E ratio by 12%.
That’s still higher than recent averages but moving in the right direction.
***For the second point, a question — do basement-level interest rates allow for more leniency with today’s higher valuations?
Well, here’s Neil’s take:
Investors and traders seem to be happy to look past the current quarter as well as the second half towards positive guesses for the opening quarters of 2021.
But what I see as a bigger potential driver for the stock market is the continued negative real yield (nominal less inflation) environment in the benchmark U.S. Treasury market.
While less negative than in March, the current market for the 10-year Treasury real yield is -0.53%. And for shorter-term maturities, the real yields are even more negative.
This means stocks are a lot more attractive and even less risky when discounting future revenues and profits using negative real interest rates.
And with the Federal Reserve not remotely ready for a course change, this condition may well continue.
If you’re less familiar with Neil’s reference to “discounting,” the idea is that when interest rates go down, the discount rate will also decrease to reflect the lower interest rates.
Since stocks get their value by discounting future income streams to the present value, the lower discount rate increases the value of those income streams.
Given this, the stock price today will increase because the present value of that income stream is now higher.
If this sounds a bit confusing to you, the theory is that lower interest rates give stocks permission to trade at higher average values without being considered as expensive as before.
As we stand today, we have a targeted 0% interest rate level from the Fed for as far as the eye can see. Not factoring this into stock valuations would omit an important detail.
***So, the relentless march higher in the stock market is totally justified then?
Not quite.
As we’ve noted before in the Digest, there are thousands of stocks all under the label “the market.” Some are great, some not so great.
Meanwhile, bored Americans, stuck at home, have been turning to the stock market for entertainment.
Many have made bets on risky stocks that fundamental investors would consider “not so great” — think Hertz, Nikola, the cruise ship companies …
Now, before we pass judgement, let’s be clear …
We’re all betting.
We’re all placing our chips on the table when we invest in the markets.
The difference is what we’re betting on.
For simplicity, let’s divide the answer into two camps …
One camp is betting that some other investor will buy their shares at an even crazier valuation (think “greater fool theory”).
To illustrate, look at those Nikola investors who assumed there would always be someone willing to buy their shares at even higher valuation multiples.
(Actually, since Nikola has no revenues or earnings, its earnings multiple doesn’t even exist.)
Here’s how that turned out for gamblers late to the party …
And here’s how it worked out for Hertz gamblers who got in too late …
Now, as we mentioned above, the second camp is betting too — though it’s different.
This wager is that a quality stock will grow its earnings so that it will eventually “live up” to its inflated P/E multiple today.
Take Disney, which soared 8.8% yesterday after posting an unexpected profit despite a massive hit to its operating income.
Its forward P/E a year ago was 21. Today, due to crushed profits from theme-park lockdowns, its forward P/E has jumped to 41.
But what sounds safer for your money? A bet that Disney will eventually reopen its parks, see an influx of loyal vacationers, and grow its earnings which will lower that lofty price valuation?
Or that Kodak will see another triple-digit surge (and you’ll sell before it crashes again)?
As Neil noted at the top of this Digest, yes, there’s a lot of green on the monitors today.
If that makes you nervous, it might be worth asking yourself which bet you’re making.
Have a good evening,
Jeff Remsburg
