The stock market year has got off to a flying start. Short sellers' are burning their fingers and the stock market is in the legendary January rumble. “Quality” stocks like Beyond Meat (+30%), Coinbase (+40%) , Peloton (+50%) or BBB (+70%) have rallied in recent two weeks.
In this post, we talk about how European stocks have been offering excess returns lately. Then we take a look at the upcoming earnings season in the US. The results have been boosted by record high profitability, but if it were to return to normal, stocks could go down up to 40%.
European equities offer excess returns
I have to start by bragging a bit about my comments about the affordability of European shares last fall. The comments seem to have hit home, at least in the short term. European equities are up almost 20% if the STOXX Europe 600 index is used as a benchmark. Similarly, the Helsinki Stock Exchange is up 15% from the bottom. The S&P 500 is close to the fall lows in dollar terms, and in euro terms it has fallen below the fall lows as you can see in this chart.
Equities have been supported by the better-than-expected performance of the European economy in the wake of the energy crisis, and the warm winter is only a bad thing if you booked a skiing holiday in the Alps. This shows the evolution of the Citi Economic Surprise Index for the eurozone. Economic data has offered positive surprises since last fall.
Cyclical stocks, which are more sensitive to economic cycles, have done particularly well. According to Bloomberg, cyclical stocks have outperformed defensive stocks recently. Just look at the share price development of Cargotec, Metso Outotec or Sandvik. The rise has been particularly sharp, even though investors are talking of a recession.
In this graph, the US Manufacturing Purchasing Managers' Index and European cyclical stocks are paralleled. I chose the US index because I could find years of data on it and it follows a similar path as the global industrial development.
Often these curves go hand in hand, but now stocks have taken a head start. It wouldn’t be unprecedented if this proved to be a bear market rally.
My personal interpretation of the situation is that investors' recession fears are fading, even though the media are trumpeting the recession like no tomorrow. There also seems to be a healthy dose of optimism about China, a country that tends to suck in cyclical companies. It’s also worth mentioning that among cyclical companies, machinery companies benefit from falling steel and logistics prices, which supports their margins in the near term, according to analyst Erkki Vesola.
Conversely, this rally in cyclical stocks means that if a recession derails the economy, those stocks will hurt all the more.
Earnings season in the US
The earnings season kicks off in earnest tomorrow, Friday. As per usual, software company Admicom starts the earnings season in Finland, whereas major banks lead the way in the US. Let's talk a little about the earnings outlook for the world's largest stock market, i.e., US equities, and raise some arguments for and against an earnings recession.
It’s entirely possible that the third quarter was the S&P 500's best performance in a while, and a standstill lies ahead. This graph shows the trailing 12 months earnings per share for S&P500.
One area of concern for investors is how results will hold up if the economy dips into recession. A very bearish view is that we are only in the early stages of a downturn and stocks will decline even more as record-high earnings tumble. Optimists, on the other hand, argue that results don’t have to fall if the economy is doing reasonably well.
Company results, market commentary and outlooks give investors an indication of what is to come this year.
A common criticism among investors is that the estimates are too optimistic. For example, the folk at Morgan Stanley expect earnings disappointments to whip stocks down another 10-20%. Why exactly that much, I don't know. However, as everyone seems to be critical of analysts' forecasts, one may wonder whether the weaker results are already partly priced into stock prices. Or at least, judging by the speeches, they shouldn't come as a surprise. Recession is the consensus view at the moment, like I discussed in the first What’s Up with Stonks of the year.
Based on forecasts compiled by Factset, the S&P 500 is expected to post a year-on-year earnings decline of around 4% in the fourth quarter. Earnings forecasts have been trimmed by several percent recently, as the consensus of analysts still expected earnings growth in early fall. The differences between sectors are stark. Results in the energy sector are expected to increase by more than 60% year-on-year, while materials and consumables would fall by more than 20%. Results in the software sector are expected to fall by 10%.
Looking a little further ahead, results are expected to effectively grumble for the next few quarters, after which quarterly results would resume their upward trajectory. In other words, the consensus might expect a recession in the economy, but the downturn in earnings would be very mild. It’s difficult to predict where the stock market will go in the near future, but it’s good to have an idea of where we are now and roughly what investors expect. It’s up to each individual to decide whether current expectations are realistic.
On average, in recessions, results have fallen by tens of percent, giving pessimists reason to think that current forecasts are far too rosy. This graph (which I have shown before) shows the decline in results historically in different recessions.
Investors are still haunted by the financial crisis and the tech-bubble, with results down 90% and 50% respectively. On average, stocks halved. Traumatized by these experiences, the basic expectation is that every recession will destroy companies' profitability for years to come.
“This time it’s are different” is a dangerous expression, but there is a small cause for optimism. For example, the American consumer is fiercely strong this time. As I have often pointed out, recessions are exacerbated by consumer over-indebtedness and lax lending by banks, because then the recession means a rebuilding of household and bank balance sheets and is removed from other economic activity. According to Bloomberg, households hold 15% of their wealth in cash, compared to only 9% at the height of the financial crisis and the bursting of the tech-bubble. Debt expenditure as a share of income remains at a low level. Once inflation eases, real incomes should also develop favorably this year, supporting consumption.
Of course, one could point out that a strong consumer fuels inflation and the Fed is doing everything it can to break the strength of the consumer. Be that as it may, at least the weaker economic cycle will start with strong wallets, unlike in recent times. Therefore, even in a recession, a certain degree of earnings optimism is justified.
What if profitability returns to the mean?
A worrying threat to the current earnings level is the sustainability of the profitability of listed companies. Publicly traded companies have reportedly never been so profitable in the US. This graph shows profit margin and return on equity of the S&P 500 as measures of profitability. The red lines show their 30-year average. According to Bloomberg, return on equity is now 19% with a profit margin of 11%.
Efficient return on equity explains why US stocks are chronically more highly valued than stocks elsewhere in the world.
If the S&P 500's profitability were to return to its 30-year average, results would plummet by around 40%. With everything else remaining unchanged, the fair value of the index would be around 2,400 points instead of the current 4,000.
However, this is not what is expected now. Needless to say, the analyst consensus expects record profitability to continue in the coming years, as this EBIT margin indicator shows.
The profitability of listed companies has been improved by several structural factors over the decades, such as globalization, digitalization, decreasing competition, the easing of capital constraints on business models, more efficient use of capital, the rise of the winner-take-all phenomenon in the form of companies like Apple, or the erosion of workers' bargaining power and the fall in interest rates, which leads to lower financing costs. The pandemic period gave an extra boost to profitability.
Many of these factors, such as pandemic exceptions, wages, falling interest rates or globalization, may no longer provide a tailwind. Interest rates are rising, wage inflation is high and globalization is slowing.
Another factor explaining the improvement in profitability has been the increase in the relative weight of the high-margin software sector in the index. This excellent graph shows the contribution of different industries to overall profitability. The expansion of the software industry is striking. Before the financial crisis, banks were the driver and the star sector of index profitability, until the financial sector exploded in its own bottomless greed. Since then, regulation has limited the sector's profitability. Nothing lasts forever.
A skeptic might well ask whether the higher profitability of the software industry is a sustainable phenomenon. Software used to eat the world, but now software companies are eating each other. The technology sector hasn’t always been this profitable. In the early 2000s, the sector's operating margin ranged from 0-15%, whereas today it stands at 30%. The smaller CD-based software companies of the early 2000s are little different from the mature platform economy mastodons of today. Despite the change, this level of profitability may not stand the test of time and competition.
I repeat once again that there are many good reasons for the strong profitability of the S&P 500, but if profitability erodes towards its long-term average, it’s worth looking elsewhere in the world. It’s good to be aware that current expectations are based on maintaining record profitability, even though a recession of unknown depth is around the corner and inflation is eroding margins.
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