Do corporate earnings matter anymore? And has the equity market become complacent?
Published on: November 13, 2019 • Duration: 15 minutes
This week we explore whether U.S. corporate earnings matter to the stock market anymore, if investors have become complacent about equities and if we should be worried about the record short in VIX (volatility) futures.
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[00:00:03] Earnings on the S&P 500 have gone nowhere for the best part of five years, and yet the S&P itself continues to make a series of new all time highs. Begging the question, do earnings even matter anymore? That is the big conversation. Is the S&P expensive? Do profits matter over a full cycle? They do, but it can be a very long waiting game for that full cycle to play out. So what is the backdrop to the S&P having a high PE having this very, very strong price action when earnings from profits remain relatively subdued? As you can see from this Rifnitiv chart of S&P profits versus the S&P rebased back in 1990, there has been an extended period of flatlining profits on the S&P over the last five years, during which time we've seen the S&P make these new all time highs. In some ways, it's very similar to what we saw around about 1998 to 2000, 2001, which was the dot com boom and bust. Now, that obviously was quite an ominous time period to be comparing today. Well what else do we have? Rifinitiv earnings data from I/B/E/S also shows that 2019 is on track to have the lowest earnings growth since the profits recession of 2015 2016. In fact, Q3 is currently forecast to be the first decline in earnings on a quarterly basis since that time period. And Q4 of this year is also forecast to have very, very low levels of growth, about nought point six percent. That's down three point five percent on early expectations. What about the PE for the S&P itself? Well, it's currently around about the 20 level in the context of the last few years. It's actually not that high. We've seen quite a lot higher.
[00:01:44] But in the very long term historical context, the average I/B/E/S PE for the S&P is fourteen point eight. So we are well in advance of that level. If earnings and profits don't matter, then what is it that's driving these markets? I mean, the three things that we can look at and they're all interlinked. But basically, it's central banks, it's bond yields and it's buybacks. Firstly, central banks have obviously been key players in the global markets over the last 10 years. Central bank liquidity has been a driver of asset prices, growth expectations and therefore bond yields. And we can see over the last 10 years that the S&P has been largely following the expansion of global balance sheets really over the whole of the last decade. More recently, the S&P has actually been following the ebb and flow of M2. This is the money supply, global money supply. So over the last 12 months, as money supply has gone up and down. So the S&P has been tending to follow that. We've also seen through this period and this actually goes back more than 10 years, is a 20 year, 30 year trend is that bond yields, particularly the US tenure in this instance, has been in a very clearly defined downward trend. And with bond yields falling, that has influenced the price that people are willing to pay for equities. Now, some people will argue, well, hang on a minute. Equities are expensive in absolute terms. But now in a scenario where bonds are also expensive in absolute terms, in fact, if anything, bonds are in more of a bubble than equities are. And so when money is coming indiscriminately into the market, which it is through pension funds, we're putting money into asset prices.
[00:03:14] And you're given the choice, let's say, between equities and bonds. Well, given where bonds are, equities look relatively cheap, even though in absolute terms that are expensive. So given that choice, people are still putting their money into equities. So if we take the S&P and we adjust it for the level of US 10 year yields and these are yields which have been falling, then we can see that the PE on the S&P adjusted is actually towards the bottom end of the range. In fact, it's significantly below the levels that we saw towards the end of 2018 when the market peaked and rolled over. So on a relative basis, equities look cheap to bonds, even though on an absolute basis arguably both are expensive and arguably we should be in cash rather than in either of those assets. And then the third element is the buybacks and this is obviously connected to the other two. If you've got low yields across the whole of the US curve, if you've got low interest rates which are being held down by central banks, and if you've got central banks who are buying bonds and keeping yields and growth relatively low, then this is an attractive environment for corporates in the US to be doing buybacks. The drivers of the US equity market, rather than being profits and earnings, are central bank liquidity, buybacks and the relationship between bonds and equities. So what really matters in markets today is a framework in which liquidity and low growth trumps true growth. This is a market which loves central banks with this exceptional accommodation rather than true earnings growth at the corporate level. As long as yields remain relatively stable and we saw that the end of 2018 getting up to three point two percent was a level which caused the equity market to roll over as long as bond yields remain relatively contained.
[00:04:58] That's what these markets like. Eventually, earnings profits will matter. So clearly the framework that the current equity market perverse is one in which liquidity is dominant. In fact, low growth and liquidity is a framework which trumps true growth and corporate earnings growth. And this is an environment which can persist as long as we believe that central. Banks are in the driving seat as it currently stands. There's no reason to think that that framework is going to change, but ultimately profits will clearly matter in the long run, they always do. But in the short run, this is all about central bank liquidity. It has been for the last five to 10 years. And unless we see cracks in that framework, then liquidity will still trump any idea of growth and earnings as the key driver for these markets.
There's been a considerable amount of chatter in markets recently about the extent of the equity breakout, particularly we've seen some impressive performance from the German DAX, the Japanese Nikkei and places like Taiwan as well as the S&P being at the all time highs. And now people are saying, are we getting complacent? Is has fear now turned to greed? Well, one of the reasons why we saw that breakout. Now, obviously, we had an environment earlier in the year where people were concerned about particularly growth, particularly manufacturing growth, and people positioned accordingly for low growth and low levels inflation by being very long bonds and being underweight equities. I think what's pivotal here is that central banks were a little bit pre-emptive a few weeks ago. We saw that data was very, very weak. People were very concerned about recession. People were concerned that this recession in manufacturing was spreading to the US and therefore central banks appeared to have been a little bit pre-emptive.
[00:06:40] We saw the Fed cutting rates. We saw the Fed adding liquidity. They were also worried about their funding markets, the repo markets overnight. And the ECB in Europe has come back and restarted QE. So they came in with a fear that markets could react negatively to this slowing of data. But since then, the data itself in many cases has shown a bit of a bounce. Now, it's not a very significant trend, but two or three of these data points have really shown a quite effective reversal from where they were. We've seen the ISM non manufacturing in the US. This is the services sector that's gone from missing expectations and heading towards 50 last month to now being back in the mid 50s level, which is a healthy expansion territory. And then we had the manufacturing isomer lead indicators, the ISM exports that had fallen to 41 well under the 50, which is the expansion contraction level. Well, it's now bounce back just above 50 to back into expansion territory. So not only is central banks coming in with liquidity, but some of the data points that people have been worried about are now improving. If anything, what we might have to worry about is that central banks themselves will be less inclined to do more rate cuts or add more liquidity because the data is nowhere near as bad as it was. So all the good reasons to believe that there is complacency in the market on what are those reasons? Well, one of the reasons people say that there's complacency is because the US yield curve has started to reach steeper. And this is the two year, 10 year portion of the curve. But it was worth pointing out here is that, yes, it's risk deepening and yes, a risk deepening has happened before all the major recessions and major market tops.
[00:08:15] But this is a steepening driven by ten year yields going up, which is growth, not two year yields coming down. What about volatility? Volatility has dropped to the sort of levels on the VIX in the US 12 or 13 that we saw prior to some of the minor market peaks of the last 18 months and also the major market peak that we saw at the end of 2018. But volatility at these levels is normally commensurate with minor market peaks. Very rare, if at all, you see the big structural peaks with volatility at these sorts of levels. In fact, it is closer to 20 rather than 10 in 2000 and 2008. But in terms of the overall framework, nothing has really changed that much, if anything. Yes, there is a risk that comes from the fact that the data is improving. The positioning has shifted from being extremely bearish down being a little bit more neutral or even slightly slightly positive, but not sufficiently so. And therefore, central banks themselves, particularly the Fed, may not be cutting rates as eagerly as they were maybe a few weeks ago. But ultimately, it's about your time frame. If you're a short term investor, you're always going to have to deal with those air pockets. And certainly one is overdue. We've had quite an extended market up move now. But if you're a middle to longer term investor, the overall framework has not really changed. If anything, at the margin, we've got more liquidity from central banks. We've got a slight improvement in the data. And therefore, what you do is you look for those dips to buy, to look for a rally towards year end and maybe into the beginning of next year as well.
Quite recently, we've seen a new record speculative short built up in VIX futures. These are futures on the volatility index on the S&P 500. And the reason why some people are a bit nervous is because back at the beginning of 2018, we saw short positions in the volatility equity indices cause an implosion on the equity market that dragged the S&P down by 10 percent in a very short period of time. And people thinking, could the same happen again? I think the backdrop is actually very, very different. In 2018, the retail sector was heavily involved in the exchange traded notes. These are effectively equities on volatility, but they were playing them from the short side. Today, retail is involved, but they're playing very much from the long side. If anything, through 2019 in the ETF space, we've seen an explosion in the overall shares outstanding or open interest in these long volatility products. Also, we've seen central banks having an influence and I think we can look at other asset classes and their volatility to give us an additional clue since the ECB has come back. We've also seen three month volatility on the euro. So this is the foreign exchange rate between the euro and the US dollar that's actually fallen back to the all time lows. And it seems that this is now leading other volatility indices. So the VIX is in some ways following that affects volatility. And we've also seen within the bond market and obviously bonds are very key to the global framework. We've seen quite a dramatic move in volatility on the MOVE index, which is the bond volatility index from around about 90 down to the 50s and 60s level, rather than volatility. Being reflective of an excessive speculative positioning or volatility is doing is merely following other asset classes to a lower level, although the positioning is is an extreme.
[00:11:28] The overall move in the overall direction that we're seeing is part and parcel of another drift in volatility that's being very much driven by the re-entry into the market of the global central banks.