EmailThe bullish and bearish arguments for the stock market are straightforward. The bearish argument is based on worsening economic and earnings fundamentals. The bullish argument is based on expectations that central banks will manage to overcome the bearish fundamentals.
Bearish Fundamentals
There is no doubt that the basic fundamentals are getting worse, almost by the day. The most prominent concerns are the earnings and economic trends.
Earnings growth has slowed considerably, as shown in the chart below of quarterly year-over-year earnings gains for the S&P 500 in aggregate.
The chart will soon dip into the red. Forecasts are for third quarter earnings to decline 3% compared to the third quarter of 2011.
There is a clear loss of momentum in the earnings trend – and there is no indication of a turnaround anytime soon. In fact, the longer-term outlook for earnings is much worse than widely recognized.
Current Wall Street forecasts call for 10% earnings growth in the fourth quarter, and 11% next year.
It is almost impossible to understand how these forecasts can be based on any realistic assumptions. They are ridiculously overoptimistic.
This is evident by the fact that earnings growth is a function of revenue growth and profit margins. Earnings will go up by the same percentage as revenue so long as profit margins hold steady. Profits can only go up faster than revenue with an increase in margins.
Yet, the outlook for revenue and margins does not support expectations of a sudden rebound in earnings growth after the expected third quarter profit decline.
First, let's look at revenue.
Revenue for the S&P 500 in aggregate for the second quarter was up 2% from the year-ago period. A similar gain is expected in the third quarter.
That may be hard to achieve, and it will certainly be hard in the fourth quarter.
The problem is that every major global economy is experiencing slower growth. Specifically:
- Eurozone third quarter real GDP (and probably much longer) will be negative.
- US real GDP for the third quarter will be lower than the second quarter. The Briefing.com forecast is now negative.
- Chinese economic growth is slowing significantly.
- Japan will post a negative number for real GDP for the third quarter.
- Emerging economies such as Brazil are slowing dramatically.
Revenue for the S&P 500 companies in aggregate is not going to surge suddenly while every single major economy is either contracting or growing at a slower pace. In fact, the global economic weakening suggests that revenue growth will be 2% at most in the fourth quarter and into 2013.
Of course, even if revenue growth remains at 2% (which is perhaps high), profits can jump if profit margins increase. That is unlikely.
Next is a consideration of profit margins, as shown in the chart below.
Profit margins are near record levels. There is no reason to expect a sharp increase in profit margins in the next several quarters. In fact, rising commodity prices may well put pressure on margins.
Expectations of a return to double-digit profit growth based on even higher profit margins seem quite a stretch.
In fact, if revenue growth was 3% in the quarters ahead, profit margins would need to increase from the current 18.7% to 20.0% in 2013 in order for profits to rise at a double-digit rate. It is simply unrealistic to expect profit margins to continue to surge as a basis for expecting strong profit growth next year.
Perhaps the optimistic profit outlook is based on what appears to be a deep abiding faith in the ability of central banks to manipulate the economy.
The Bullish Argument
The US stock market has rallied the past few months on the belief that central banks in the US and Europe will provide additional liquidity that will lift asset prices.
This has been bolstered by a long-term bullish argument that the Big Picture has been making for the past two-and-one-half years: that stocks offer excellent relative value compared to alternative investments.
First, let's take a look at the liquidity argument. The bullish argument can be based on several possibilities.
- The additional liquidity promotes economic growth.
- The additional liquidity reduces the risk of a credit meltdown.
- The additional liquidity creates additional demand for equities.
The first of these possibilities should be dismissed.
The first two rounds of quantitative easing (increasing liquidity) from the Fed couldn't get real GDP growth in the US above 2%. A third round is likely to be even less effective. Lowering interest rates from current levels isn't going to stimulate the economy.
Furthermore, additional liquidity isn't likely to be a factor to induce banks to lend more.
Hardly any economists expect a third round of quantitative easing to provide any significant boost to real GDP growth.
This is also true for Europe. The recently announced bond-buying program by the European Central Bank hasn't changed any forecasts for economic growth in Europe. The recession is deepening.
The second argument has validity and is related to the long-term relative value argument.
The European Central Bank bond-buying program will reduce the borrowing costs for Italy and Spain. There will be additional liquidity in the credit markets that will reduce the risk of a credit implosion, which is of course what caused so much turmoil in the US in 2008.
The reduction in risk associated with a smoother functioning credit market provides support to equities. There is an extremely large risk premium in stocks right now, and any reduction in risk will lead to an increase in demand for stocks. If stocks can be counted on to deliver solid dividend returns and even modest earnings growth, they have increased appeal relative to bonds.
In this regard, central bank action provides legitimate justification for some of the stock market rally. It isn't the biggest reason for the stock gains, however. That rests with possibility number three listed above.
Most market participants believe that another round of quantitative easing should boost stock prices because of increased demand due to additional liquidity. This is a very dangerous argument on which to invest.
It is an argument that implies increased demand is not due to improved fundamentals, just liquidity. It is an argument that the Fed is supporting a mini-bubble in stock prices.
In 1999, I wrote a Big Picture article titled, Learning to Love Bubbles. It was an argument that the stock market was overvalued and would eventually have to retreat to reflect the fundamentals. It recognized that valuation arguments often take a long time to prove accurate. The article was a year too early, but it ultimately proved correct.
Current conditions are nowhere near 1999, but the issues are the same. The fundamentals eventually always win out. It may take a long time, but stocks will ultimately reflect the present value of expected future returns – earnings and dividends.
In summary, stocks are now priced for slightly lower risk. Yet, a reasonably high risk premium is likely to remain in stocks for a few years. It isn't going to shrink a whole lot. There isn't a lot further to run solely on this basis.
Stocks aren't priced, however, for the very real possibility that US economic growth will remain below 2% through 2013, and that Europe and Japan will stay in recession through that period while Chinese economic growth could slow significantly.
Stocks aren't priced for the possibility that earnings growth in the third and fourth quarters will be negative. Stocks are priced to assume a strong rebound in earnings in 2013 that is mathematically hard to rationalize.
What It All Means
The bearish argument is based on the hard data of economic and earnings trends.
The bullish argument is based largely on the hopes that US and European central bank liquidity actions will increase demand for stocks – a mini bubble.
Markets often take a long time to adjust to fundamentals and value. For now, the markets are clearly reacting to everything related to central banks and ignoring economic and earnings trends.
The bullish argument can easily dominate market sentiment for a while. Investors, however, should be clearly aware of just what is moving the markets.
And never forget: in the long run, the fundamentals always win out.
Founder and Chairman, Briefing.com
