Writer, Desmond Jordan, Executive Director, FLLC.ca
Or should I say, the U.S. stock markets?
New records have recently been set for both the Dow Jones and the S&P 500 indices! All time highs… amazing! O.K., now that I got that out of the way, is this the beginning, or the end?
We are told that in the long run, earnings or growing earnings is what moves stocks up. History has proved this to be true. Inflation alone assumes this. The Dow Jones and S&P 500 indices are at all time highs. One would assume that earnings are still growing. That has not been the case.
Most U.S. corporate earnings peaked last July! In fact most stock markets, including Canada, peaked two years ago. Markets are now experiencing “multiple expansion”. This is happening to a group of stocks, not most stocks. Corporate profit margins, or the ability to maximize profits, are at all time highs too.
Let’s refer to one specific multiple – PE Ratios (price/earnings ratio, or price of a stock divided by what it earned per share over the last year).
Example: on April 11 BCE was trading at $46.85 per share. It earned $3.39 per share over the last year.
PE = $46.85 ÷ $3.39
If BCE was trading at 10x earnings, the share price would be $33.90
Multiple expansion can grow share price without earnings growing at all. Stocks and markets will fluctuate within PE ranges historically. Canadian bank stocks have tended to trade between 10x and 15x earnings over the last 20 years. Buying a Canadian bank at 10x earnings and selling at 15x earnings has proven very profitable historically.
The S&P 500 itself also trades within a PE valuation range. Below is a chart created by economist Robert Shiller.
Multiple expansion is more typical of the end of a market cycle, not the beginning. Optimism causes investors to pre-pay and build in future earnings growth. As long as corporate profits can maintain that growth, then PE ratios can remain at high levels. There usually is little room for any disappointment. Stock prices are perfectly priced for a perfect earnings growth environment. This, eventually, comes to an end.
There has been very slow economic growth among Western economies since the financial crisis in 2008. The U.S. economy is growing at a 1.5% to 2.0% pace. Typically 3% to 5% growth rates should have occurred because Government deficit spending alone is contributing 1.5% growth per year. Europe has been in and out of recession a few times since 2008 and is now gone back into recession with an average unemployment rate of over 10%.
China provided the big growth this time around. Their economy grew at an explosive rate of 7% to 10% per year since 2008. China became the world’s biggest construction zone. They became a massive consumer of commodities to feed all that growth. This was a great benefit to countries like Canada, Australia, Brazil and Russia who are big exporters of commodities. The U.S., Germany, and Japan exported machinery and technology to China.
China now is reporting slower growth. Anyone who visits China today can’t help but notice many empty buildings and malls. There is an entire city that can house 1 million people that is currently empty! Talk about pre-planning. To the world, China became a massive “make work project”. China’s future appears bright, with higher than normal growth rates, but it cannot grow the whole planet alone. Much of China’s success came from becoming the “factory” to the world by providing cheap labour and grabbing market share from the rest of the world. This is not sustainable forever.
How have Corporations grown earnings in this environment?
Falling interest rates and government stimulus.
This is typically what has practiced since the 1930s. A powerful method to get an economy growing or get out of a recession is to drop interest rates and ramp up government spending by running deficits to employ more government workers and build infrastructure.
In 2008-2009 the World collapsed interest rates to depression levels. Money was practically free and massive deficits were created to stimulate economies.
This worked in certain countries like Canada, Australia, Norway, Brazil, etc. In the large economies of Europe, U.S. and Japan there has been very little growth. In economies where the financial system was intact, falling interest rates encouraged consumer confidence and bank lending. Consumers were more optimistic and are willing to borrow money to buy homes, goods and services.
This overall environment grew earnings since 2009 along with the China phenomenon. Falling interest rates alone can cause high dividend paying stocks to go up in price without growing profits at a fast pace. If a stock is paying a dividend of 6% and GIC rates fall from 5% to 2%, investors will shift to the higher paying investment and push it up in price. That’s why dividend funds have been successful recently. The same occurs for Bond Funds. Unfortunately there is little room for interest rates to fall. We have the lowest rates in history! Dividends are now going to have to grow at a fast pace to maintain these high multiples.
Much has been done to grow earnings. Low interest rates have caused interest payments to fall. Job outsourcing has made it cheaper to produce goods. Government spending and 2 wars have been good for business. Falling corporate taxes contributed to earnings growth. Lower than normal contribution to research and development for future growth has helped current profits. Less investment in capital and equipment is typical this cycle. Everything has been utilized to grow profits except for this last method that is being implemented this year; Share Repurchasing.
A company can grow it’s profits without falling interest rates or growing sales or reducing capital spending by buying back their own stocks with cash on hand or borrowing at low interest rates. At the last market top in 2007-2008, the S&P 500 companies bought back a record $589 billion worth of their own shares. This action stopped with the market crash but has begun again. Companies are on track to double the 2007 record this year!
This doesn’t sound logical because stocks are currently being purchased at high multiples, not when they are cheap. Money is chasing expensive paper and not going into capital investments and research.
It does sound logical if you want to maintain high multiples and higher stock prices without growing sales. This market is priced for perfection, let’s hope economies around the world can start growing normally. I would bet that the next move for interest rates in Canada would be DOWN.
There is one more reason for stocks to rise dramatically in the future which is very rare historically. This topic is for another article.
Financial Literacy Learning Centre of Canada
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