So we made it through non-farm payrolls Friday unscathed. In fact, we got a humdinger of a number that at one point during the session propelled the S&P to new record highs. The next hurdle for markets: earnings season.
On the whole, y/y earnings growth for S&P 500 companies is expected to come in somewhere in the neighborhood of -5%. That’s negative five percent. Should that prove accurate, it would mark the fifth straight quarter of negative earnings growth.
So what gives, you might fairly ask. That is, if we’re mired in an earnings recession, how are stocks still near all time highs? Well, multiple expansion for one thing:
(Charts: Morgan Stanley)
And then there’s the corporate bid courtesy of debt-funded buybacks:
(Chart: Deutsche Bank)
We should all be thankful that i) some investors are willing to pay more for a dollar of (estimated forward) earnings these days and ii) corporate management teams are price insensitive when the cost of debt is so low because the flows are moving in the wrong direction:
(Chart: Goldman)
One thing you may want to keep in mind as we trudge through what’s likely to be a difficult earnings season is the equity risk premium or, ERP. Put simply, it’s the expected excess return above the risk free rate that compensates investors for taking on the extra risk of owning stocks over safe haven government bonds. Here’s a visual to give you some historical context:
(Chart: SocGen)
According to SocGen then, stocks are pretty much fairly valued versus Treasurys. In other words, we’re not overextended - yet.
If we assume the historical ERP is 2% rather than 4% (in the interest of brevity, we’ll leave aside the reason for that deviation), we’ve got more room to compress, which could in turn give stocks a bit more room to run:
(Charts: Deutsche Bank)
Here’s a bit of color from Deutsche Bank which helps to explain the dynamics at play:
“One should also look at how the equity risk premium has evolved to get an appreciation for the role it plays in supporting equities. From 1982 to 2009 it behaved fairly predictably, staying in a range between zero and 4 percent. The ERP climbed even as earnings increased because investors start demanding more from equities over the risk-free rate for protection against higher inflation and a maturing business cycle. In the two decades preceding the early 2000s, the ERP had seemed to be trending down ever so slightly, perhaps because of steady declines in inflation from levels observed during the 1970s. The dot- com boom saw the ERP reach a near-record low, and the subsequent market decline pushed it back up nearly to historical highs, which had prevailed for most of the 2000s.”
“After the SPX lost nearly 60 percent of its value between 2007 and 2009, the equity risk premium reached new highs. Investors demanded as much as a 7 percent premium from stocks over government bonds as late as 2012, even as the general outlook was steadily improving. It wasn’t until the last couple of years that the ERP began to decline, supporting equities even as earnings slowed. Currently at 3.6 percent the ERP is at its lowest level since the recession but still sits above the upper bound of its pre-crisis historical range. The important takeaway is that to the extent the ERP still has room to fall back to its historical average of 2 percent, it could provide roughly another 200 points of upside to the SPX.”
The problem is this: the ERP could be being kept artificially high due to overly optimistic earnings estimates and artificially low Treasury yields. That is, analysts’ unrealistic projections for earnings growth combined with plunging yields on US debt are exaggerating the gap between equity returns and the risk free rate. Should Treasury yields spike at the same time EPS estimates are revised lower, the ERP could compress quickly triggering a rotation out of stocks and into bonds. Here’s what SocGen said last month:
“A combination of flat earnings growth in 2017/2018 and a UST yield at 2.25% should lead to re-allocation from US equities to government bonds. In our analysis, we change the earnings growth rates and the bond yields for 2017 and 2018, while keeping the other parameters the same.”
“A double-digit equity market correction is possible should the equity risk premium fall 1- standard deviation below the long-term average. The chart below shows the equity market return in the 12 months subsequent to the equity risk premium falling 1-standard deviation below the long-term average level. Except for the 2000-03 period, such an event (ERP falling below 2.9%) has triggered an equity market correction of 10% to 30%.”
(Charts: SocGen)
How worried should you be about the scenario SocGen presents? We’ll leave you with two final charts and let you decide (hint: in the left pane you can see just how dramatically analysts expect earnings to rise and in the right pane you can see that the yield on the 10-Year Treasury has now fallen more than two standard deviations below its 200 day moving average):
(Charts: BofAML, Morgan Stanley)