The 'Markets' vs Me on the Markets...Two Views
Diupdate
An old friend who recently touched base asked me what I think of the markets here. I told him I'll tell him what I think of the markets, but more importantly, I will tell him what the market thinks of the markets! And those are two different things!
First me:
I think equities are overvalued by a significant degree. Refinitiv, in their report dated 12/2/22, showed y/y S&P earnings growth for Q3 (blended: reported and estimated) of 4.4%. Not shabby...except that the Energy sector component was up 160%!! The next most positive sector was Industrials at 19.7%, with most of the others much lower and several negative! So without Energy, the actual Q3 S&P earnings would be ghastly at best!
Perhaps more importantly, expected earnings growth for all of next calendar year 2023 is 4.9%...again, not too shabby, all things considered, but Consumer Discretionary is expected to lead the way with growth estimates of 30%! Seems rather optimistic in the face of higher interest rates, anticipated increases in unemployment and an increasingly likely broader if not deeper recession.
The same report shows analyst bottom-up estimates for S&P earnings in 2023 at $231. Given where the /es are currently (3,936), that implies a P/E of 17x. Not terribly inflated, given that FactSet says the forward-12mth P/E 5yr average is 18.5 and 10yr average is 17.1. But suppose that wage and cost of employment inflation makes that $231 estimate unreachable, and suppose it misses by let's say 10%....so the actual earnings turn out to be closer to 210 (or lower). Then, today's /es reflects a fwd P/E of almost 19. And if earnings really disappoint and are $200, then today's fwd P/E is almost 20! And with earnings at $200, to have a P/E of 17 would require the /es to be 3,400, a 500+ point drop from here!
I believe the risks are for earnings to disappoint substantially, again, largely due to the miscalculation of today's wage/price pressures. I've posited, and maintain, that just like the Fed's mistake of 2021 was missing the 'transitory' nature of inflation, their mistake for 2022 will be not recognizing the degree to which we already have wage/price inflation, which will ultimately eat further away at profit margins, earnings and stock valuations!
Now, looking at the charts,
I'll note that the S&P remains in a downtrend that started late in '21, and the most recent attempt to rebound and break back up above the upper bound failed. I'll also note that the percentage of S&P stocks over their 50dma is roughly 77, and Nasdaq is 75, both levels indicating 'over-extended'.
Finally, a word on the 'war on inflation'. The early signs indicate some degree of victory for the Fed...the energy complex has rolled over, the ag complex too. But supply/demand fundamentals in both spaces have been horribly distorted by both the Russia/Ukraine war and the China Covid lockdowns. While the former shows no sign of improving (which along with the recently enacted EU Embargo on Russia sea-bound oil and the $60 Price Cap are sure to err on the side of increasing risks of higher energy prices), the latter does appear to be showing movement towards re-opening of China demand. If that has the impact that I believe it will, the seemingly certain victory on inflation that appears to be the main narrative at the moment, will evaporate rather quickly! What that will do to consumer and business confidence is clear, and not good. And speaking of the consumer, it's important to note that while I'm very bearish on equities, I'd be even more so if not for the fact that the Covid subsidies are still very much in the hands of consumers, with some Wall Street houses estimating the absolute amount in the several TRILLION dollar range!! It's that massive amount of savings (so-called, instead of 'helicopter money') that has pushed out the day of reckoning of corporate profits and stock market valuations!
Now for the "markets'" view. I believe this market wants to trade higher. There appears to be a belief that while the war on inflation isn't over yet, there is, nonetheless, a battle plan in place that assures victory. It's only in the past couple of days that the markets have turned some attention to the earnings growth risk that I've highlighted above, but even with that, any hint that Fed rate-hiking will take a slower pace is likely to fuel more 'bottom-fishing' driven by FOMO!
The apparent divergence of views between the markets and me, however, isn't really as wide as it might seem at first. To the markets, it seems that now is the time to find value in stocks, well in front of the evidence of a victory on inflation. To me, the strength of the consumer is pushing out on the timeline the day when it becomes all too clear that inflation hasn't been beaten and that spending power has been eviscerated, a day that will not be pretty for equity prices. And at that point, when equities are valued to the reality of inflation's devastating consequences, I'll be ready to share in the FOMO.
As always, time will tell. But for me, two things are clear: Number one: the risks point to a tumultuous 2023, and number two: my friend wishes he'd never asked!
First me:
I think equities are overvalued by a significant degree. Refinitiv, in their report dated 12/2/22, showed y/y S&P earnings growth for Q3 (blended: reported and estimated) of 4.4%. Not shabby...except that the Energy sector component was up 160%!! The next most positive sector was Industrials at 19.7%, with most of the others much lower and several negative! So without Energy, the actual Q3 S&P earnings would be ghastly at best!
Perhaps more importantly, expected earnings growth for all of next calendar year 2023 is 4.9%...again, not too shabby, all things considered, but Consumer Discretionary is expected to lead the way with growth estimates of 30%! Seems rather optimistic in the face of higher interest rates, anticipated increases in unemployment and an increasingly likely broader if not deeper recession.
The same report shows analyst bottom-up estimates for S&P earnings in 2023 at $231. Given where the /es are currently (3,936), that implies a P/E of 17x. Not terribly inflated, given that FactSet says the forward-12mth P/E 5yr average is 18.5 and 10yr average is 17.1. But suppose that wage and cost of employment inflation makes that $231 estimate unreachable, and suppose it misses by let's say 10%....so the actual earnings turn out to be closer to 210 (or lower). Then, today's /es reflects a fwd P/E of almost 19. And if earnings really disappoint and are $200, then today's fwd P/E is almost 20! And with earnings at $200, to have a P/E of 17 would require the /es to be 3,400, a 500+ point drop from here!
I believe the risks are for earnings to disappoint substantially, again, largely due to the miscalculation of today's wage/price pressures. I've posited, and maintain, that just like the Fed's mistake of 2021 was missing the 'transitory' nature of inflation, their mistake for 2022 will be not recognizing the degree to which we already have wage/price inflation, which will ultimately eat further away at profit margins, earnings and stock valuations!
Now, looking at the charts,
Finally, a word on the 'war on inflation'. The early signs indicate some degree of victory for the Fed...the energy complex has rolled over, the ag complex too. But supply/demand fundamentals in both spaces have been horribly distorted by both the Russia/Ukraine war and the China Covid lockdowns. While the former shows no sign of improving (which along with the recently enacted EU Embargo on Russia sea-bound oil and the $60 Price Cap are sure to err on the side of increasing risks of higher energy prices), the latter does appear to be showing movement towards re-opening of China demand. If that has the impact that I believe it will, the seemingly certain victory on inflation that appears to be the main narrative at the moment, will evaporate rather quickly! What that will do to consumer and business confidence is clear, and not good. And speaking of the consumer, it's important to note that while I'm very bearish on equities, I'd be even more so if not for the fact that the Covid subsidies are still very much in the hands of consumers, with some Wall Street houses estimating the absolute amount in the several TRILLION dollar range!! It's that massive amount of savings (so-called, instead of 'helicopter money') that has pushed out the day of reckoning of corporate profits and stock market valuations!
Now for the "markets'" view. I believe this market wants to trade higher. There appears to be a belief that while the war on inflation isn't over yet, there is, nonetheless, a battle plan in place that assures victory. It's only in the past couple of days that the markets have turned some attention to the earnings growth risk that I've highlighted above, but even with that, any hint that Fed rate-hiking will take a slower pace is likely to fuel more 'bottom-fishing' driven by FOMO!
The apparent divergence of views between the markets and me, however, isn't really as wide as it might seem at first. To the markets, it seems that now is the time to find value in stocks, well in front of the evidence of a victory on inflation. To me, the strength of the consumer is pushing out on the timeline the day when it becomes all too clear that inflation hasn't been beaten and that spending power has been eviscerated, a day that will not be pretty for equity prices. And at that point, when equities are valued to the reality of inflation's devastating consequences, I'll be ready to share in the FOMO.
As always, time will tell. But for me, two things are clear: Number one: the risks point to a tumultuous 2023, and number two: my friend wishes he'd never asked!
Catatan
Just a friendly reminder: Nothing written here, whether explicitly or implied, is meant to be advice in any way! It's only written as food for thought and for discussion purposes.Catatan
Today was a good example of the "market" vs "me"! The 'market' acted like a coiled-up spring ready to explode, which it did in late afternoon trading, ratcheting up over 500 points on the DJIA and 56 points on the S&P, seemingly reflecting what I mentioned in my piece above from Dec 7, a sense that the Fed's 'war plan' on inflation will meet with success. And as long as tomorrow's CPI is close to inline, I'd expect more of the same. Add to that, any 'nod and a wink' from Powell on Wednesday as if to say regarding inflation, "I've got this!" and KaBOOM...up and away the market will go.
As for the fears of earnings disappointing in early '23? The market is quick to push that aside. Not me! I look at days like today as a way to sift through my holdings in search of 'overvalued' stocks with risk to the downside on any disappointment from overly confident expectations. Eli Lilly (LLY) is one such stock. Don't get me wrong...I love the company. Strong balance sheet with a terrific new product pipeline. In the past, that was the upshot on LLY. But now, ask anyone about LLY (even the JPMorgan urban legend style of asking one's shoe-shiner) and they'll tell you that LLY is all about Mounjaro! The diabetes drug is already a blockbuster, but more because even without FDA approval yet for the weight-loss indication, doctors are prescribing it with abandon, enough that LLY just announced a sort of triage distribution plan to limit availability to better ensure that diabetes patients, for whom the drug is currently approved, can get access. Taking a look at LLY's PE, at 55, it's meaningfully higher than its 5yr average and median. Further, it's PEG is in the low 30s, meaning that earnings growth has to nearly double for the current valuation to be justified. Now, it is possible that when/if the FDA approves Mounjaro for weight loss, that these earnings goals can be met. But it's also possible that demand will be so great that LLY will still have a hard time meeting up w/supply! Further, and I pray this is not the case, but beyond a drug investment's 'probability', there's also 'possibility', and in the case of relatively new drugs, it's not a too infrequent event that some unforeseen side-effect unearths itself especially after the drug is in more widespread use. Given all of that, I trimmed a long-held position in LLY today, and if it continues to run, I'll trim further, if not exit entirely.
As always, whatever I've written here both explicitly and implied is NOT meant to be advice in any way, just food for thought and discussion.
Comments welcome.
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