April Showers, but No May Flowers

Stock analysts (bottom up) remain on crack. They almost always love their stocks and they basically get paid to tell a good story on why you should buy them. Very few are unbiased even after years of regulatory changes and the fact that they swear that they are in every report.

For years, they have persistently forecast earnings growth that has not materialized. At Dec 31, 2015, they expected about US$124 in S&P 500 earnings for 2016 and a similar number at the end of 2014 (white line). The actual earnings for 2015 was about $111.41, but even at the end of December they were still forecasting higher numbers as we can see in the chart. It is well known on the Street that analysts start the quarter high and then companies guide them lower only to “beat” the revised down estimate to say they “beat” earnings—it’s a game and all are complicit to it.

We think it is part of the conflict of interest we see in the C-Suite today along with share buybacks versus boosting dividends. So far, in 2016 at 31% of free cash flow, share buybacks are the biggest use of corporate cash and source of demand for equities, the largest since (gulp) 2007. If there were business growth opportunities, the money is much better spent building new plant or stores to grow revenues. Instead, companies are growing earnings per share by buying back their own stock with their free cash flow. They could be increasing dividends due to the near lifetime low yields of the U.S. market, but the C-Suite gets paid more (via options compensation) when the stock goes up.

The market is still largely valued on earnings per share. Friday, the market closed at 2,073 with trailing earnings of 110.10 for a trailing multiple of 18.83 times earnings. The average 50-year historical trailing earnings is 16.5. The extreme high in 2000 was almost 31 and extreme low in the early 1980s was about seven before decades of debt-fuelled spending and the boomer years expanded the market multiple. Demographic trends and massive debt suggests this will not be repeated and in fact should be a headwind to economic growth. In the past five years, about 30 per cent of earnings per share growth has come from share buybacks and not real business expansion. It’s sort of like the Fed buying U.S. Treasuries (QE) when China stopped buying them a few years back so they can weaken the Yuan. The market is not expensive compared to high valuation crash years of 1961, 1987, or 2000, but given a share buyback normalization adjustment, it would be getting close. If we see only modest or no earnings growth as the year develops, history suggests we should see a small multiple contraction (where stocks move down due to the lack of earnings growth) to about 15x or 16x (a bit below average), then we are looking at targets between 1650 to 1760. Technically, we should see major support above the 2000 and 2007 highs in the 1550-1575 range. A break below the 1800 lows we saw in January and February would likely lead to an additional panic sell off somewhere in this range which would likely be the next backup the truck buy.

Top down market strategists are even more useless as forecasters. The chart below shows the consensus target for the S&P 500 for year-end 2016: currently it’s at 2152, but it started the year at 2190. Note how poor predictors of the year-end number they are early in the year. At the end of 2011, they thought the end of 2012 would be about 1,349 and the actual was 1,426. They simply and mostly tend to forecast a 5-10% gain every year. In other words, they are very poor predictors of multiple expansion and contraction. The table below shows the details of the past few years.

Year Estimate Actual

2012 1349 1426

2013 1543 1848

2014 1956 2059

2015 2233 2044

2016 2190 ?

The current estimate has been revised down to 2152 as they tend to follow the market trends like lemmings, which suggests they will be taking that number higher soon. In fact, they have no clue on how to forecast where prices will be. None of us do, to be fair. I have said that for years—it’s just an educated guess! So if the high-paid Wall Street talent does not have a clue, how can we know what to do? The long-term return for U.S. large cap stocks as measured by the S&P 500 and its predecessor indexes going back about 90 years is about 9-10 per cent per year with an 18% standard deviation. That means that the return has been somewhere between +64% and -44% in any given year. The markets are volatile and we have been in a period of relatively low volatility for a few years, but the signs are suggesting that for the next several years, we will revert back to higher average volatility. This comes as central bank policies are less effective at creating growth due to the massive debt and ageing demographics.

The event risks in the coming months suggest that taking some cash off the table during the recent strength makes sense (sell high). In my sleep at night portfolios, I have taken the risk levels down in the past few weeks to the lowest we have had it in years. In my long/short strategy I’m net short U.S. small caps that are still in “stupid expensive” multiple range despite having fallen about 24% at the February lows from the 2015 highs. The U.S. earnings risk (April), the credit risk in energy countries (Sept) and companies (Q2), European banks risk (Q2), BREXIT risk (June 23), Syrian & North African migration crisis into Europe (ongoing), Greece debt part IV (July), and the very depressing U.S. election cycle (Nov) sets up for a few quarters of uncertainty ahead.

Watch the segment on BNN: http://www.bnn.ca/Video/player.aspx?vid=842047

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