Do Trough Earnings Equal Peak Prices?

Steve Smith Headshot (1)

A lot of ink has been spilled discussing how the world of ZIRP/NIRP (for the uninitiated that stands for Zero (Negative) Interest Rate Policy) has distorted pricing of not only the bond market but has bled over to all other asset classes.

In the U.S., one can still find Treasury bonds with a positive yield but globally over $13 trillion of sovereign bonds have negative yields.

The poster child for this insanity is a 50-year Swiss sovereign bond which yields negative .023%. Try to make sense of intentionally investing your money for 50 years with the guarantee of losing money.

The most obvious impact has been to force everyday investors to chase yield dividend paying stocks such as utilities and consumer staples.  The following two graphs highlight how those stocks with the highest dividend yields are clearly most in demand this year.

The first graph below plots the average, non-weighted, year-to-date returns for the stock of each S&P 500 company, categorized by their respective dividend yield ranges. The second image breaks it down by sector.

Return on dividein yield image 8.24.16

Dividend sector 8.24.16


These historically high valuations making them extremely vulnerable to a sell off should interest rates normalize.  And with an increased probability that the Fed will indeed boost rates another 25 basis points at the September meeting some of these stocks such as Campbell Soup (CPB) and Con-Edison (ED) have come under pressure of late.

And it’s not just the dividend payers that are carrying high valuations as most of the recent market gains have been attributable to p/e or multiple expansion on the theory that Q2 represented trough earnings. That is, after 5 consecutive quarters in which the S&P 500 stocks posted a decline in both top and bottom line we might finally be see an upturn in profits and sales. The belief we had reached Trough earnings has justified the recent multiple expansion and higher stock prices.

As you can see the p/e multiple expansion over the past year has been dramatic, but just for utilities but for the broader market as well.

P.e ratios 8.31.16

But with most rational people begging for the Yellen and company to hike another measly 25 basis points it begs the question; “Would a rise in rates pinch corporate profits and leave stock valuations, currently with the S&P 500 trading at 18.6x 2017 estimates, vulnerable if earnings fail to climb.”

“Roughly two-thirds of the companies in the S&P 500 Index have now reported their latest quarterly earnings. And while the headlines are filled with companies that continue to “beat” expectations, the reality is that the downward revisions in corporate earnings are even worse than what this stock market bear expected this quarter. And the readings for the latest week have almost assured that corporate earnings are going to fall short of the reasonable targets set at the beginning of the quarter.”

However, the only reason that companies are currently beating estimates, is because those estimates had been dramatically lowered since the beginning of this year turning earnings season into a “participation event.” In other words, if you lower the bar enough, eventually everyone “gets a trophy.”

The chart below shows the evolution of earnings expectations since March of 2015, to present with the bottom part of the chart showing forward estimate changes from January, 2016.

Forward earnings image 8.24.18

As an article in ZeroHedge noted, “While earnings are set to decline again this quarter, which will push valuations even further into the proverbial stratosphere, the real risk to watch is the US Dollar. While Central Banks have gone all in, including the BOJ with additional QE measures of $100 billion, to bail out financial markets and banks following the ‘Brexit’ referendum, it could backfire badly if the US dollar rises from foreign inflows.  A stronger dollar will provide another headwind to already weak earnings and oil prices in the months ahead.”

Unlike the stock market which is pushing extreme overbought levels, the dollar is at an extreme oversold condition and has only started a potential move higher. This is something to pay very close attention to in the months ahead.

Earnings forecaste 8.26.16

Let’s look at a much simpler graphic that makes clear the trend that consensus estimates have a long history of being overly optimistic at the beginning of the year only to be forced to ratchet them down as the year goes on.  I expect the same trend to occur for the back half of 2016 meaning the market will not grow into its current multiple.

EPS Forecasts 8.25.16

Value Trap

The flip side of the bloated p/e’s for the utility and consumer staple stocks are the seemingly low values placed on sectors and companies that still have true potential earnings growth.

Michael Santoli, who has broad experience in market commentary recently presented on the theme of this blog post Is 2016.

He accurately observed that cyclical stocks trade at low PE’s at times of economic tops and high PE’s when the market is low. This widely-known observation (Peter Lynch from 30 years ago, for example) is certainly accurate. Santoli listed several current value trap stocks such as large mega biotech such as Gilead (GILD), General Motors (GM) and some old line technology such as Cisco (CSCO)

With interest rates negative in many areas of the world, the push of capital into the U.S. for a higher return on reserves is very likely which will continue to suppress earnings and economic growth making it unlikely these companies will see a significant pick up in earnings power.

All of this continues to present an increasing dilemma for an already richly valued stock market trading at all-time highs. For with each passing day, stocks are becoming more expensive even if they simply stand still.

Bottom Line:  Stocks are vulnerable to a decline if rates raise or earnings don’t continue to recover. And one could lead to the other creating quite the conundrum for investors.

Kind Regards,

Steve Smith

Steve Smith is an expert options trader with 25 years experience in the markets. Steve was a seat-holder of the Chicago Board of Trade (CBOT) and the Chicago Board Option Exchange (CBOE) from 1989 – 1997. Steve is currently the editor of The Option Specialist and runs the 20K Portfolio Program which provides all types of options trades for all types of traders.

*Editorial Contributors’ Disclaimer
The information contained within this article solely reflects the opinion and analysis about the performance of securities, investments and financial markets by the writer whose articles appear on this site. The views expressed by the writer are not necessarily the views of Weiss Educational Services, its affiliates or members of its management. While Weiss Educational Services and its affiliates accept editorial content from outside contributors, the content provided herein has not been independently verified for its accuracy. Nothing contained in this article is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Information provided on the website is for educational purposes only. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Weiss Educational Services writers, its affiliates and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Nothing on this website is intended to solicit business of any kind for a writer’s business or fund. Weiss Educational Services, its affiliates, management and staff as well as contributing writers will not respond to emails or other communications requesting personalized investment advice.