The cheerleaders for the US stock market have been out in force in recent months.
Barely a day goes by when I don’t see some kind of article arguing that prices should keep rising.
Most of the arguments centre around more money printing by the Federal Reserve, and the lack of attractive alternatives (trust me – there are plenty). After all Europe remains distressed and future policy moves are uncertain. Even the US – with its false recovery – looks quite attractive by comparison.
In the short term prices could keep going up. But they could just as easily correct sharply or even crash. One thing I am sure of though, is that US stocks are likely to be very poor long term investments from current levels.
As always, the main issue – irrespective of the state of the US economy – is that prices are high and dividend yields are low. According to the Financial Times, the US stock market P/E ratio is 17.6 and the dividend yield is 2.1%.
In other words US stocks are already on the expensive side and dividend income is on the low side, historically speaking. US stocks are poor value at current prices.
…EPS hasn’t been growing at all. It has been flat or falling…
This leaves future success depending heavily on strong earnings growth. But in recent quarters, earnings-per-share (EPS) hasn’t been growing at all. It has been flat or falling, depending on how you look at it.
The first chart below shows EPS for the S&P 500 from 2003 until end of 2012. You can see that it has been flat for the past four quarters and is barely above the level of the second quarter of 2011. In fact it’s barely above the level of the second quarter of 2007, the last peak in both EPS and the S&P 500’s price level.
EPS – S&P 500
But it gets worse. Once we exclude “extraordinary items” the EPS has been falling. Extraordinary items are one-off gains or losses that are not expected to be repeated in the normal course of business. They include things like profits from asset sales, or restructuring costs from closing down businesses or laying off employees.
The next chart excludes these extraordinary items. You can clearly see that this cleaner EPS – which reflects the strength of the underlying operating businesses – has been falling. Total EPS has been propped up in recent quarters by one off gains.
In fact the underlying EPS fell by around 15% between the second and fourth quarters of 2012. We’re now back to levels last seen in mid 2006. That’s nearly seven years ago!
This trend seems to be continuing. At time of writing Bloomberg reports that EPS is down another 1.1% in the first quarter of 2013, based on the 174 companies that have reported so far (out of 500).
EPS – S&P 500
The high market valuations and falling earnings are my biggest concerns. But I have more.
Here are my eight reasons for believing that the fundamentals of the US stock market are poor.
- The P/E ratio is high and the dividend yield is low
- Underlying EPS has been falling, despite record levels of stock buybacks (see 4 below)
- Around half of S&P 500 revenue comes from overseas, and most of that from Europe. Europe remains in recession or depression, so this will drag on earnings.
- Stock buybacks, which act to increase EPS by reducing the number of shares issued, are at record levels which may be unsustainable
- Corporate profit margins are at record levels and are likely to fall due to competition or if interest rates rise in future (higher interest costs)
- The spending power of American workers has been falling since fewer are working, and those still in work are earning less (e.g. full time jobs have been replaced by part time jobs). Corporations need spending to grow sales.
- Margin lending (borrowing to speculate) is at a record high in relation to the size of the stock markets – even more than during the peak of the dot-com bubble in 2000 or the top of the commodities bubble in 2007. Both were followed by crashes.
- Based on 113 years of historical evidence, U.S. stocks are unattractive long-term investments, likely to give poor returns from these levels.
I’ll return to some of these themes in future. There is too much detail to cover today. But for now just be aware that there are at least eight reasons for caution when it comes to US stocks.
Sooner or later the fundamentals will overpower the current fashion of talking up US stocks. Watch out below!
Until next time,