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US stocks continue to defy gravity (and logic)

US stocks just keep on ticking higher, even though earnings are falling. Also, corporate debt levels are at record highs relative to profits, meaning higher risk. Without profit growth, higher stock valuations and higher financial risks are a toxic combination. Unless some kind of massive profit boom is around the corner – which is unlikely – eventually something’s gotta give.

So far this year the S&P 500 index of large US stocks is up 6.8%, from 2,043.94 at the end of 2015 to 2,183.80 as I write. The index keeps hitting record highs.

S&P 500: flattish since late 2014 but now hitting new highs


But according to Factset, a data provider, S&P 500 second quarter profits are down 3.5% year-on-year, with 86% of companies having reported results. In fact there have now been five consecutive quarters of falling year-on-year profits, and we look set to have two consecutive whole calendar years of lower profits as well (2015 and 2016).

Falling corporate profits combined with rising stock prices can mean only one of two things. On the one hand that investors are willing to accept very low future returns on their investments. On the other hand that there’s an expectation of some kind of massive profit boom on the horizon. Neither seems like a good basis for investing in US stocks.

What do I mean by low future returns? Somewhere between zero and 4% a year, including dividends, assuming valuation multiples stay up at their high levels. That’s a pretty pathetic return compared with the 9.5% long run average, since 1900.

You’d need significant and prolonged price deflation to get a decent real (inflation adjusted) profit. And no doubt the Federal Reserve already has an itchy trigger finger when it comes to printing more money to avoid deflation.

You’d need significant and prolonged price deflation to get a decent real (inflation adjusted) profit. And no doubt the Federal Reserve already has an itchy trigger finger when it comes to printing more money to avoid deflation.

Of course the outcome could be much worse than low single digit returns. Prices need to fall by around 40% just to get to the median (mid point) of historical valuation levels. That would mean the S&P 500 trading at 1,310, a level last seen four years ago.

A valuation fall of that magnitude could happen quickly, in a sudden crash, or slowly, over 2, 3, 5 or even 10 years. Even if it took a decade it would be enough to wipe out any return from dividends, tepid earnings growth, and stock buybacks. (Buybacks goose up the share price by reducing the share count, meaning assets and earnings are split across fewer remaining shares.)

So let’s say that elusive profit boom is just around the corner. The one that didn’t materialise during the lost decade for US profits that we’ve just been through (see here for recent analysis of weak US profit growth).

Let’s see. What was the best period for profit growth in the past, and is it likely to be matched in coming years?

In the five years from 1945 to 1950 earnings per share (EPS) grew at a huge rate of 16.6% above inflation. But that was the post-World War II boom, when America was the only industrial power left standing. It was a historical outlier.

The second best five year period was 1960 to 1965, when EPS growth beat inflation by 8.3% a year. Third best was 1990 to 1995, at 6.8% a year, followed by 5.4% in the five years to 2000. In the past five years it’s been a miserable 0.7% a year.

Let’s see what EPS growth would be needed to keep the S&P 500 at its current level, let alone heading further upwards. Over five years, let’s say P/E falls to 60% of the current level, from 25.3 today to close to its long run median of 14.6. Back at the median valuation level the index would be set up for decent future returns, unlike today.

If the index level was to hold up in this scenario, trading flat over five years, EPS would need to grow by 67%. With compounding, that works out as total EPS growth of 10.8% a year for five years. Taking away, say, 2% average inflation leaves 8.8% real EPS growth.

That would make it the second best five year period for real EPS growth in the history of US stocks. Second only to the post-war boom. And it still wouldn’t result in any price gains due to the falling P/E multiple. Just a dividend yield of around 2% a year (before tax).

Does that fast EPS growth sound likely, given what we know about the state of the world today? Given the state of Europe and Japan? Given that around third of S&P 500 revenues come from outside the US? Given the US’s own problems? I don’t think so.

It’s all a bit of a mystery really. Why are investors hanging in there? It seems like a triumph of optimism over realism.

It’s all a bit of a mystery really. Why are investors hanging in there? It seems like a triumph of optimism over realism.

There’s an argument that stock investors should accept lower returns because bond yields are so low. A 10 year US treasury bond yields just 1.56%.

But given the best outcome for US stocks is barely above that level, and the worst outcome is pretty terrible, why are people taking the risk? There’s little prospect of big profits, but plenty of chances to lose money.

In any case, US treasuries also aren’t worth owning with such pathetic yields. Just because stocks, possibly, could return more than bonds doesn’t make them attractive in absolute terms.

And then consider this: US corporate debts have gone through the roof, at least in relation to profits. Low interest rates have encouraged an orgy of borrowing. It’s all more of the same that got us into this mess in the first place. Debt piled on top of debt.

Unfortunately little of the borrowed money appears to have been invested in growing the businesses, judging by virtually non-existent profit growth in recent years. Instead much of it’s been wasted on stock buybacks, and probably some overpriced acquisitions as well. (For more see: The S&P 500 is being looted by management.)

Below is a chart which compares debts of S&P 500 companies, excluding banks and other financial companies, to a measure of profit called “EBITDA”. That stands for “earnings before interest, taxation, depreciation or amortisation”, which is a bit of a mouthful. But basically it’s something close to pre-tax cash profits.


As you can see, debts have gone ballistic in relation to profits in recent years, hitting record highs. But, many will argue, that doesn’t matter because interest rates are so low. In other words interest costs are still low, even though debts are higher.

Of course that’s right. But how do we know interest rates will always stay low? Just when everyone gets used to a “new normal” is usually when some surprise comes along to upset the apple cart. Who’s to say that inflation isn’t about to jump, meaning rates will have to rise?

In any case, more debt means more financial risk. It all has to be paid back one day.

Here’s a chart which I came across a number of years ago. It shows how companies’ interest costs went ballistic the last time interest rates were on the rise, between the mid ‘60s and mid ‘80s.


At that time companies went from paying 10% of profit as interest charges to over 50%. If there was a big economic boom – which is what’s needed to justify high US stock prices – wouldn’t there also be price inflation? Wouldn’t rates rise?

Wouldn’t over indebted corporations suddenly have to pay more interest when they rolled over their debts? Wouldn’t that kill bottom line profits, even though top line sales were growing rapidly due to the boom?

Given all this, it’s really difficult to see a scenario where US stocks, taken as a whole, make sense for investors at their currently high valuations. As long as they continue to defy gravity and logic I recommend that you stay away from this market. Or at least make sure that you are really selective.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.