Bulls undermined by shrinking margins


Serious Money:Even the most casual observer of recent financial market behaviour can come to only one conclusion: return-chasing is back in vogue, and, as always, it’s joined at the hip with a general disrespect for risk that, historically, has proved damaging to legions of savers, who have postponed current consumption in the hope of more spending power later.

The bulls are back in charge for now, but their newfound optimism appears to be predicated on hope and not grounded on fact, as growth continues to disappoint. Can the major stock market averages truly be relied upon to defy reality indefinitely?

The upward move in stock prices that began last November has pushed the major market averages to within touching distance of all-time highs. The virtually uninterrupted advance has been accompanied by a surge in bullish sentiment that has seen a number of notable bears change sides or soften their usual negative tone.

Much of the positive investment commentary appears to stem from the behaviour of equity prices themselves, and even former Federal Reserve Board chairman Alan Greenspan recently noted that “the stock market is the key player in the game of economic growth”.

It is undoubtedly true that stock prices are an important leading indicator of economic activity, but little – if any – of the gains of more than 20 per cent in equity prices since last summer can be traced to an improvement in growth expectations. In fact, the rise in the valuation multiples that investors are willing to pay for stocks can be better explained by unconventional monetary policy and the associated increase in inflation expectations.

Simply put, 10-year inflation expectations have jumped by more than half a percentage point over the past year. The reduced deflation risk has allowed the equity risk premium to fall.

Stock prices also received a welcome boost last July following the declaration by ECB president Mario Draghi that the monetary policymaker was “ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Central bankers have successfully contained potentially-destructive tail risks, which allowed the appetite for risk assets to return, but the growth outlook remains challenging.

The economic contraction afflicting the euro zone deepened during the fourth quarter of last year, while economic momentum slowed to a standstill in the US over the same three-month period. Not surprisingly, the corporate sector is finding the lacklustre growth environment difficult to navigate.

The most surprising aspect of this particular growth cycle has been the robust performance demonstrated by the corporate sector. Earnings-per-share dropped almost 60 per cent on an operating basis between the summer of 2007 and the autumn of 2009, and more than 90 per cent on a reported basis – ie after exceptional and extraordinary items.

The corporate sector’s troubles proved temporary, however, as concerted management effort to control variable costs allowed corporate profits to exceed their pre-recession peak just two years later, despite relatively tepid top-line growth. All told, profit margins and returns on equity soared to record levels.

It appears to have gone unnoticed, however, that corporate America has been struggling to produce further increases in profitability for some time. Quarterly earnings on an operating basis have stagnated at roughly $24 to $25 a share since the summer of 2011, and look set to register the second consecutive year-on-year decline during the current reporting season.

Margins are declining in virtually every sector, and have dropped by a cumulative 125 basis points (1.25 percentage points) since the autumn of 2011. Costs have already been trimmed to the bone, which means that margin compression is virtually inevitable without robust top-line growth.

Viewed in this light, it comes as no surprise that management guidance has been more negative than usual during the current reporting season.

This growth cycle has pushed earnings numbers to levels more than 30 per cent above their long-term trend – a level that has rarely been exceeded over the past half century, and has typically been followed by poor growth outcomes in subsequent years. It seems unreasonable to conclude that the profit boom will continue without a quick return to robust growth.

The bulls are back in town, and falling risk premiums have pushed valuation mul- tiples into nosebleed territory once again, while the outlook for corporate profitability leaves little room for complacency.

As renowned value investor Benjamin Graham warns: “Even the intelligent investor is likely to need considerable will- power to keep from following the crowd.”