Is a big earnings season priced into stocks?

Stocktake: Howard Marks warns market is getting bubbly with ‘elevated complacency’

Facebook shares soared after the firm trounced expectations, and stock indices in general have risen since earnings season began

Facebook shares soared after the firm trounced expectations, and stock indices in general have risen since earnings season began

 

US earnings season has got off to a fine start, with the vast majority of companies beating estimates, but much of the good news may already be priced into stocks.

Earnings season is often referred to as cheating season, and with good reason – companies deliberately issue cautious guidance, then beat artificially lowered estimates. Consequently, almost two-thirds usually beat estimates.

This quarter, however, looks genuinely impressive. So far, three-quarters of companies are beating forecasts. Importantly, 77 per cent are beating on revenues, which are harder to game via accounting tricks. On average, about half of companies ordinarily surpass sales estimates, and the current season is on track to mark the highest percentage since financial research firm Factset began tracking the data in 2008.

Last week, Facebook shares soared after the firm trounced expectations, and stock indices in general have risen since earnings season began. However, investors don’t actually seem excited by the results. On average, says CFRA Research, companies beating both earnings and revenue estimates are rising by just 0.2 per cent; those missing on both fronts are falling by 4.9 per cent.

Stocks have rallied hard over the past year and now trade on 17.8 times estimated earnings, well above their five- and 10-year averages (15.4 and 14.0 respectively). Clearly, much of the good earnings news is already priced in.

Markets getting bubbly, warns Oaktree’s Marks

Billionaire investor Howard Marks famously warned that stocks were headed for trouble prior to the technology crash in 2000 and the global financial bust in 2007. Now, he’s increasingly worried things are once again getting bubbly.

Marks is the founder of Oaktree Capital, a so-called vulture fund which has attracted controversy in Ireland due to its property investments. However, he is very influential and well-regarded in the US – Warren Buffett is a big admirer – and his latest 22-page client letter is making waves in investment circles.

Marks is concerned on multiple levels, pointing to “some of the highest equity valuations in history”; elevated complacency; the “elevation of a can’t-lose group of stocks” (technology giants such as Facebook, Amazon, Apple, Netflix and Google, the FAANGs); the “lowest yields in history on low-rated bonds and loans”; record private equity fundraising; and billions invested in soaring cryptocurrencies.

These and other factors indicate today’s market temperatures are “elevated”. This is “not a nonsensical bubble – just high and therefore risky”.

Marks is cautious rather than bearish and admits his warning is likely to be premature. Overall, however, “I think it’s better to turn cautious too soon rather than wait until it’s too late.”

Bitcoin: a bubble or a fledgling currency?

Like most value investors, Marks has no time for digital currencies such as bitcoin – an “unfounded fad” or even a pyramid scheme, he says, little different to the tulip mania of 1637, the 1720 South Sea bubble or the 1999 dotcom bubble. A new Merrill Lynch report is less damning, but nevertheless warns bitcoin faces three big obstacles if it is to become a reserve currency.

There’s the problem of safety – hacking, identity theft and scams make bitcoin risky. Then there’s volatility, although Merrill is less critical here. Although much more volatile than the euro, yen or gold, bitcoin’s volatility actually twice fell below that of silver – the world’s currency for 400 years – in 2016. Liquidity is tiny compared to other assets, but trading volumes have “skyrocketed” so volatility may diminish over time.

The third and “crucial hurdle” is whether major financial institutions will ever accept cryptocurrencies as collateral.

At the moment, the answer is no. Bitcoin’s status may evolve over time, but for now it remains the plaything of speculators and thrill-seekers.

Diversification makes a comeback

You could be forgiven for wondering if there’s any point in diversifying these days. All over the world, stocks are rising, pullbacks are minor, and there’s no volatility – a trend many attribute to the outsized role played by central banks in today’s markets.

Appearances can be deceptive, however. Movements in international stock markets are now less correlated than at any time over the past 20 years, according to Schwab analyst Jeffrey Kleintop.

Globalisation and the impact of the technology and housing bubbles meant that for most of the 2000s, global diversification “all but faded away”, notes Kleintop, with international stocks moving in sync. However, correlations among international markets peaked in 2011, but have since been falling. Today, correlations have fallen to levels unseen since 1997, near the “normal” levels that prevailed through the 1970s, 1980s and for most of the 1990s.

A major event such as a global recession could upend the current trend and cause correlations to spike, but that’s very unlikely at the moment.

Diversification has always been regarded as the only free lunch in finance, offering decreased risk without decreasing returns. Now, it has has “made a comeback”, says Kleintop, and that’s good news for investors.

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