I was on the Gold Coast earlier this week presenting at the Australian Investor Association Conference and the most frequently asked question I got was, “what do you think of US equities?”
Clearly, SMSF investors are interested in what comes next for Wall St and, of course, it’s a very important question when US equities account for around 50% of world equity indices and the US economy remains the largest in the world.
As you know, I continue to believe most SMSF investors are under-exposed to large cap US equities, but particularly the dominant tech “M.A.F.I.A”.
TWIN MILESTONES: THE SECOND LONGEST AND MOST HATED BULL MARKET
In April this year, the US equity bull market achieved a significant milestone by becoming the second longest in history. The current cycle is now 2,713 days old, and only the dot.com bull market, which lasted 3,452 days, is longer.
The old adage dictates bull markets climb the walls of worry and this one is no exception. Since March 2009, US equities have endured countless growth and recession scares. In addition, other worries include: a QE-ending taper tantrum, the US budget fiscal cliff, a possible EU break-up, a Chinese equity meltdown and never-ending Japanese deflation. More recently, a bear market in oil and commodities and Brexit have failed to end the bull run.
The heightened volatility over the last two years has resulted in three US equity market corrections of -10%. But each time, equities have rebounded in a dramatic V-shaped recovery to regularly defy calls for the start of a bear market. While the dot.com boom was marked by investor euphoria, the current bull market has often been viewed with a combination of fear, derision and cynicism.
This chronic scepticism, which has consistently infected investor sentiment, must surely brand the current US equity bull market, the most hated, as well as the second longest, of all time.
THE DEBATE: BULLS vs. BEARS
As the chart below reveals, the bulls see increased earnings driven by cost cutting and productivity gains as the main drivers of the S&P’s 210% rise since March 2009. Indeed, S&P earnings have nearly doubled from $US62 in 2009 to expectations of $US118 for C16. Assuming the C17 forecast of $US128 per share, US earnings have more doubled since the GFC.
In contrast, the bears point to the massive liquidity injection by central banks as being the primary driver of equities. In the current cycle, S&P earnings have consistently grown at double the pace of GDP growth. The bears believe this anomaly has been supported by QE, which has stimulated asset price inflation, and ZIRP, which has encouraged massive share buybacks.
THE CONUNDRUM: WEAK ECONOMIC GROWTH AND STRONG EQUITY PERFORMANCE
The weak, sub-trend US growth in the aftermath of the GFC has followed a similar path to recoveries from recessions driven by a credit crisis. Despite 1.5% to 2% average growth, US corporate profits have consistently grown at more than double (4-5%) the pace of GDP growth. Intuitively, this trend would appear unsustainable over the long term without a recovery in sales revenue and a pickup in economic growth.
To be sure, an aggressive cost-cutting cycle, declining wage growth and online productivity gains have acted to mitigate weak sales growth. The confirmation is US profit margins, which, as a percentage of GDP, remain at all-time highs. It’s worth noting, however, that corporate profit margins have been static since 2014.
So, with a peak in margins combined with the dramatic fall in the oil price and a higher US dollar, it’s not surprising that 2Q 16 (currently -3.5%) will mark the 5th consecutive decline in S&P quarterly earnings. The last time this occurred was in the GFC. It’s clear the juxtaposition of declining earnings and weak growth has led to the recent increase in volatility and increased investor scepticism over the longevity of the cycle.
EARNINGS DOWNGRADES: DEVA JU ALL OVER AGAIN?
According to FactSet, the S&P 12 month forward PE is currently 17.1x. This represents a 14.7% premium to the 25-year average of 14.9x. While valuations are high by historic standards, the PE premium should be viewed through a prism of a 1.5% US 10-year Treasury and the Fed’s recently downgraded long-term inflation forecasts. In such an economic climate, history shows that equity bull markets can sustain higher PE multiples.
As the US reporting season winds down, earnings have been downgraded yet again. As at December 31 last year, analysts expected S&P CY 16 earnings growth of +5.9%. By March 31, the forecast had fallen to +1.3%. Currently, analysts expect CY16 earnings to actually decline by -0.3%. If realised, this will mark the first consecutive CY earnings declines since 2008 and 2009.
If forward forecasts are to be believed, the long-awaited earnings recovery will occur in 4Q 16 (+5.7%) due to the cycling effects of a lower oil price and a higher US dollar. In addition, C17 (+ 8.5%) is expected to see a dramatic rebound. Certainly, the economic data appears supportive, particularly employment.
As investors await the recovery, PE expansion rather than earnings, continues to support further price gains and scepticism remains.
EQUITY OWNERSHIP: HIDDEN DEMAND?
Set against the conundrum of rising equity prices and falling earnings, there are positives. Bull markets invariably end on over-valuation and over-ownership. Although valuations are currently elevated, equity ownership is actually falling. According to Fundstrat Global Advisor data, since 2007 investors have slashed equity holdings by over $US2 trillion.
The last time such an event occurred was 1979 when Forbes ran the story, “ The Death of Equities.” Subsequently, US equities rallied 400% through the decade of the 1990s.
As the chart below shows, unlike the euphoric lead up to the dot com crash, this bull cycle has been characterised by pessimism and equity outflows. While taxi drivers remain fearful, FOMO is a big driver of equity demand and potential price gains.
SHARE BUYBACKS: DECLINING SUPPLY?
The other potential positive for US equities is share buybacks. Factset reports that US companies have repurchased approx $US2.95 trillion shares since March 2009. In fact, share buybacks have outstripped traditional demand every year since 2010. This year, US companies are expected to repurchase $US450b in equities. Once again, this will represent the largest share of US domestic equity demand.
Share buybacks are a two-edged sword. Apple is the prime example, purchasing 760m shares from September 2013 to the end December 2015 reducing the outstanding shares on issue by 12.5%. Sadly, with an average price of $US115 per share, the massive repurchase plan has failed to halt the share price slide.
The bears will argue that although effective at raising earnings per share, the downside is that PEs would be significantly more expensive without share repurchases. The upside is share buybacks are acting to reduce equity issuance, which, in turn, improves the demand/supply fundamentals for equities. Coupled with low levels of retail share ownership, this provides a potentially explosive backdrop for US equities once the taxi driver starts recommending shares to his customers.
US EQUITIES: AN END OR A NEW BEGINNING?
In July, the S&P broke upwards despite much scepticism and technical resistance to post a new record high. It appears the bull lives on. Significantly, this followed 14 months of static trading and one of the longest bull market periods without making a new all-time high. Importantly, such an event has occurred just three times in post WW2 bull markets. On each occasion, the equity market has averaged a +22% gain in the subsequent 12 months.
Meanwhile, there is no shortage of risks both real and imagined. Are record low bond yields signaling a US/global recession and an end to the seven-year bull cycle? Or will US economic growth rebound, and the forecast recovery in earnings provide the next leg up for US equities and the bull market? Time will tell, but this bull refuses to die.
Sir John Templeton famously said, “Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria.” Certainly, pessimism and scepticism are commonplace. And while there are a few signs of optimism, it’s clear that euphoria is nowhere to be seen. Maybe this bull is still young?
I remain of the view that large cap US technology companies are compelling investments and if the US equity bull market continues, which I think it will, they will lead it to fresh highs.
You all use Microsoft, Alphabet (Google), Facebook, IBM and Amazon, but do you own any of their shares?
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
