In “Mitigating volatility,” (January, Modern Trader) we discussed how markets adjust to downside volatility and reconcile projected with actual results, examining the “delta” or difference. We learned that an important “adjustment” factor in pricing of markets is the cost of money, as set by the Federal Reserve and arguably at least in part responsible for the recent increases in volatility. All of this against a backdrop of slower growth.
But, what is “slow growth”? Well, if a simple average aggregate of world economies usually churns along at 3% to 4% annual growth, then slow growth could be represented by the current U.S. rate of 2% (or less). The Western world has been in a sustained period of slow growth since the 2008 credit crisis, and Japan arguably for two decades. We are trending toward — if not already in — a slow growth environment as documented by numerous domestic and international metrics. Traders need to ask: Where might there be opportunities in this environment?
Previous predictions on the change in principal value of fixed-income-related assets as a result of the impending rise in interest rates have yielded estimates in a range of 10% to 30% decline. That is arguably already “baked into” market prices, despite the Federal Reserve’s tepid and delayed move of a quarter-point increase in the discount rate. While minor, the move into a tightening environment — however methodical it plays out — is a significant one.
So, why are markets roiling? Why is there more downside pressure at a time when the economy is recovering pretty well and things are looking better? Answers may include one-time events such as the juggernaut in China’s markets with the hamstringing of regulatory remedies that have resulted in uneven and unintended consequences. Also, the continued pain in the energy sector where Iran is facing off with Saudi Arabia and many U.S. high-cost producers are under water with excesses driving down fuel prices to levels unseen in a decade or more. And the ongoing and increasing conflicts in the Middle East that continue to cost more in opportunity and resources.
Extracting all of these immediate “worldly conditions” from the equation, perhaps we could look at what might be a “reasonable” valuation for markets in a slow-growth environment? What Price/Earnings ratios (P/Es) might be deemed justifiable?
Price/Earnings ratio = Company’s stock price ÷ company’s earnings
A reasonable place to start is defining what P/Es run under “normal” growth conditions. They typically range from 12 to 22. When determining if the market is nearing a bubble, this range can be used as a measure of “normalcy” with regard to P/Es. The numbers are derived from the Value Line 1700 — or group of 1700 stocks – as published by their Survey. In the good old days of normal growth, typical P/Es would include figures in the 30s for growth /tech stocks – as much as 50% higher than the averages. And, high-flying Internet stocks — anywhere from there and up — including cases like Amazon that took years to turn a profit.
But, high-flying Internet stocks, while making up a focus for growth, individually are not meaningful from the perspective of looking at large groups of aggregated stocks because they make up a relatively small – although rapidly increasing — percentage of the group. So, anything above a P/E of 30 could be considered at best in the anticipating-high-growth category and at worst overvalued.
The market’s recent post-2008-crisis rally left the S&P 500 at or near an all-time high in regard to P/Es: 19.73 as of Jan. 21, 2016; around the higher end of its practical range. In other words, for every dollar in stock price, companies earned a nickel. By no means is the market way overvalued or in bubble range. In May 2009 the P/E on the S&P 500 reached 124 – in part because the stoppage of economic activity had widely and temporarily constrained earnings (see “Now there’s a bubble,” below).
So P/Es ranging from 12 to 22 are a decent benchmark for normal growth conditions. Now, superimpose the slow growth condition. What does this mean? It means that companies will be earning less because people are buying less. And, that has a negative impact on earnings. Companies are adjusting for this condition with stock buy-backs — that shrink the pool of shares that are used to calculate earnings, thereby inflating the impact of lower earnings — and “purchasing” growth by increasing the top (and bottom) line through acquisition. These kinds of activities help to mask but do not eliminate the impact of slow growth.
Perhaps a better way to illustrate the point is that owning stocks represents ownership in actual assets, whether or not those assets create earnings. For example, mineral resources in the ground might represent an asset that does not produce earnings until they are extracted and sold – but, nonetheless represent some form of value prior to extraction.
What do we find when we take the current conditions of normal growth and remodel it for conditions with slow growth? The slow-growth environment may demand lower stock prices to correspond to lower earnings. This, perhaps, is why markets are still adjusting and may continue to adjust on the down-side after the impact of rate changes, world events and all else are discounted.
So, as P/Es are trending toward the higher range of adjusted historical averages, there’s room for their adjustment down environment of and corresponding stock prices, as well environment of as the new reality of the slow-growth environment persists.
An alternate scenario could emerge that includes earnings declining along with stock prices so that P/Es could remain at a more constant level or even go up – contributing to a less clear view of corporate health as high P/Es typically indicate more fully-priced stocks and higher growth (see “P/E dilemma,” below). This could lead to a false read as both earnings and stock prices could suffer simultaneously. As earnings have remained intact, cost-cutting, share buy-backs and acquisitions could reduce P/Es as more-widely expected or, with earnings deterioration, be contributing to a new normalization of higher P/Es in a slow-growth environment.
Once you define the parameters for a slow growth environment, you need to adjust what constitutes normal P/E ranges, and once you do that, you will discover over-priced issues that provide opportunities to short.