"[I’m] not loving it …I have problems with earnings growth [and] problems with multiples, …So I can't really call myself a bull "
- David Tepper, 9/10/15
Earlier today David Tepper made headlines (HERE) in advocating for higher cash allocations and defensive positioning amidst increasingly challenged fundamentals, concerns over current multiples and pervasive over-optimism around forward growth prospects.
Having authored the 2015 Global #GrowthSlowing thesis, we’d agree.
Tepper’s fundamental and valuation concerns are really just manifestations of our current late-cycle reality. Given that his comments were largely a re-capitulation of our call from July and our 2Q15 Macro theme #LateCycleUSA (Here), today offers an opportune time to update the charts and re-highlight a selection of canonical late-cycle metrics.
Below is a visual tour of the data. The larger fundamental takeaway is not different than the one we’ve been voicing YTD. Slower for longer remains the call, lower gross and net equity exposure continues to make sense and dynamically trading the risk of the immediate-term range remains the best means of tactically risk managing late-cycle market volatility.
Labor: Best Before the Crest | The employment data always looks best before the crest and the current labor cycle is certainly cresting. As we highlighted in our review of initial jobless claims this morning we are now 19-months into the sub-330K environment (ave over the last 3 cycles = 33months) and within ~a month the year-over-year rate of change will be ~0% as we beginning lapping the floor in the claims data.
With the convergence to zero complete, any trending positive growth in claims activity will offer a low-intensity means of monitoring deterioration in the labor market. There is still some modest runway for ongoing labor strength but the clock tick is getting louder.
Valuation: Stocks Still Hoping It’s the 1990’s | The simple fact that we’re not at peak tech-bubble valuation is not particularly sweet solace.
Below is an updated look at our valuation composite which represents an equal weighted composite of three of the most widely used conventional valuation metrics: Shiller PE, SPX Market Cap-to-GDP and Tobin’s Q.
- Shiller PE: Inclusive of the hundred’s of billions of market cap lost in the recent correction, the Shiller PE remains above 24x and sits just south of the top decile of its historical range. Mapping the Shiller PE by decile vs subsequent market performance suggests return expectations should move systematically lower alongside incremental increases in valuation. Historically, 1Y and 3Y returns progressively decline for each decile change in the Shiller PE.
- Tobin’s Q: Longer-term valuation arguments center on the premise that returns on capital should equalize to cost of capital and market values should normalize to economic value. Tobin’s Q ratio is not a measure we use to tactically manage risk, but we can appreciate the intuition underneath its application – why buy an asset when you can “re-create” it for less and compete away existing, excess profit. Currently, the q-ratio sits at ~1.06 and greater than 1.0 standard deviation above the long-term mean value – a level that has generally not been a harbinger of positive forward returns historically.
- S&P 500 Market Cap-to-GDP: Assuming the collective output of SPX constituents credibly reflects aggregate national production (or serves as a credible proxy for it), the Market Capitalization-to-GDP ratio effectively represents a price-to-sales multiple for the economy. At current levels we are well above both the LT average and the 2007 highs.
PEAK PROFITABILITY: Earnings, Corporate Margins and collective SPX profitability all peak late-cycle and all three appear to be moving past peak in recent quarters. Unless you think peak returns to capital provide a sustainable path to aggregate demand growth in the face of negative trend growth in real earnings, trough returns to labor, middling productivity growth and secularly depressed investment spending, then the mean reversion risk for operating margins remains asymmetrically to the downside.
- 2Q15: With 2Q earning largely rearview for SPX constituents, the final score shows revenues and earnings down -3.5% and -2.2% year-over-year, respectively. Yes, the commodity rout was an outsized impact to energy/industrial’s profitability and that collapse becomes next year’s comp but still, negative top & bottom line growth is not the stuff escape velocity, private-sector handoffs are made of or multi-year tightening cycles anchored on.
Policy = Lost in Transmission | The Phillips Curve and output-inflation cycle on which conventional monetary policy is based looks broken. Meanwhile, the empirics on Janet’s hope for policy flow through to Main Street remain dismal. Labor’s Share of National Income only rises at the tail end of an expansion and after growth and profits have been strong for a protracted period. The cratering in the latest cycle looks like some measure of a structural break and even if we follow the pattern of gains in the late innings of expansion it won’t close the gap. Lower highs & lower lows remains the trend.
Slower for Longer: Underneath the current business cycle oscillation remain the secular realities of over-indebtedness and negative demographics. The combination of voluntary and involuntary deleveraging in the post-crisis period has improved the aggregate household balance sheet, but certainly not enough to jumpstart another credit cycle or drive sustained debt supported consumption growth. And while the Millennials sit as an emergent demographic force, the core consumption demographic of 35-34 year-olds will remain in retreat for the balance of the decade – across all the major DM economies.
Christian B. Drake