Stocks: Rally On For Now

The stock market rally continued Thursday. It feels like a big correction is happening because every index isn’t hitting new all-time highs (only the Dow hit a new high). Making up for this, Bitcoin is hitting a new all-time high. There was a CNBC article today explaining how this may be bullish for stocks. Anything can be construed as bullish for stocks, but correlation doesn’t equal causation. In fact, as the article states, equities and Bitcoin aren’t even correlated. I think Bitcoin’s price is likely to move higher over time if the U.S. continues to incur debt it can’t pay for. The other trend pushing the currency higher is it is inherently deflationary. Bitcoin’s advancement which allows for trustless transactions is one of the biggest advancements in our lifetimes. The point I’m getting at is bitcoin rallying is neither a good nor a bad sign for the stock market. Even gold has rallied along with equities. Looking a tea leaves isn’t going to help you predict where stocks are going.

This type of analyzation of meaningless factors is what happens when investors feel the economy and valuations aren’t effecting stocks; they try to grasp at various irrelevant indicators to make sense of the irrational moves in stocks. The most irrational stock in the market, Tesla, reported an earnings miss, negative $1 billion in cash flow, and its CFO resigned. After hours the stock rallied, but now it is falling. You can try to make sense of the senseless, but I think it’s better to watch instead of participate in irrational trading. The question investors looking at the whole market are wondering is when sanity will come back in style.

As you may have gleaned from other posts, I don’t think that will happen in the next few months. The chart below counters the premise that stock won’t correct. It shows the historical stock performance before and after inauguration day. In periods where stocks were up more than 2% in the month after the inauguration, stocks have usually fallen in the next month. Keep in mind, global central banks weren’t buying stocks in 1909 after Taft’s inauguration. That was even before the Fed existed.

The debate between the bulls and the bears has lately become focused on earnings. More specifically the difference in opinion centers on the difference between the trailing 12 month earnings multiple and the forward 12 month earnings multiple. Stocks are expensive based on trailing estimates. As you can see below, the trailing 12 month earnings are at Q4 2011 levels. The stock market is up 88% since then which means stock multiples have expanded. The buybacks, seen in the light blue bars, are partially responsible for stocks rallying. However, buybacks have recently slowed, but stocks have still skyrocketed. The main point made by bears is that trailing earnings are real results while future estimates may be too optimistic.

Not surprisingly, the bears are using the worst metrics to prove their negativity. The bulls point to charts which show forward earnings multiples. The market is always looking at the future, so the bulls make the point that the forward PE is more important than the trailing one. As you can see in the chart below, the forward PE is only slightly above the 20-year average. It’s true that stocks were expensive during that stretch of time, so it may not be a great indicator. However, 17.6 is above average, but not a signal of a bubble, no matter what which period you look at.

The counterpoint bears make to this is they say historically in this recovery estimates haven’t been met. Estimates have generally fallen during quarters even if you look at long term charts. However, the deficit is more important now because there’s a difference between estimates for growth coming in lower than expected and the contractions we’ve seen recently. As you can see from the chart below, there’s a 36.5% earnings deficit from the original estimates in June 2014. Trailing earnings still haven’t met the peak in 2014.

However, just because past estimates haven’t been met doesn’t guarantee that the future results shown in the chart below won’t be reached. The market is only trading at 16 times 2018 earnings. Those earnings estimates are pure guesses, but if Trump cuts the corporate tax rate causing firms to pay 5% lower effective tax rates, they can be met. Plus, the repatriated money from overseas will go to buybacks which will inflate earnings per share. I would rather buy stocks because investments being made to grow earnings pan out, but buyback-inflated earnings are better than earnings declines. I’d also rather buy stocks when margins are low and improving instead of near the peak like they’re at now.

I recognize, that while stocks are expensive, they aren’t going to get less expensive because I decide they are too high. There’s nothing new about that fact that the Shiller PE is at 29.29. The market will need a catalyst to correct these expensive valuations. I don’t see how the latest accelerated growth rate in earnings will bring it lower. There needs to be earnings disappointments which is why I’ve focused on the possibility that earnings could fall if oil crashes. Currently the glut in gasoline is the largest in 27 years. The chart below shows gasoline stocks have consistently been above the 5 year average this year.

Conclusion

In the beginning of the article I’ve mentioned how the financial press focuses on the price of bitcoin and gold to try to predict future stock prices because valuations and economic growth haven’t mattered. Fed policy hasn’t mattered much lately either. As a bear, I recognize that stocks are rallying because money managers are chasing performance. They can’t make a stand against stocks because of high valuations because they will be steamrolled and lose their jobs. Therefore, there aren’t many bears left. The accelerated earnings growth in Q4 isn’t going to stop this rally. The oil glut causing a crash in the price of the commodity may give the bears a better argument which is why I focus on it so often.

---

Don Kaufman: Trade small and Live to trade another day at Theotrade.