Comstock Partners, Inc.April 11, 2013
Blind Faith In The Fed Is Not Enough
The move of the S&P 500 into new all-time highs is based on neither the economy, nor earnings, nor value, but almost completely on the blind faith that the Fed can single-handedly flood the market with enough funds to keep the illusion going. In this sense the similarity of the current stock market to the dot-com bubble of the late 1990s or the housing bubble ending in 2007 is glaring.
Although first quarter GDP growth looks as if it could come in at 3%-to-3.5%, the economy was clearly losing steam in March. The NFIB small business survey slipped in March, and is just two points above its lowest point of the past year and three points lower than a year ago. The breakdown indicated lower sales, weak expectations and historically low plans to hire. March payroll employment dropped sharply to only 88,000 while the ISM manufacturing index declined to its lowest level since August with drops in new orders, employment and export orders. The March ISM non-manufacturing index declined to 51.3 from 54.2 a month earlier, the lowest point since December.
Real consumer spending has been growing at a mediocre 2% rate over the past year despite growth of only 0.9% in real disposable income over the same period. This was accomplished mainly by decreasing the savings rate to only 2.6% in February, compared to rates of 7%-to-11% in more prosperous times. With employment growth diminishing and the negative effects of the January tax increases and the sequester yet to kick in, consumer spending is likely to slow markedly in the period ahead. While March year-over-year comparisons may benefit from an earlier Easter, the reverse will probably be true in April. Keep in mind, too, our over-riding theme that consumers, still burdened with most of the debt built up in the housing boom, are in no shape to jump-start their spending.
Investors have also apparently forgotten the January tax increases and the sequester. The combination is likely to reduce GDP growth by 1.75%. First quarter GDP would have to grow 3.6% just to maintain the 2% trajectory of the past two years. Subtracting 1.75% from the 2% leaves very little room for growth.
Corporate earnings, too, are no longer behind the rise in the market. S&P 500 operating earnings were up only 0.4% in 2012 with the third and fourth quarters down from a year-earlier. The consensus is looking for a 15% rise in 2013 earnings, a number we regard as highly unrealistic given the substantial headwinds facing the economy. We note that year-ahead earnings forecasts have historically been extremely inaccurate, and have usually erred by being too optimistic.
In addition the market is actually substantially overvalued. Those who believe that the market is either undervalued or reasonably valued use year-ahead estimates of operating earnings. In our view this method of valuation is flawed. As we stated above, the estimates are usually wrong, and mostly on the high side. Furthermore, the use of operating earnings is not compatible with generally accepted accounting principles (GAAP). Historically, the use of GAAP earnings always results in significantly higher P/E ratios than operating earnings.
Another distortion occurs as a result of the volatility of earnings over the business cycle. The P/E at peak earnings are almost always lower than the P/E at trough earnings. Therefore the use of P/E ratios at periods of high earnings tends to show misleadingly low P/E ratios. The way to solve this distortion is to smooth earnings over a longer period that includes one or more complete business cycles. Our estimate of smoothed trailing GAAP S&P 500 earnings is about $81, resulting in a P/E ratio of 19.6 at current levels. Other estimates of smoothed earnings by Robert Shiller and Ned Davis result in even higher P/E ratios than ours.In sum, the lack of support from the economy, earnings or valuation leaves the Fed as the only game in town. Although the old adage says “Don’t fight the Fed”, it did pay to fight the Fed in 2001 and 2002 and again from late 2007 to early 2009. In our view, the Fed can only try to offset the tightness coming from the fiscal side, but cannot get the economy growing on a sustainable basis