In a blog published by Yahoo Finance on February 20, Author Sam Ro cited a piece of research by Goldman Sachs US Chief Investment Strategist David Kostin.
“Cognitive dissonance exists in the US stock market,” Goldman Sachs’ David Kostin said. “S&P 500 is up 10% since the election despite negative revisions from sell-side analysts.”
The chief evidence is a chart produced by Factset Research which is shown here.
There are indeed a trove of evidences to build a case for investors’ excessive enthusiasm. Yet the tendency to over estimate S&P 500 earnings in the intermediate time horizon by both top down strategists and bottom up analysts has been firmly established. Over the past several years, after each quarterly earnings report, estimates for future quarterly earnings would invariably be reduced. Surely such well established facts are discounted by the market. Indeed, stocks have risen despite negative revision over the last several years.
Another firm that studies the details of S&P 500 earnings is Zacks Research. In their weekly earnings trend report, analyst Sheraz Mian states, “With 75% of Q4 results already out, the earnings picture continues to be positive and reassuring. Not only is growth on track to reach its highest level in two years, but total earnings are on track to reach a new quarterly record.
Estimates for the current period have started coming down, but they aren’t falling as much as would typically be the case historically.” There goes Mr. Kostin’s “cognitive dissonance”. Stock market is a forward discounting machine. Its current price already reflects investors’ best guess of future level of earnings growth. So, the less negative level of earnings revision in fact represents a positive revision to expected future earnings growth rate. That means earnings revision figure is not a dissonance but a justification for investors’ enthusiasm.
With the recent rise of S&P 500, another valuation milestone was crossed. Indeed, the forward P/E ratio on S&P 500 is now greater than its 5 year, 10 year, 15 year and 20 year historical averages.
It is interesting to note that current forward multiple on S&P 500 is very similar to its level 20 years ago, when another authority of the market pronounced a warning. It was Alan Greenspan with its now infamous question, “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
Adding the two decades of United States experience to the now three decades of experience of Japan, the answer to Mr. Greenspan’s inquiry, it seems, cannot be determined precisely. The gulf between “mere enthusiasm” and “irrational exuberance” is marked with fuzzy and shifting boundaries. Such indeterminacy is not only a function of the market’s complexity, but also due to the interactive nature of the world we live in. Chief among the actors are a couple of silver maned septuagenarians who control our fiscal and monetary policies respectively.
Current S&P 500 level of 2362 is about 52% higher than the last stock market peak of 1549 accomplished in 2007. Yet estimated 2016 earnings per share of 119 is only about 20% higher than the 2006 level. Clearly the abundance of liquidity supplied by a market friendly Federal Reserve was responsible for the heavy lifting. We are now at a point in the economic cycle where core CPI is firmly entrenched at above 2% and unemployment rate by some measure is below the natural rate. The Fed has already raised interest twice and threatens to do it thrice in 2017. As this happens, multiple expansion should turn to contraction and the hope of the market would rest solely on a faster earnings growth rate. Here the news is quite favorable and possibly may even get better. Fourth quarter S&P earnings are on pace to set a record and should grow mid-single digit. The ever-optimistic analysts expect the large cap index to grow earnings over 10% for each of the next two years to $147 per share by 2018. “It could get even better,” as the late-night TV commercial would shout. A new maverick administration has promised a round of corporate tax cut and infrastructure spending. Contrast this with the deliberate and consensus building nature of the Federal Reserve, it is not hard to image a scenario where the earnings are growing faster than expected and the Fed is still running a relatively loose monetary policy. Suddenly, a new race is on toward Y2K.
Here back on planet Earth, bad things can of course happen too. Inflations are rising in the United States, in Europe Zone and in China. It is creeping up even in Japan where they have been fighting disinflation for over three decades. One must wonder if indeed the Fed would deliver its promise of three interest hikes and thus turn liquidity into a hindrance for stocks. Protectionism is on the menu of promises by the new administration. Would such squabbles be the root cause of our next recession? Speculate as the markets do, but in reality, the economy is quite healthy. The earnings trajectory established in the fourth quarter of 2016 should extend into 2017. Coupled with the still ample liquidity, the near-term trajectory of the stock market should continue to be upwardly sloped, albeit very gently.
Are investors enthusiastic? Of course, but not yet over the top.