Ah, how simple was life as an observer of financial markets back in those heady summer days of June and early July. Everyone "knew" that a market correction must be imminent, if for no other good reason than we were long past due for one. The correction did indeed occur, as the S&P 500 Index declined more than 12% between its July peak and Aug. 25. The big question now: Does the upward climb resume or was the summer selloff merely a taste of more dark days ahead?
The median price-to-book-value (P/B) ratio of the 2,160 stocks in the U.S. equities database maintained by Morningstar's CPMS division has drifted down to 2.4 times from 2.6 times pre-correction. While this is the lowest median value for this metric since August 2013, investors in U.S. equities should not be under any illusion that somehow stocks are now relatively inexpensive.
On the positive side, U.S. stocks continue to show high returns on equity (ROE), net of the risk-free rate as measured by the yield on 90-day U.S. Treasury bills. The risk-free rate remained unchanged in September as the Federal Reserve governors once again decided to sit on their collective hands, but it could present a higher hurdle before the end of this year.
The real issue for the U.S. equity market is how long this healthy ROE is sustainable for much of corporate America. While short-term interest rates remain historically low, the earnings growth that is vitally needed to support ROE continues to erode. As I noted back in January, declining earnings growth is a worrisome trend that needs to be monitored. At that time, the median EPS growth in the U.S. equities universe was a robust 10.5%, but it was projected at that time to fall to about 7.5% with the January round of earnings reports.
In each quarter since then, earnings growth has receded by approximately 200 basis points. Following the summer corporate reports, earnings growth now stands at just 4.5%. The mere fact that this figure is positive is good. However, there's cause for concern since normal earnings growth in the U.S. equity market is 9% to 12%. Only twice since 1993 has this indicator breached 6% on the downside. That occurred during the mild recession of 2001-02 and during the 2008-09 financial crisis. In fact, during both of these periods, earnings growth sank well into negative territory over several quarters.
At the risk of over-simplifying the causes of the bear market of 2008-2009, earnings growth was dramatically affected by the seizing up of credit markets. Equity prices had already largely recovered in mid- to late 2009 by the time corporate earnings bottomed out.
While 2000 was a negative year for the Dow, S&P 500 and NASDAQ indexes, median U.S. earnings growth was still clipping along in double digits before receding in the first quarter of 2001. By the end of May 2001, earnings growth fell quickly to zero before bottoming out at -6.5% at the end of that year. This was also the year of the devastating terrorist attacks in the U.S., but earnings had already been deteriorating well before 9-11. Earnings growth did not become positive again until the spring of 2002. Both 2001 and 2002 were also miserable, double-digit losing years for investors in U.S. equities.
Is the U.S. equity market, 2015-16 edition, heading for a similar fate? While earnings growth has been in slow decline rather than suffering a decisive swoon, the eventual landing point may be just as important as the pace of arrival. If overall analysts' estimates for U.S. corporate earnings come true for the October round of earnings reports -- as is likely to be the case -- earnings growth will fall further to just 1.5% at the median.
Can an equity market sporting still lofty valuations avoid a further significant drop in light of this earnings picture? The wild card is the Fed's next move on short-term rates. Entering both the 2001-2002 and 2008-2009 periods of earnings decline, short-term rates hovered in the 4.5% to 6% range when things got messy. By contrast, short-term rates now are zero, so there's essentially zero potential now for ROE to get a boost from lower rates.
If median earnings growth turns negative, which is where it's heading, short-term rates of zero may not be enough to compensate. How much can earnings deteriorate before even sub-basement-level rates don't matter any longer? The risk-averse among us would be well advised to sit on the sidelines to wait for earnings growth to rebound.
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