Crisis averted -- for now, at least. Our analysis from the end of March suggested that combining a generationally high price-to-book value ratio (P/B) for the median U.S. stock with uncharacteristically high cuts in analysts' earnings estimates at that time was a possible recipe for disaster.
Investors in Canadian stocks are accustomed to dramatic cuts in earnings estimates. This is due in large part to the cyclical nature of the earnings for several prominent Canadian industries. For instance, for much of 2012, 2013 and to date in 2015, earnings estimate revisions breached -10% per quarter. This is nothing new for Canadian investors, although it's certainly one reason that American stocks consistently garner higher P/B ratios than do Canadian stocks.
However, for investors in U.S. equities, dealing with estimate revisions worse than -6% may bring on the type of shock that an A+ high-school student experiences upon getting back his/her first university paper … and receiving a D.
That's why the first-quarter earnings revisions in the U.S. -- down 8% -- set off alarm bells for investors. The last time U.S. earnings estimates were cut at a pace greater than 7% in any quarter was in 2009 in the aftermath of the global financial crisis. Fortunately, the earnings-revision picture has improved. By the end of June, revisions have eased to -3.8%, which is well within normal territory.
So off again to the races then? Well, there hasn't been much, if any, racing to be had thus far in 2015, unless one considers currency gains for those who may be converting their U.S. holdings back to Canadian dollars. Some seem distracted while trying to determine when a long-expected Federal Reserve interest-rate hike will finally materialize. Others seem to think that a market that has hit new highs so frequently must surely come back down again. Headlines such as "three years since the last 10% market pullback" and "bull market enters seventh year" help perpetuate that belief.
It will never be the mandate of Morningstar CPMS-derived analysis to declare that because the average bull market lasts X number of months and the current bull market is two weeks older than this average, it must surely be time to sell everything. Yes, valuations are more expensive now than they have been in 25 years, save for the technology bubble in the late 1990s. However, since the return on equity (ROE) on the median stock net of the risk-free rate is also sky-high, the market appears fully valued but not overvalued.
Even with estimate revisions back to normal, there is one key remaining indicator that bears a lot of scrutiny. The catalyst that fuels ROE is earnings growth. Over the past 25 years, U.S. stocks collectively have demonstrated a remarkable ability to generate impressive earnings growth, quarter after quarter, for several years running. Outside of the 2001-02 recession and the 2008-09 financial crisis, median U.S. corporate-earnings growth has been north of 6% in every quarter. This value is frequently in double digits.
Perhaps ominously, this 6% level has now been breached slightly as of the first quarter. Worse, if all analysts' estimate consensus values for the second quarter are realized, this reported earnings growth will recede to 3.1%. Even if positive earnings surprises materialize for many stocks, as they almost always do, earnings growth will be at best 4% to 5%. Not a disaster quite yet, but the arrow is pointing down and that's not good.
The U.S. equity market simply cannot withstand flat or declining earnings from many of its constituents, especially at the current median P/B valuation of 2.65 times. Even if we ignore the 2008-09 meltdown on the grounds that it was brought on by other excesses, we cannot breeze past the fundamentals of 2001-02.
In that period, median U.S. earnings growth went negative for just a nine-month period and valuations were far less pricey than they are today, yet the S&P 500 and NASDAQ indexes both suffered double-digit losses in 2001 and 2002. (Incidentally, reported earnings growth was already negative at the time of the September 2001 terrorist attacks in the U.S.).
As with the Canadian equity market but for different reasons, corporate earnings growth is the most critical factor that demands monitoring in U.S. equity markets in coming quarters. Upside in equity prices continues to be limited at these valuations as the risk of significant downside builds.
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