Waiting (In Vain?) For An Earnings Rebound by Worth Wray, STA Wealth Management

Inside This Edition:

Stocks Reverse Course Post-Brexit…For Now
For What It’s Worth
Weekly Technical Comment
401k Plan Manager
Features Articles & Interviews

Stocks Reverse Course Post-Brexit…For Now

Written By: Luke Patterson
CEO & Chief Investment Officer

As we see the U.S. equity market reverse course from the post-Brexit sell-off and make a renewed attempt to test its all-time highs (2,130.82 close on the S&P 500, which was hit way back on May 21st, 2015.), the question is whether this effort will prove more successful than the others we have seen over the last year. (see chart of S&P 500 below)

Earnings Rebound

The big question here is whether there is any fundamental justification for equity prices sustain their current levels, let alone move higher.

Pretty much every valuation metric for the S&P 500 make the broad stock market seem fairly expensive relative to history – the forward price-to-earnings (P/E) ratio at 18x compares to longer-run average of 15x; on a trailing earning-basis, the P/E ratio of 20x compares to norms of 17x.

This week investors await Friday’s June employment report. The U.S. economy is expected to have added 180,000 jobs in June, up from the shockingly low 38,000 reported for May.

What is difficult to square is the massive rally in the government bond market, which seems to be discounting a troubled future – yet the equity market appears to be pricing in a whole lot of hope.  Can they both be right?

Last week’s divergence of bonds and stocks isn’t healthy.  Bonds are screaming that the world economy is slowing, and shareholders are ignoring the signals. Stocks no longer seem to be about growth, but about the desperate search for safe alternatives to low-yielding bonds.

Since Brexit, the bond driven nature of the stock market has been particularly stark.  Four sectors in the S&P 500 are now higher than they were on the eve of the British vote, and none is a bet on the American economy’s underlying strengths.

The bond market has really taken the show. The 10-year U.S. Treasury note has triggered a net positive return of 8% while the 30-year U.S. Treasury bond is up almost 17% in the third best first-half performance on record.

This past week, for the first time, the entire Swiss government yield curve, out to 2064 maturity, went negative in yield.  The yield on the 10-year Treasury note fell to a record low at one point of 1.38%.

Throughout this entire Brexit saga, another trillion dollars of global government debt went negative in yield, bringing the tally now to $12.7 trillion.  There is another $14.5 trillion between zero and one percent. We are down to just $5.7 trillion between one and 2% and a paltry $2.2 trillion worth yielding over 2%.

Consider that for a second – 36% of global sovereign debt trade below zero and 77% in total less than 1%.

These are signals that the excessive indebtedness is constraining growth and has become even more acute.  A stuck-in-the-mud economic backdrop, and nobody is going to run out and raise their GDP forecasts anywhere based on the poor economic data and heightened political uncertainty in Europe.

It’s deeply troubling to think that nearly eight years after the collapse of Lehman Brothers, the only “solution” apparently available to our continued economic travails is another dose of monetary steroids.

Brexit may have provided a further push, but the underlying causes of the collapse in global interest rates lie far deeper in sluggish productivity growth, declining global growth and the excess in industrial capacity.

For What It’s Worth… Waiting (in Vain?) for an Earnings Rebound

Written By: Worth Wray
Chief Economist & Global Macro Strategist

“Fair was she and young, when in hope began the long journey; faded was she and old, when in disappointment it ended.”

~ Henry Wadsworth Longfellow, Evangeline (an epic American poem published in 1847)


  • While corporate profits staged an impressive recovery in 2009, 2010, and 2011, the vast majority of S&P 500 returns since then have been driven by multiple expansion.
  • What’s more, earnings have been contracting for the past five quarters; so it’s difficult to see how rising multiples can keep supporting current prices near all-time highs with liquidity contracting and the risk of a global recession rising.
  • Either earnings need to rise or prices need to fall. And the market has already been waiting a long time.
  • Although an earnings rebound in the second half of 2016 is now the consensus forecast among big bank analysts, I am skeptical. All it takes is another leg down in energy prices or another leg up in the trade-weighted US dollar (among other macro risks) for the profits recession to continue and for a major correction to ensue.
  • With that in mind, my colleagues and I on the STA Investment Committee believe the risk/reward of being overweight stocks is pretty unfavorable. Richly valued US equity prices could rise a little, or they could fall a lot. Meanwhile, the option value of cash and other defensive assets can fall a little, or it can rise a lot.
  • Rather than pining away for a surge in earnings to revive an aging bull, we know and trust that a new expansion will eventually bring new opportunities. Until then, we think it is prudent to stay defensive and take what the markets give us.

 When I was a child growing up along the bayous of South Louisiana, my grandmother used to tell me a story about an Acadian girl who spent much of her life waiting for her long-lost love under an old, mossy oak tree.

Waiting (In Vain?) For An Earnings Rebound

Like most folktales, there are countless versions to this story. In Henry Wadsworth Longfellow’s version, Evangeline finally finds Gabriel moments before his death. But in the version I remember, she dies alone under that tree – waiting in vain for a soul mate who never comes.

It’s one of those stories that’s imprinted deeply in my heart. And, oddly enough, it keeps popping into my mind as I think about the ongoing in contraction in S&P 500 earnings.

The US equity market, you see, has been waiting for earnings growth for quite a long time. While corporate profits staged an impressive recovery in 2009, 2010, and 2011, the vast majority of S&P 500 returns since then have been driven by multiple expansion. In the following chart, you can see that multiples have grown by an impressive 37% while earnings expanded by a slight 11%.

Earnings Rebound

That shouldn’t be a huge surprise given the striking relationship between the Fed’s balance sheet and the S&P 500, but it’s difficult to see how multiples can keep rising if the US economy continues to slow and the Fed continues to sit on its hands.

Earnings Rebound

This isn’t simply a question of whether relatively rich multiples can drive prices higher in the face of sluggish earnings, but whether high valuations can continue to compensate for negative earnings growth in an environment where the index is trading near its all-time high,

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