US President Donald Trump’s pro-business policies are being credited for boosting US equities, with the Dow passing the 20,000-point mark last week to set a new record. But with earnings still lagging valuations, are the bulls counting their chickens before they are hatched?
THE Dow Jones Industrial Average (DJIA) breached the 20,000 mark last Wednesday. With the return of investment money to the US amid anticipation of a hawkish US Federal Reserve policy, the music at the party on Wall Street seems to be loud still.
Mind you, the party has been on for seven years following the recovery from the US subprime loan crisis. In fact, the benchmark index broke the 19,000 level just last month.
But with valuations beginning to chase pre-global financial crisis (GFC) levels, will fundamentals be able to catch up?
So far, that appears to be the rationale of markets that have rallied behind the pro-business and “America first” rhetoric of the newly inaugurated US President Donald Trump.
Trump’s policies will still take time to implement, but he has signalled strong commitment to his election promises by signing several executive orders during his first week in the White House.
Among Trump’s key promises that are driving markets higher are tax cuts, increased fiscal spending on infrastructure and a reduction in regulatory red tape for businesses.
To be fair, Trump will be able to launch his policies on a relatively low base of economic growth, but one that is already on an upward trajectory.
For 2016, US unemployment is expected to settle at a new low of 4.7% while gross domestic product (GDP) growth is expected to come in at a modest 1.9%. This year, economists are predicting that growth may accelerate to as much as 3%, the highest since the GFC in 2008. Unemployment is expected to fall further to 4.5%.
Against this backdrop, the DJIA has leaped 206.5% since the GFC-lows. It closed at a record high of 20,068.51 points last Wednesday.
The concern is that the rally was driven by higher valuations, as opposed to earnings growth. On average, the DJIA’s 30 component stocks are being valued at an average price-earnings ratio of 18.5 times. This is a record high since the GFC. Similarly, price-to-book valuations have also risen to a post-GFC high of 3.43 times.
Meanwhile, the S&P 500 has gained almost 240% during the same period. It closed at a record high of 2,298.37 points last Wednesday. Similarly, the index’s average valuation has risen to 21.18 times earnings and 2.96 times book value.
“US equities have definitely run ahead of fundamentals. In fact, it is beginning to approach levels last seen in the tech bubble back in 2000,” Inter-Pacific Research head of research Pong Teng Siew tells The Edge.
He blames excessive optimism for making US equities among the most expensive in the world.
“My guess is that markets are pricing in benefits from the Trump administration. However, the odds of disappointment are high. People are expecting a blue sky scenario. But what happens if markets wake up and the assumptions of blue skies go out the window? The disappointment will take markets down very sharply,” he explains.
Will earnings meet expectations?
In fewer words, investors are holding very high expectations for earnings growth this year.
To be fair, corporate earnings have been growing steadily since the GFC. The trouble is, it is still lagging behind the rally in stock prices.
Since 2009, the average revenue per share for S&P 500’s component stocks has risen 26% while the average earnings before interest, taxes, depreciation and amortisation per share have grown 49%. The Dow saw similar gains.
Recall that both the Dow and S&P 500 have gained over 200% during the same period.
It is also interesting to note that the bulk of the revenue and earnings growth came in between 2009 and 2014. Subsequently, the growth has been relatively choppy (see Chart 1D and 2D).
Keep in mind that these are per-share figures. A major problem with these figures is that US companies have been actively undertaking share buybacks since the GFC to boost earnings per share.
The low interest rate environment that the Fed created after the GFC with quantitative easing was supposed to stimulate investment. But with a deficiency of demand in the US economy and arguably, the global economy as well, American companies have been relatively reluctant to invest.
In fact, data shows that most companies have kept debt and gearing levels relatively low (see Chart 1C and 2C). At the same time, companies’ cash levels have begun to rise.
Between the surplus cash and low interest rate environment, however, companies have shown a preference for share buybacks instead.
Apple Inc is perhaps one of the most notorious companies for its share buybacks — a US$175 billion programme — that have been partly funded by borrowings. Other notable index heavyweights that have been buying back shares include General Electric and Microsoft, with a US$50 billion and US$40 billion buyback programme respectively last year.
In fact, share buybacks have become such a prominent feature in US equities that a slowdown in buyback announcements is seen as a negative for the market.
“Corporate cash levels in the US are still high relative to history, but have been worked down in recent years and are nearing the low end of the lows seen ahead of the financial crisis in mid and large cap,” writes Credit Suisse in a report late last month.
The report notes that overall, “there appears to be less firepower in corporate coffers”.
“The decline in buyback activity from peaks was a worrisome signal for US equities throughout most of 2016, as peaks in buyback announcements occurred around peaks in major index performance in the last cycle,” it adds.
Against the backdrop, there is some optimism that lower tax rates under the Trump administration will encourage some US companies to repatriate foreign earnings. Apple, for example, holds a large amount of its cash abroad to avoid paying taxes in the US.
In the short term, more cash repatriation means more share buybacks, which will boost earnings per share and share prices. But this is just a trick of financial engineering. While buybacks use leverage to boost earnings, it does little to improve the companies’ long-term earnings prospects.
On top of that, the lack of investment in the US also stunts job creation, which is important for stimulating demand and growth in the domestic economy.
It is interesting to note that there was a net outflow from US equities in 2015 and 2016, with more money flowing into bond markets instead. According to a Credit Suisse report, US equities (excluding exchange traded funds) saw US$151 billion in net outflows last year and US$102 billion in 2015.
Yet, both the major US bellwether indices saw year-on-year gains despite the net outflows. This highlights the importance that buybacks may be playing in propping up share values.
In turn, that raises a big question: What happens when the buybacks stop?
In the first half of last year, it was estimated that S&P 500 companies paid out 112% of their earnings in the form of dividends or share buybacks. This should not be the case this year if companies are confident of growing economic growth and demand, and choose to channel more funds into capital expenditure instead.
The irony is, if funds are diverted from buybacks to investment, stock prices may stall as well, unless there is strong inflow into US equities.
Twin deficits still growing
If sentiment remains bullish and Trump is able to execute his election promises, he may well kick-start the US economy — a self-fulfilling prophecy to make America great again.
But by the same token, the country’s massive twin deficits remain the elephant in the room.
After all, Trump’s expansionary fiscal policies will test the limits of the country’s budget deficit — estimated at US$587 billion for 2016 or 3.1% of GDP. Keep in mind that US’ national debt is estimated at 106% of GDP in 2016, or US$19.2 trillion.
Meanwhile, the country’s current account is also in deficit of 2.4% of GDP, or US$113 billion, as at 3Q2016.
“The strong US dollar will make it challenging to reduce the current account deficit as it will make US exports less competitive. Meanwhile, it will make imports cheaper. Not only will this put pressure on the country’s twin deficits, it will also make it more challenging for US exporters. This is why Trump is upset with China for devaluing the yuan,” explains Dr Yeah Kim Leng, a professor at Sunway University Business School.
While Yeah is generally positive about the US’ fundamentals heading into 2017, he cautions that a trade war could be a black swan event, destabilising both the US and global economy.
Yeah also notes that the Fed has indicated that it will raise interest rates multiple times over the next few years, which will soften some of the growth momentum.
Put it all together, and the US economy has a decent chance of getting back on a solid footing. However, it will have little margin of error.
In the meantime, global markets will be paying close attention to the world’s largest economy as its success or failure will have global ramifications.
“If the US equity market sees a correction, it should not have such a bad effect on our market. We are less exposed as our market is trading at a lower level, about 10% off the high point,” explains Pong.
“But if the US equity market crashes, it can lead to a spillover in the financial sector, which can cause a recession in the US. If that happens, no market outside the US will be immune to the effects.”
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