The biggest risk for stocks isn’t what you think

By David Nelson, CFA

CEO and Consumer Confidence are polar opposites while Brexit chaos continues. The House marches toward Impeachment and China drags their feet on meaningful trade reforms. Earnings estimates have been falling for a year and corporate debt vs income is approaching financial crisis levels. What could possibly go wrong?

S&P 500 1 Year Chart
Sp_1_year_all_time

In a vacuum, the S&P 500 would likely be at the bottom of a 20% slide with calls for another 20 just around the corner. Magazine covers and blogs would have titles like Business Week’s 1979 article “The Death of Equities.”

Of course, we don’t live in a vacuum and like most things in life even asset classes are in competition for your dollar. Suddenly in that dynamic the playing field levels. Stocks like JP Morgan (JPM) on the heels of record revenue along with a near 3% dividend look attractive especially in comparison to tying up capital for 10 years in a U.S. Treasury at just 1.75%. Even the S&P 500 has a yield close to 2%, well above the 10 year and begs the question which is the better asset class?

The risk-free rate is at the heart of most security analysis and with Fed Funds at under 200 basis points a trailing and forward PE of 19.3 and 17x respectively looks appropriate.

S&P 500 vs 10 Year Yield – 2 Year Chart
sp_vs_10_yr_2_yr

Investors have been fixated on falling yields fearing recession. The bigger fear may be just the opposite. A year ago, markets were plummeting just as 10-year yields were breaking above 3%. My call last year looking for yield normalization to continue was off the mark. Yields didn’t sustain themselves above 3% for very long but the damage had been done.

Insurance companies, pension plans and other asset allocators could suddenly fund future liabilities with investment grade debt. These are entities that had been dragged into stocks post the financial crisis with few alternatives. Quantitative easing had changed the investable universe forcing these decision makers to up their equity allocation. It took a full reversal in Fed thinking just around Christmas to halt the decline and today has pushed the market once again just shy of all-time highs.

Earnings Estimates on I-95 South
sp_earnings_monthly

Modestly rising yields at the long end of the curve would be welcome but only if earnings growth follows. For the moment earnings estimates continue to be on I-95 South and until that reverses or at least stops going down, I have to remain skeptical that multiple expansion alone can take us much further.

It’s still early in the earnings season with over 200 companies big and small reporting this week. While the headline numbers and scorecard are important key will be conference calls that might give us some insight into CEO enthusiasm which has been notably absent. As pointed out in a recent research piece by Goldman’s David Kostin, CEO sentiment is at the lowest levels since the financial crisis so we shouldn’t be surprised they are holding cash, delaying some CAPEX and even cutting back on their favorite pastime buybacks.

With stocks just shy of records sentiment and hard data must improve to drive the next leg higher. A better than expected revenue picture would be a great place to start. Management seems to always find a way to beat the bottom line but there isn’t a lot you can do about revenue growth. Either you have it or you don’t.

*At the time of this article some funds managed by the author were long JPM