Do investors recognize how much risk they’re taking on at this stage in markets? I think it’s a highly relevant question as things may not be as well as they seem. On the surface all looks well as markets just made new all time highs in July and big cap stocks such as $AAPL are near trillion dollar valuations and show strong balance sheets.
But there’s something insidious going on underneath the valuation equation and that is: Investors are paying higher and higher forward multiples not realizing that they do.
Why? Because corporate profits are actually not expanding. Not only are they not expanding they’re shrinking on an aggregate level.
What if I told you corporate profits before taxes actually peaked in 2014, 5 years ago? Really, it is true:
And if you look closely you realize that this a trend that happens preceding recessions. Now this trend can last a few years as it has now, or in the period in the mid 90’s leading to the 2000 top, or it can happen more quickly as in the 2006 – 2007 time frame.
But note, this decline in corporate profits presages the end of a business cycle, i.e. an upcoming recession, but markets tend to keep rising until that happens:
Why don’t markets react to this decline in corporate profits? The last cycle and this cycle in particular give a clear answer: Buybacks.
Even more so now than in 2006-2007 we are still in a very aggressive buyback cycle and this form of financial engineering masks a lot of things.
Here’s how I explained it on twitter the other day in reference to a chart about how earnings growth has come to a halt:
How this works:
Say you earn $1 in year 1 and $1 in year 2.
Earnings are flat.
But because you shrank your float via buybacks you can claim earnings growth.
$1 over 1 share = EPS of 1
$1 over 0.9 shares = EPS of 1.11
Look: 11% earnings growth. Magic.
Now pay me a bonus. https://t.co/kJ6mIviixQ— Sven Henrich (@NorthmanTrader) July 29, 2019
And here is how this translates into risk to investors. Take $APPL.
The company is trading around $200 these days, nearly double the level it was trading at in 2015. Why is 2015 relevant? Because $AAPL’s earnings were exactly the same as they are now: Around $53B.
But what did they do? They bought back shares since 2015. Lots of them. 1.2 billion shares to be precise. The net effect:
“With flat net income, the purchase of a net 1.2 billion Apple shares means that per-share earnings are slated to rise from $9.22 in fiscal 2015 to $11.51 this year”.
What’s that mean for investors? Well, you’re paying a near double premium in share price for a company that hasn’t grown earnings in 4 years. That’s called multiple expansion. $AAPL’s forward earnings multiple in 2015 was 11-12, now it’s near 17. That means you’re taking on a lot more risk than in 2015. In fact the multiple expansion is between 45%-55%.
Who says there’s no inflation?
And it’s not only with $AAPL, it’s common across the board. So investors be aware: You’re taking on a lot more risk in paying for shares either directly or in ETFs and index funds, especially at a time when market valuations to GDP have exceeded 140%. Buyer beware.
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Categories: Opinion
Was the biblical great flood like a reset. Are we due for another one?
Asset inflation is not only contained within the stock market. I run a corporation that owns and manages farmland. Much of the farmland in the states I operate has appreciated 300% to 700% over 15 to 20 years, due mainly to ZIRP and the reach for yield by rural investors who needed more than 1% CDs to survive (and throw all their money at farmland at any price). Now one of my biggest issue is retaining my farming tenants, as they are ready to throw in the towel. A common question is why slave away at farming the land, with constant weather and tariff concerns, when the farmers could simply put their borrowed crop money into the markets instead, and make 10 times their current profit margins (currently zero to negative, even with the so called “bailouts”). Corn inputs alone cost around $585/acre in 2019, so if your farm 2000 acres corn, you typically borrow $1.2M to plant your crops. So they ask why not borrow the $1.2M, put it all in a SP500 ETF, and sit on their butts all day and get free money (because it has worked for 10 years, they believe it will work into perpetuity). The fed is really destroying a lot of future generations with their trickle down Reaganomics policy (note the top 10% own 80% of stocks so ZIRP is trickle down policy), as even farmers are turning to Wall Street gambling to survive. The unintended consequences will take decades to realize after the everything bubble bursts. So much more is on the line than simply a 40% drop in virtual net worth for the top 10% of society. Socialism seems to be our future, as amoral, profit at all cost capitalism is quickly reaching it’s trickle down limits. It is all fun and games until the consequences can not be contained by free money policies. Sure the central banks can remove the time value of money, yet time itself can not be removed from the equation…which makes the current policies look mathematically insane.
Great article Sven. Thank you.
Ok, I buy your premise, Sven.
Is the cited risk partially ameliorated by investors using DCF when selecting companies?