Podcast Summary
Rally in S&P 500 not based on strong fundamentals: Investors focus on future earnings growth amid current earnings downturn, despite 5.2% YoY decline in Q2 blended earnings
The current rally in the S&P 500, despite the third straight quarter of falling profits, may not be based on strong fundamentals, but rather on sentiment and optimism for future earnings growth. Nearly 90% of companies in the S&P 500 have reported earnings for Q2, and the blended earnings decline is forecasted to be around 5.2% year on year. However, this is better than the grim expectations set by analysts. The current rally might be considered an "echo bubble" of the market's previous growth, and it remains to be seen whether investors are looking past the current earnings downturn and focusing on future growth prospects. The dynamic between single stock analysts and macro strategists within investment banks can sometimes lead to differing perspectives, with single stock analysts seen as the experts on individual companies and macro strategists as the top-down, big-picture thinkers. However, both sides can get it wrong at times.
Underperforming earnings and market reactions: While earnings are currently 5% below expectations, this difference can lead to negative market reactions due to the comparison to expectations. Additionally, the current earnings growth rate is below historical averages, and the market's high price-to-earnings ratio could result in a potential 22% drop in the S&P 500.
While earnings for a company were predicted to decline by 7%, they are currently tracking around 5% below expectations. This may not seem like a significant difference, but it's important to remember that earnings are compared to expectations, and underperforming can lead to negative market reactions. Additionally, the current earnings growth rate is far below the historical average of 12%, making the current state a cause for concern. The market's current price-to-earnings ratio of almost 20 times forward earnings is significantly higher than the long-term average of around 15 times, which could lead to a potential 22% fall in the S&P 500 to reach that average. The split between growth and value stocks remains, with growth stocks trading at a premium of around 22 times and value stocks at around 17 times. Overall, the current market situation underscores the importance of understanding historical averages and the impact of expectations on market reactions.
Market euphoria causes large disparity between growth and value stocks: Market euphoria can lead to large disparity in valuations between growth and value stocks. This disparity can almost disappear during market downturns, leading to significant declines in growth stocks' valuations.
During periods of market euphoria, there can be a significant disparity between the valuations of growth and value stocks (dispersion). This disparity was particularly large during the peak of the market euphoria in 2021, with growth stocks commanding high multiples. However, when market euphoria dissipates, as it did during the global financial crisis, the dispersion between growth and value stocks can almost disappear, leading to significant declines in the valuations of growth stocks. Currently, the market is not close to the peak valuations seen in 2020, but there are concerns about the potential for a decline in earnings growth, which could lead to a snapback in valuations. Analysts predict modest earnings growth in the near term but significant growth in 2024, driven by the large tech companies that have been leading the market rally. However, there are also risks to this outlook, including the possibility of higher input costs, labor disputes, and geopolitical tensions that could lead to inflation and further declines in margins. Overall, the market environment remains uncertain, and investors should be prepared for potential volatility in the coming months.
Companies defend margins during pandemic, but inflation pressures persist: Companies maintain profit margins despite pandemic, but inflation forces may lead to higher prices and wages, impacting some sectors more than others.
Despite some compression in profit margins for the S&P 500 in the latest quarter, companies have managed to defend their margins during the pandemic. The net profit margin for the S&P 500 is currently 11.5%, which is in line with the 5-year average but down from 12.2% the previous year. The Bank of England noted that companies and households are trying to recoup losses from inflation, which could lead to higher prices and stronger wage negotiations, making inflation more persistent. However, not all companies have been successful in passing on costs to consumers, as seen with Procter & Gamble's 1% year-on-year decrease in sales volumes despite a 7% price increase. Apple, on the other hand, reported a record profit margin of 44.5%. The consumer discretionary sector has seen the most earnings growth, while energy and materials have experienced significant profit declines. The energy sector's profit decline could be due to a base effect or genuine trouble, but it's still doing relatively well historically. Overall, the earnings report shows a mixed picture, with some sectors thriving and others struggling.
Economic climate impacts profitability expectations for tech companies: Tech companies face pressure to become profitable as economic climate shifts, with some reporting first profits while still facing significant losses, and the sustainability of loss-making models questioned.
The current economic climate is leading to a shift in profitability expectations for companies, particularly those in the tech sector. This was highlighted during the recent earning season, where Exxon's earnings decline was put into context by looking at its history, while Uber reported its first ever quarterly operating profit but still faces significant cumulative losses. The volatility of the energy industry and the long-term sustainability of loss-making business models were discussed, with Uber's focus on cost control and profitability being seen as a response to the current economic climate. The question was raised about what will happen to the profitless tech sector if the easy access to capital dries up, and whether only companies with useful products or services will survive. The metaphor of sandcastles in the sky was introduced to describe the visionary CEOs, early adopters, and investors in these companies, with the implication that many will collapse when the rent collection comes due. Overall, the conversation underscored the importance of profitability and the potential consequences of prolonged loss-making.
S&P 500 companies shifting focus from share buybacks to capital expenditures: Companies in the S&P 500 are investing more in capital expenditures and less in share buybacks due to pandemic-induced pause and new US tax, contributing to growth and innovation instead of just benefiting existing stock owners.
Companies in the S&P 500 are shifting their focus from buying back shares to investing in capital expenditures. This trend, which saw a 15% increase in capital expenditures and a similar decrease in share buybacks in the first seven months of 2021, could be a response to the pandemic-induced pause in capital investments and the new US tax on buybacks. While share buybacks benefit existing stock owners by concentrating ownership, they don't contribute to growth or innovation. Companies, particularly those in the tech sector, are facing challenges in finding new product categories to drive growth, as market saturation and slowing markets limit the potential for sales growth. The high forward PE ratio of the information technology sector suggests that investing in undervalued sectors, like energy, could yield significant returns if the market recovers.
US Stock Market's Exceptional Valuation: Investors concerned about US market's high valuation could consider increasing non-US weightings through regional funds, but avoiding market timing and drastic changes.
The US stock market, specifically the S&P 500, is currently one of the most expensive markets compared to other global markets based on their Price to Earnings (PE) ratios. This trend has been exacerbated during the decade of low-interest rates. Historically, this level of US exceptionalism has not been well-supported. The speaker suggests that investors who are fully invested in global indices but are concerned about the US valuation could consider increasing their non-US weightings through regional funds. However, they also caution against trying to time the market or making drastic changes based on current valuations. Ultimately, history suggests that no country remains exceptional over the long term, and there will be a point when the US market normalizes.
Exceptional economies can lose their edge: The US economy's exceptional status may not last forever due to potential substitution of US tech products or falling behind in tech innovation.
While the US economy currently holds exceptional status, it is not immune to the forces of attrition that have brought down exceptional economies in the past. The Netherlands, with its strong navy and Dutch East India Company, is an example of a country that punched above its weight financially. However, even its exceptionalism ended. The US economy's strength and potential for rapid growth may prevent the current valuation from looking ridiculous, but it's uncertain how long this will last. The biggest risks for the US are substitution of its tech products by alternatives from Europe or Asia, or the tech simply moving on and the US falling behind. The US's exceptionalism in the global economy may change due to a combination of planning, luck, or both.
Share buybacks and dividends: Two sides of the same coin: Both share buybacks and dividends return capital to shareholders, reduce outstanding shares, and increase shareholder ownership. However, buybacks can be controversial due to potential debt funding.
Share buybacks and dividends are equivalent when it comes to returning capital to shareholders and impacting valuations. Both methods increase the return for investors and reduce the number of outstanding shares, thereby increasing the shareholder's ownership and dividends. However, the morality of debt-funded buybacks is questionable as it involves the company borrowing money to buy back its shares. Buybacks can benefit shareholders by increasing the stock price, which in turn can boost earnings per share and the value of executive stock options. The US tax system, which favors capital gains over dividends, may influence the preference for buybacks over dividends. The recent tax on stock buybacks in the US is an indication of the controversial nature of buybacks, but Warren Buffett argues that not all buybacks are detrimental to shareholders or the economy.
Warren Buffett's Preference for Stock Buybacks and Similarities to Dividend Investing: Warren Buffett prefers stock buybacks, particularly from companies like Apple, resulting in a more concentrated holding. Buybacks and dividends offer similar attractive returns, but buybacks are more volatile and heavily concentrated in consumer discretionary, financials, and health care sectors. US investors may prefer buybacks for tax advantages.
Warren Buffett, known for his investment acumen, is a fan of stock buybacks, particularly from companies like Apple that consistently repurchase their own shares. This strategy results in a more concentrated holding for Buffett and allows him to own a larger stake in the company without having to make additional purchases. The discussion also highlighted the similarities between dividend investing and investing in companies with high buyback yields, as evidenced by the nearly identical total returns since 2007 for the S&P 500 Dividend Aristocrats and the Nasdaq US Buyback Achievers Index. Despite the higher volatility in the buyback index, both strategies offer attractive returns for investors. It's worth noting that the US market, particularly large companies like Apple, has seen a significant reduction in shares due to buybacks, making the market as a whole shrink. Companies in the Nasdaq US Buyback Achievers Index are heavily concentrated in consumer discretionary, financials, and health care sectors. While some funds combine both dividends and buybacks, such as the iShares core dividend ETF (DIVB), the preference between the two strategies may depend on investors' tax situations and personal preferences. US investors, for instance, may favor buybacks due to the tax advantages they offer compared to dividends.
Discussing UK investment preferences and accumulation funds vs total return: Investors in the UK often use accumulation funds, but some prefer total return for greater flexibility and potential higher gains.
During our discussion, we touched upon the fact that in the UK, many investments are accumulated in one type of fund called an accumulation fund. However, our personal investing preferences lean more towards total return rather than dividends or buybacks. We believe that return, no matter the form, is what ultimately matters. It's important to remember that this podcast is for informational and entertainment purposes only and should not be considered financial advice. We do not provide recommendations or endorse any investment decisions. Listeners are encouraged to seek independent financial advice before making any investment decisions. Many happy returns!
