S&P 500 Rising at Five Times GDP Shows Recovery Priced in
For almost six years, one of the most powerful bull markets on record has coexisted with the weakest economic recovery since World War II. This month’s selloff in stocks shows how much investors want that to change.
In the latest fit of nerves, market volatility soared to a three-year high and the Standard & Poor’s 500 Index dropped as much as 9.8 percent in the 26 days ending Oct. 15. Everything from Ebola to Europe and the Federal Reserve were blamed for the retreat, the fourth to exceed 3 percent this year.
Another explanation is that investors are finding their patience taxed after waiting five years for economic growth to catch up with the market. From March 2009 through June 2014, the S&P 500 has increased 4.7 percent a quarter, about five times faster than gross domestic product, data compiled by Bloomberg show. That’s the biggest gap since at least 1947.
“I don’t think the dispersion can sustain at the level that it did, which is why the market is struggling,” Daniel Genter, who oversees about $4.5 billion as chief executive officer at Los Angeles-based RNC Genter Capital Management, said in a phone interview on Oct. 22. “The market wants to see growth going in the right direction or it’s going to be upset.”
As quickly as markets lurched, they recovered, with the Chicago Board Options Exchange Volatility Index (VIX) dropping 27 percent last week as the S&P 500 increased 4.1 percent. Data on housing and consumer confidence showed acceleration in the American economy, while the European Central Bank added to bond purchases, quieting concern about a region whose economy is at risk of falling into a third recession since 2009.
Market Signal
Stocks have historically started to climb before GDP, anticipating economic expansions by an average of two months, data beginning in 1927 show. In 14 recessions since then, the S&P 500 posted gains of 12 percent in the quarter prior to a rebound in GDP. That happened in 2009, when the index rose 15 percent in the April-June quarter, the last of the recession.
Anyone using above-average GDP gains as a signal to buy would have missed the 190 percent advance in the S&P 500 since March 2009 that rivals almost any rally in the past nine decades. While economic growth has held below 3 percent, stocks rallied as the U.S. unemployment rate fell to 5.9 percent from a 26-year high of 10 percent in October 2009, interest rates stayed at record lows and new home sales climbed 73 percent since 2011.
Better Guide
“I don’t think you can find a relationship, a consistent ratio, between economic growth and the stock market,” Laszlo Birinyi, president of Birinyi Associates Inc. in Westport, Connecticut, said in a phone interview. “Maybe what we saw in 2010, 2011 was a stronger market than the economy. Maybe going forward, we’ll see the economy catch up and the stock market may not have strong gains.”
Throughout the rally, corporate profits have been a better guide than GDP growth for when to buy stocks. With S&P 500 12-month earnings doubling to $103.21 a share since the end of 2009, the index trades at a price-earnings ratio of 19, compared with its average of 25 since 1990, data compiled by Bloomberg and S&P Dow Jones Indices show.
At the same time, investors are concerned that the money was made via means that are nearing depletion. Earnings have grown at an annual rate of 14 percent since 2009, about three times faster than sales, as companies cut costs. Rather than investing to meet demand that might not come, executives juiced returns by spending near record amounts on buybacks.
‘Big Disconnect’
“You can’t do a whole lot more cost cutting and you can’t buy back a whole lot more stock,” David Lafferty, the chief market strategist for Natixis Global Asset Management in Boston, said by phone. His firm manages about $930 billion. “The big disconnect where companies have been able to grow their earnings significantly faster than top-line revenue growth is coming to an end.”
More than $11 trillion has been added to S&P 500 stock values since the bull market began. Over the same period, GDP rose 0.9 percent a quarter amid the weakest recovery since 1947, data compiled by Bloomberg show. The 68-month advance in stocks is unique among 16 bull markets since 1938 in that it occurred without a single year of GDP growth above 3 percent.
One hazard for investors is shown in valuation gauges tied to revenue. Since global equities bottomed in March 2009, the S&P 500’s price-sales ratio has expanded about three times as fast as price-earnings, rising from 0.7 to 1.8 last month, the highest level in more than a decade.
‘Fully Rational’
Stock volatility spurred partly by international concerns may be increasing but the influence of foreign markets is a reason profits have been able to outrun American GDP, according to Stanley Nabi, vice chairman at Silvercrest Asset Management Group in New York. S&P 500 companies get 46.3 percent of sales overseas, according to data from S&P.
“They’re accounted for in the S&P earnings, but they’re not accounted for in the GDP,” Nabi said by phone. Silvercrest oversees about $16 billion. “Profits have risen ahead of nominal growth. It’s fully rational.”
Growth in earnings isn’t poised to end, according to analysts, who say income among S&P 500 companies will rise at an average rate of about 9 percent through 2016, estimates compiled by Bloomberg show. Economic growth has strengthened in the past year, with GDP expanding at an annualized rate of 3.5 percent or more in three of the last four quarters.
3% GDP
GDP probably rose 3 percent in the third quarter and will hold around that level for another two years, according to the median estimates from more than 80 economists surveyed by Bloomberg. Economists predict employers will add 228,000 jobs to payrolls in October after a 248,000 increase in September.
Too much growth is the last thing the economy needs anyway because it may prompt the Fed to raise interest rates sooner than expected, according to Tim Rudderow, chief investment officer at Mount Lucas Management LP in Newtown, Pennsylvania.
“The modest economic growth is a recipe for continued run-up in equity prices,” Rudderow, whose firm oversees $1.6 billion, said by phone. “Once we get a hint that the Fed begins to reconsider their position on interest rates, that’d be the time when the equity market will be more challenged.”
Just as lackluster demand has made company executives hesitant to boost capital investment, their reluctance to spend on new plants and technology in turn held back the economy. CEOs have cut the proportion of cash flow used for capital spending to about 40 percent from more than 50 percent in 2002, data from Barclays Plc show.
Capital Spending
Capital spending may be little changed next year as lower oil prices limit investments by energy producers, according to Tobias Levkovich, Citigroup Inc.’s chief U.S. equity strategist, who derived the data from more than 670 non-financial companies that the firm’s analysts cover.
“We’re already at a market price that’s greater than what GDP growth can sustain in the next seven to 10 years,” John Allen, chief investment officer at Aspiriant LLC in San Francisco, said in a phone interview. The firm oversees about $8 billion. “Equities will either be choppy or come down.”
After buying stocks indiscriminately in 2013, investors are punishing companies now that fail to deliver growth. International Business Machines Corp. and Coca-Cola Co. tumbled at least 4.3 percent last week amid disappointing sales. IBM (IBM) has spent $19 billion buying back its shares in the past 12 months and Coca-Cola plans to repurchase between $2.5 billion and $3 billion of its stock this year.
Profit Margins
IBM, grappling with an industry shift to cloud computing, reported a 10th straight quarter of revenue declines and abandoned its earnings forecast for 2015. Coca-Cola, the world’s largest beverage maker, missed analysts’ sales estimates and its $3 billion cost-cutting plan failed to satisfy investors.
The boost to earnings from plant closures and layoffs has lessened over the past two years as profit margins near a record 9 percent, data compiled by Bloomberg show. At the same time, buybacks are losing their allure. The S&P 500 Buyback Index is up 7.5 percent this year, compared with the 6.3 percent advance in the S&P 500, after beating it by an average of 9.5 percentage points every year since 2009.
“This past couple of weeks should serve as a good wake-up call for investors that the market going forward is unlikely to be as smooth as it was,” said Leo Grohowski, chief investment officer at New York-based BNY Mellon Wealth Management, which oversees about $187 billion. “The overshoot to the downside of the market has been corrected. With valuations back to fair levels, you’re not going to see this degree of dispersion.”
Source: Bloomberg
