PE expansion has essentially been the sole driver in this market. Over the past 3 months, the S&P is up 9.6%, 8.5% of which came from expanding PE, and just 1.1% coming from better earnings estimates. This is one reason why this risk rally has been perplexing for fundamentals based players, and less so for technical analysis based players, who don’t distinguish between the drivers. On a trailing basis, the S&P’s PE ratio is now within a hair of the March highs.
Over the near term, this is probably sustainable. The confidence effects following from QE announcements & improving data should last a bit longer. And my own indicators for PE ‘fair value’ do not suggest that it is too high yet. But obviously, P/E expansion alone can’t drive the market higher indefinitely. Better earnings will be necessary. And the outlook there remains challenging.
S&P profit margins peaked in Sept of last year, and have drifted lower since. This suggests that cost cutting measures have hit their limits. Consequently, further real EPS growth will need to come from expanding sales, which in turn will require stronger employment growth. Today’s payrolls print suggests that this is still not likely. Non Farm payrolls have averaged around 150k per month since early 2011, and have printed below that every month since March. Furthermore, the 4yr contraction in the participation rate to the lowest level since 1981 suggests hysteresis or demographic aging effects, both of which are negative for future employment growth. And of course, fiscal contraction is coming.
None of this necessarily suggests that the rally is at immediate risk. Corporations could well maintain low single digit top line growth for the foreseeable future. But prices and fundamentals do converge over time. As the risk rally progresses, it will be important to recognize how much of it has been built on sentiment, as compared to fundamentals.
- China rallied 3.7% overnight after Beijing announced a 1 trillion yuan infrastructure spending plan ($158bn). The money will be used over several years
- Intel cut their revenue outlook to $13.2bn, +/-$300mm, down from the previous guide of $14.3bn
- US Non Farm payrolls declined to 96k in Aug vs 130k prev. Last month’s figure was revised lower by 21k
- Unemployment declined to 8.1% from 8.3% as a result of a drop in the participation rate from 63.7% to 63.5%. The civilian labor force declined ~400k.
- Both Hourly Earnings and Hours worked came in weaker than expected.
- Sun: China IP, Retail Sales, Trade Balance, Japan Current Account, Eco Watchers Survey
- Mon: EU Sentix Investor Confidence, Australia NAB Business Confidence, China Money Supply
- Tues: Canada Housing Starts, Trade Balance
- Wed: UK Jobless Claims, US Import Prices
- Thu: US PPI, Jobless Claims, FOMC
- Fri: EU CPI, Employment, US CPI, Retail Sales