What determines a share price?
In fact it’s very simple: the underlying company’s financial position – in particular, how much money it’s making – multiplied by the valuation that investors are prepared to pay to buy into it. This also applies to overall stock markets.
Earlier this week I examined how the actions of major central banks have boosted equity valuations worldwide. That’s led to lots of investor complacency and very little fear. But there’s one saving grace – at least company profits still seem fine.
Or are they? The more you look, the more you find they’re not so hot…
Europe has done well
Granted, in Europe the first-quarter reporting season has been the strongest quarter in a decade, according to Morgan Stanley’s Equity Strategy team, with earnings on track to expand at 20% year-on-year. Further, revenues are heading for 15% growth and have beaten expectations by the most since at least 2003.
But while the team remains bullish on the European earnings outlook, it says that Q1 is likely to be the peak quarter for year-on-year growth. It also suggests that markets have already baked in “a reasonable degree of earnings optimism”. That makes sense considering the strong rises seen in European equity markets this year.
In addition, Morgan Stanley notes the sheep-like tendency (my words) of analysts to respond to good financial numbers by upping their forecasts immediately and then cutting estimates later on. Right now, the industry is very much in upgrade mode.
To sum up the European profit position, then: the earnings recovery may be peaking. And most of the good news is already in the price.
How about the United States?
Meanwhile, at first glance the US picture also seems fine. First-quarter earnings have increased by 15.4% from the equivalent three months in 2016, says Thomson Reuters.
But drill deeper into the numbers and you’ll find things aren’t quite so promising.
Last week the US released its first estimate of Q1 ‘whole economy’ corporate profits as reported by the National Income and Product Accounts (NIPA).
The NIPA data add up to an accurate and wide-ranging ‘top-down’ early-warning profit indicator. In contrast, the aggregate of ‘bottom-up’ figures supplied by individual companies is more likely to be manipulated by the firms themselves.
Sorry about the jargon: yes, I know this is getting a bit geeky, but please bear with me for a minute.
Anyway, on an equivalent basis NIPA US first-quarter post-tax profits increased by 12% year-on-year. No worries there, or so you’d think.
But “as far as the economic recovery is concerned,” says Albert Edwards at Societe Generale, “one major blemish on the seemingly rosy profits outlook can be found by scratching the surface of the NIPA whole economy profits data”.
For those of who don’t know Albert Edwards, he’s the author of the Ice Age theory which says that global equities will replicate the experience of Japan though the 1990s. In other words, they’ll become very poor investments.
He also reckons that western central banks’ excessively loose monetary policies are creating a giant Ponzi scheme (where later investors pay for the returns of the earlier players who are getting out). Agreed – you can see why I like reading his work!
Edwards’ favourite NIPA indicator is the total of US domestic non-financial sector profits. These are actually down 6% year-on-year as unit labour costs rise. This trend is set to continue. As I pointed out in my final chart here, wage earners are overdue a bigger slice of the corporate pie.
America’s domestic non-financial sector profits lead the country’s investment cycle. And here there’s a real danger of a nasty downward spiral developing.
Falling profits mean stunted business investment. The latter is a major factor in economic growth. If this slows, company profits suffer once again. That leads to a further drop in business investment, which then means…well, you’re probably getting the picture by now. It’s not exactly a great backdrop for the stock market.
As John Higgins at Capital Economic points out, “investors have often been reluctant to bid up the stock market’s valuation when profits have been squeezed by rising wages.”
So at this point you might expect to see some disquiet amongst investors. But US equities continue to hit new all-time highs. The VIX index, the market’s so-called fear gauge, is right back at its all-time lows. This, says Edwards, means “that we are witnessing heights of complacency not seen even prior to the 2007 financial crisis.”
How will this all end? Probably not well. There’s a point where central bankers can’t keep adding extra cash into the system without completely losing credibility. Hence the US Fed’s plan to raise interest rates to pre-Great Recession levels while slimming down its balance sheet – again, see my article earlier this week for the details – and more pressure on the European Central Bank to curb its bond buying.
So the boost to stock valuations from central bank action is set to end.
Add in the potential for a deteriorating earnings outlook and there’s a growing chance of a ‘perfect storm’ in global equity markets. Both profits and valuations could be squeezed at the same time. This would lead to a sharp sell-off.
Put another way, all that investor complacency could soon be replaced by the return of the fear factor. That’s always been the way that markets work. It’s not likely to be any different this time.