Juggling Dynamite

ECB’s Draghi is in full PR mode today explaining why what he said yesterday was actually much more bullish for financial assets than what market participants seemed to think yesterday when they sold with both feet.  The algos have grabbed the headlines and run US stocks up the hysteria pole (S&P 500 and TSX still negative for the week notwithstanding), while oil (just closed the week under $40), corporate bonds (lower), treasuries (higher) Canadian stocks (flat) and the loonie (lower) are all rejecting a jubilant read.

A few charts to help cut through the noise…

First as US stock prices leap this afternoon, the year over year change in earnings per share for the Russell 2000(small-cap in blue) and S&P 500 (large cap in orange) companies has been falling since 2011 and is negative over the past 15 months.

Prices up, earnings way down means the price to earnings ratio for US stocks is at nosebleed highs only bested once in human history at the fleeting tech-wreck peak of 2000. For the S&P 500, the Shiller PE is today an eye-popping 26.39. While the Russell 2000 is trading at a hilarity-inducing 145x earnings! All proof positive that stocks are still stuck within the secular bear that began in 2000. The next, third, and likely to be equally massive (as 2001-03 and 2007-09) cyclical correction is coming folks. Stay-ready.

Missed in all this madness(as graphed in blue), the S&P 500’s PE of 26 (never mind the Russell’s 145) suggests that annual returns will be zero and less for the next 10 years from current price levels (see far right bar below) and this is even if one managed to hold on through a decade of heart-thumping volatility and collect the meager dividends.  Like them apples?  You can have ’em.  Peace out!

One thing is clear from year over year holiday season sales (in blue below). Shoppers don’t seem to be buying Janet Yellen’s ‘all clear on the western front’ spiel.  We haven’t seen them this miserly since the onset of the 2008 recession.   Good, because the best present we can give our families is more savings and less debt.  Pass it on.

For many months we have noted the foreboding gap that was building between plunging real economy sectors (like materials and energy at lower purple arrow in first chart below) and still levitating, expanding leverage sectors like financials (in mauve at top) and real estate investment trust shares (REITs in black at top).

As interest rates plunged since 2011, income-seeking buyers kept herding into dividend paying equities.  These companies meanwhile became obscenely overvalued even as their revenues turned down.  Trying to keep the dream alive, they began borrowing funds to buy their own shares and maintain and increase dividends.

Think about it in practical terms for a moment.  If your business is under pressure because revenues are falling, is the smart play to a) reduce your expenses and try to figure out ways to grow revenue or b) keep borrowing money so that you can pretend and extend and burn through cash on non-essential activities?

Well company management has been going with the short-term gain, long-term pain strategy inherent in option b) and now the short-term gain period has ended.  As we can see in this next chart, stripping out payments made to holders since 2014, the share prices of dividend paying sectors (XFN, XRE and XDV) have been falling.

This should be taken seriously by those still hoping that income will be enough to make up for capital loses in the mean reversion phase. As can be seen in our first chart above, the wide chasm now under dividend paying sectors is huge and menacing for capital allocated there. And if historical correlations hold, the short term out-performance of these sectors and indeed the broader market (TSX in red top chart), is not long for this world.  A catch-down period lies in the offing.

Closing keynote “When timidity triumphs” by Robert Jenkins, formerly member of the Bank of England’s Financial Policy Committee; Adjunct Professor of Finance, London Business School; and Senior Fellow at Better Markets. Here is a direct video link.