The Economics Are Great, But Valuations Point Toward Stock Picking To Limit Risk

November 9, 2016

The Economics Are Great, But Valuations Point Toward Stock Picking To Limit Risk

  • GDP, productivity and earnings are growing which is great news.
  • However, valuations are high and interest rates are likely to rise soon.
  • Given the variations in revenue and earnings growth, and the upcoming changes in interest rates, now may be the time to switch from index investing to stock picking.

Introduction

As the earnings season is almost over—and GDP, productivity and labor data is in—it’s a good time to look at what kind of conclusions can be made out of the multitude of information. By putting the noise aside (the election) and focusing on news that impacts future earnings, we’ll relate recent developments to the potential risks and rewards for your portfolio.

Economic Data

GDP data came in strong as real gross domestic product increased 2.9% in Q3 2016 which is the highest growth rate since Q3 2014.

figure-1-gdp
Figure 1: U.S. real GDP growth. Source: Bureau of Economic Analysis.

The GDP in current U.S. dollars increased by 4.4% indicating that inflation is finally getting some traction and returning to normal levels.

figure-2-inflation
Figure 2: U.S. inflation in the last 5 years. Source: Trading Economics.

In line with inflation, wage growth accelerated to its strongest pace since the recession with a 2.8% jump in hourly earnings, while the unemployment rate remained at 4.9% indicating the reaching of a natural unemployment rate. The majority of newly added jobs comes from health care, professional and business services, and financial activities.

With more jobs and higher wages, another very important indicator for faster GDP growth is productivity where we’re finally seeing some good news. Nonfarm business sector labor productivity increased at a 3.1% annual rate in Q3 2016. As this indicator is very volatile, we’ll have to wait to see if this is the start of a new trend or just a temporary surge.

figure-3-productivity
Figure 3: U.S. productivity growth and GDP growth. Source: FRED.

The choppy chart above doesn’t provide much longer-term confidence as productivity is the primary long term factor for economic growth. GDP growth can be higher but when it is, it is under the influence of debt.

In the figure above, it is clear that GDP growth has consistently been a notch higher than productivity growth indicating an unavoidable deleveraging in the future. In the last 10 years, productivity growth has been on the slowest pace in the last 40 years.

figure-4-productivity-loong-term
Figure 4: U.S. productivity growth in economic cycles. Source: Bureau of Labor Statistics.

Inflation picking up, a natural unemployment rate being reached, and rising wages, mean that things are going to change in the economic environment soon as the FED will be out of excuses to keep interest rates low. Most people understand the impact higher rates will have on the economy and businesses, but after seven years of low rates, very few people really believe higher rates will happen.

My biggest concern is that higher interest rates will impact demand through increased borrowing costs. As the biggest part of GDP growth in the last few years was propelled by debt, we will see deleveraging sometime in the future, and this trend will impact revenues and earnings.

On the other hand, if productivity growth remains above GDP growth as it did in this quarter, we could see a continuation of sustainable economic growth, and perhaps on a faster pace than what we have been used to seeing in the last few years.

S&P 500 Earnings

Similarly to economic data, earnings data up until now has beaten expectations. After 85% of S&P 500 companies reported earnings for Q3 2016, earnings are finally in growth territory after 6 quarters of declines. The current earnings growth rate for the quarter is 2.7%. On a sector-by-sector basis, the sector with the best earnings growth was real estate with 34.9%, while the energy sector is still the laggard with earnings declining 63.2%.

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Figure 5: S&P 500 earnings growth per sector. Source: FACTSET.

As energy earnings are mostly related to global commodity prices, the fact that all other sectors apart from industrials and telecom had positive earnings is reassuring.

Revenue also grew in Q3 by 2.6%. Utilities lead the pack with revenue growing 15.8%, followed by consumer discretionary and information technology. After accounting for inflation, real revenue growth would be around 1% but it still is growth.

Analysts see S&P 500 earnings growing at 11.6% in 2017 on an expected rebound in energy earnings. However, even if the energy sector rebound doesn’t materialize, the S&P 500 should enjoy positive earnings, especially if good economic news continues.

figure-6-2017-earnings
Figure 6: Expected 2017 earnings. Source: FACTSET.

Risks & Rewards For Your Portfolio

Economic, productivity and earnings growth are excellent news even if everyone tries to convince you otherwise. However, as always, there are certain risks that have to be considered. The greatest risk comes from higher interest rates and lower credit availability which could lower demand and put the economy back onto the weak growth track. The second greatest risk comes from valuations and yields. Higher interest rates will increase required yields and consequently push the value of the underlying assets downwards.

Positive earnings have brought the S&P 500 PE ratio down to 23.99 from almost 25, but these levels are still relatively high. A good economic environment could keep stock prices at these levels for a longer period of time, but it seems that there are small probabilities for rational jumps toward the upside. Therefore, the plausible long term reward at this point in time is around 5% per year with the notion that the economy continues on this track. The risks are always the same, slower earnings or a recession which could create a bear market and higher interest rates that increase the required return and dividend.

When rebalancing your portfolio, ask yourself how much of it do you want to have in assets that will give you 5% per year and a probable 25% decline somewhere in the next 5 years.

Given the variation in earnings and revenue growth, and a low general expected earnings yield, the time has come for a return to stock picking after 7 years of index investing. Keep an eye on Investiv Daily for tomorrow’s article on how and why to switch from index investing to stock picking.

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