Blog

Posted on

U.S. Corporate Profits

S&P 500 earnings declined in 2022 by 18.0% and subsequently increased by 7.8% in 2023.  Standard and Poor’s currently estimates that 2024 earnings for the S&P 500 index will be $216.61, representing 10.6% growth for the calendar year.  At the current price level of 5,283.4, the S&P 500 Index sells at 24.4x 2024 estimated earnings.

There has been much commentary about the “Magnificent 7” (Microsoft, Amazon, Meta Platforms, Apple, Alphabet, Nvidia, and Tesla).  The Magnificent 7 sell for roughly twice the P/E ratios than most other US stocks.  While five of the stocks have high growth rates, Apple and Tesla have negative revenue growth when we compare the most recent quarter to a year ago.

Richard Bernstein Advisors (RBA) has this to say in their commentary about the divergence between the large cap tech stocks and the rest of the stock market.

Our work in the early-1990s demonstrated that stock market leadership narrows when profits cycles decelerate because fewer and fewer companies can accelerate or even maintain growth in an increasingly adverse environment.  Markets effectively reflect Darwinistic survival of the fittest as earnings growth becomes increasingly scarce.

However, the opposite occurs when profits cycles accelerate.  Markets tend to broaden as the cycle accelerates because an increasing number of companies are growing, and investors become comparison shoppers for growth.

RBA notes that a high percentage, 32% of S&P 500 companies, have more than 25% earnings growth based on the last 4 quarters.  In their opinion, “profits are accelerating and credit conditions remain healthy.”  They expect the performance of the stock market to broaden and the Magnificent 7 to “substantially underperform.”

The Atlanta Fed’s GDPNow forecast for the second quarter has declined during the last month from 4.1% to 1.8%.  A slowdown in economic growth will make it difficult to sustain earnings growth for many companies.

One of the reasons why small capitalization companies have been underperforming the S&P 500 since 2021 is that they typically have a higher debt load with a greater proportion of variable rate debt.  Interest rates have been rising since June 2020, so small companies with more interest-sensitive debt have suffered.  According to Pacer Financial, an ETF provider, the S&P Small Cap 600 has net debt/EBITDA (earnings before income tax, depreciation, and amortization) of 3.5 compared to 1.4 for the S&P 500.

Pacer’s US Small Cap Cash Cows ETF (CALF), which is included in many portfolios, has a lower ratio of net debt/EBITDA at 1.26, but sells at a more attractive valuation than either index.  CALF has a price/free cash flow ratio of 8 and a price/earnings ratio of 11.

While there are reasons to be concerned about the economic future of the country (see my May 3 blog, “Prepare for All Eventualities), some stocks offer better fundamentals and more attractive valuations than other stocks.  Also, we deal in a world of probabilities rather than certainties, and an allocation to common stocks makes sense as a hedge against inflation.

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

Posted on

GMO is Cautious but Selectively Optimistic

Jeremy Grantham, co-founder and chief investment strategist of GMO LLC, has an excellent reputation among investment managers due to many of his prescient statements of the past.  He and his asset allocation team garner attention when they publish their commentary and 7-year forecasts on asset class returns.  GMO is currently cautious about the US stock market but selectively optimistic about pockets of opportunity.  Their comments reflect a defensive stance at the present time.

In his March 11 commentary, Jeremy Grantham writes that “the U.S. is really enjoying itself if you go by stock prices.  A Shiller P/E of 34 (as of March 1st) is in the top 1% of history.  Total profits (as a percent of almost anything) are at near-record levels as well.  Remember, if margins and multiples are both at record levels at the same time, it really is double counting and double jeopardy.”  However, while U.S. stocks are generally overpriced, he believes that there are some relatively attractive investments.  He highlights quality, resource, and deep value stocks.

Quality stocks are defined at GMO as stocks with a high stable return on equity and a strong balance sheet.  Grantham argues that they have “a long history of slightly underperforming in bull markets and substantially outperforming in bear markets.”

Grantham likes resource stocks that provide raw materials which are finite and getting scarcer.  He also likes the diversification benefits because “at longer horizons (10 years) resources are the only sector of the stock market to be negatively correlated with the broad stock market.”

There has been a divergence in valuations among U.S. stocks.  Deep value stocks (the cheapest 20% of the US market) “are in the best 7% of their range” while the most expensive 20% of U.S. stocks “are in the worst 10% of their 40-year range (compared to the top 1000 stocks).”

As of February 29, 2024, GMO is forecasting an annualized real return (for 7 years, after inflation) of -4.1% for US large cap stocks and -2.6% for US small cap stocks.  They have higher expectations for international stocks, with a range that varies from a low of 1.1% for international large cap stocks to the highest ranked category of emerging market value stocks at 5.8% (after inflation, in local currency terms).  In terms of US dollars, GMO expects an additional 2 to 4% per year from currency gains for international stocks.

GMO has modest expectations for fixed income.  At the end of February, their 7-year forecast for fixed income has real returns (after inflation) for U.S. bonds and U.S. inflation-linked bonds of 1.7%.  The highest ranked category is emerging debt at a 3.5% real return.

GMO does not provide any forecasts for precious metals, but they are starting to receive more attention.  Central banks and investors continue to buy gold, primarily due to the rapid growth of US government debt and interest expense.  Also, the geopolitical landscape is changing and the world is less willing to follow America’s lead.

Silver demand is picking up as well.  India imported a record 2,200 metric tons of silver in February 2024, a portion of which will be used for lithium-ion battery production at a new factory.

If you would like to read more research directly from GMO, it is available to the public here: https://www.gmo.com/americas/

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

Posted on

Reading the Fed’s Tea Leaves

Financial markets price securities based upon future expectations.  Based on the shape of the yield curve, financial markets reflect anticipation of the Federal Reserve (Fed) cutting rates aggressively in response to a recession.  Given the recent market rally and high equity valuation levels… READ MORE