On Sunday morning, while sitting cross-legged on the back deck and frowning out through the kind of heavy, wet mist that settles on you, I scanned a piece from Bloomberg about earnings season and how purportedly detached equities are from near-term profit expectations.
The adage about guidance being all that matters “is being taken to absurd extents right now,” the journalist announced. “The S&P 500 is pricing in profits that virtually cannot materialize in two years.”
That assertion is based on the notion that in order to push down the index multiple to its longer-term average, corporate America would need to conjure up EPS of $250. For reference, bottom-up consensus for 2021 is around $175. For 2022, it’s around $200, give or take (figures below).
So, US equities come into earnings season trading at around 24 times this year’s expected profits.
That’s elevated, historically. And before I take you into a longer discussion, I’ll admit that it makes me just as uncomfortable as the next guy or gal with money on the line. I may consider myself a god, and I’m adamant when it comes to reminding the world that “money” is a mere human fiction, but on a daily basis, I’m a human who doesn’t like to lose money.
Assuming the S&P’s multiple needs to “correct,” there are two ways for that to occur. One is for profits to rise to the occasion, figuratively and literally (chart below).
The bottom pane in the first set of visuals (above) shows that consensus is looking for $203 in 2022. For 2023, the figure is about $220. By extension, US stocks are trading around 15% rich to projected 2023 profits, where “rich” is an adjective derived from the long-term average for how much investors have historically been willing to pay for a dollar of earnings.
The other way for the index multiple to correct is simply for stocks to crash. By how much? Well, simple math suggests a 27% plunge would just about do the trick, assuming estimates for this year’s corporate profits are accurate.
The linked article (from Bloomberg) acknowledged that “no one can predict with confidence the lasting power of stay-at-home demand, or the boost to consumer spending from stimulus checks.” It noted that “the extent of profit hit from supply chain disruptions and rising commodity costs are also big wild cards.” Finally, the journalist admitted that “the truth is that when you’re looking ahead… nothing is really knowable.”
After that, the piece quoted an April 7 note from JonesTrading’s Mike O’Rourke, but I found the truncated version Bloomberg used somewhat inadequate. In the note, O’Rourke discussed Jamie Dimon’s contention that the forthcoming US economic boom could last until 2023. That suggestion, delivered in Dimon’s latest shareholder letter, was accompanied by a recommendation (from Dimon) that government should spend more money and invest in things like infrastructure as long as those investments are made “wisely.”
The uncomfortable reality for some in the investment community who aren’t enamored with the direction policy is taking inside the Beltway, is that Dimon’s lengthy remarks were overtly Progressive — as much as a billionaire bank CEO can be Progressive, which obviously isn’t much. Below, for example, is a direct, verbatim quote that found Dimon advising Republicans:
Republicans need to acknowledge that America can and should afford to provide a proper safety net for our elderly, our sick and our poor, as well as help create an environment that generates more opportunities and more income for more Americans. Republicans could acknowledge that if the government can demonstrate that it is spending money wisely, we should spend more. And that may very well mean higher taxes for the wealthy.
That just is what it is. You can read it for yourself, straight from the source (linked article above).
Suffice to say that, in the note from O’Rourke cited by Bloomberg, Mike expressed a bit of incredulity around the idea that money will be spent any semblance of “wisely.” The longer version of the quote that Bloomberg used from O’Rourke read as follows:
Dimon followed the 2023 ‘boom’ comment with a line that reads more like a warning. Dimon asserted, ‘The permanent effect of this boom will be fully known only when we see the quality, effectiveness and sustainability of the infrastructure and other government investments. I hope there is extraordinary discipline on how all of this money is spent. Spent wisely, it will create more economic opportunity for everyone.’ Just like everyone, we hope for the best, but the political power grab is not consistent with ‘extraordinary discipline’ nor would it be described as ‘wise.’ As we head into earnings season with the equity market at all time highs, investors need to recognize nothing we are about to witness is ‘growth.’ First, we will have the continued snap back over the next couple of quarters. After that it will still be impossible to identify a discernible economic trend due to the frivolous monetary and fiscal policy environment. Even worse, there won’t be real clarity for a couple of years. This abandonment of the market based economy will hurt investors. Investors will not be able to quantify which aspects of growth, earnings and the economy are organic, and which aspects are the result of a simulated world where monetary and fiscal excess artificially create a facade of health and wealth.
While I’d agree with the thrust of the last sentence (more on that below), I’d quibble with some other bits. For example, “political power grab” is a subjective assessment and “wise” is a subjective term.
I’ll flip this on its head so I can make the point without any of my Republican readers accusing me of partisan bias. Would it be strictly (i.e., objectively) accurate to call the Trump tax cuts an unwise, political power grab? No. Why not?
First, Republicans controlled the government. When voters put you in a position to push your agenda through the legislative process, passing legislation isn’t really a “power grab.” It’s certainly true that in a deeply divided nation with a deeply divided legislature, laws passed with the slimmest of majorities are more power grab-ish (if you will) than they would be otherwise, but where do you draw the line on that? How much Democratic support (when Trump was president) or Republican support (now that Biden is president) is sufficient for a given proposal to be considered “legislation” versus “power grab”? Is it two defectors? Five defectors? Eight? And what about the Republicans who voted to impeach (and remove) Trump? There were several of them, after all. Does that mean the impeachment proceedings weren’t a “political power grab”?
Second, there’s no immutable definition of “wise,” especially as it relates to intersubjective phenomena like money and markets. With apologies to readers who aspire to some high morality, there’s no such thing as “right” and “wrong” — not really, anyway. The Trump tax cuts weren’t “wrong” and they weren’t “unwise” just because the benefits accrued disproportionately to corporations and the wealthy. They may have been unwise to the extent exacerbating inequality risks adding to the societal discord that could eventually be our undoing not just as a nation, but as a species. But considered in a vacuum, there is nothing inherently “right,” “wrong” or “unwise” about delivering a windfall to corporates and rich people.
By the same token(s), Democrats’ effort to push Biden’s rescue proposal through with no Republican support, and their intention to do the same with the infrastructure plan, is no more a “power grab” than the Trump tax cuts were. And spending trillions on proposals which will disproportionately benefit Democratic constituents is no more (or less) “right,” “wrong” or “wise” than GOP proposals that skew in the other direction.
With those caveats, and to close on the same note that Bloomberg closed on, I’d agree with JonesTrading’s O’Rourke when he said that “investors will not be able to quantify which aspects of growth, earnings and the economy are organic, and which aspects are the result of a simulated world.”
Indeed, I penned a kind of trilogy during the first three months of the crisis, one installment of which was called “Simulation Game.” Below is an excerpt:
Earlier this week, I spoke to a young lady who used to bartend at one of my favorite local haunts. To my surprise, she was relaxing on the beach a mere two miles up the street. That was an unexpected piece of news. The last time I spoke with her, she was in New York, where she moved three years previous. Long story short, she lost her job and returned to the island, presumably because she knows virtually everyone here, and was able to locate affordable living arrangements.
That anecdote will resonate with my long-time readers. In August of 2016, I wrote a piece about CLO tranches. It opened as follows:
What started with the usual hot sake carafes and tuna tataki ended at around 3 AM sitting on the patio of a decidedly loud bar with two Albanian girls, one of whom had to translate what I was saying to the other. And they were chain smoking. Good company, great stories, but finally, I just wandered off back home.
The translator in that story is the young lady who is now jobless and back here on the island as a result of the crisis. I don’t know her citizenship status, nor am I apprised of how that might factor into unemployment benefits, but what I do know is that for many of the millions of Americans who have recently lost their jobs, incomes are being replaced in their entirety.
As O’Rourke put it last week, this is “a simulated world.” And it has been for more than a year now.
He also said that the “monetary and fiscal excess” which are behind the simulation “artificially create a facade of health and wealth.”
That’s certainly true in one sense. What is a simulation if not an artificial facade?
But, like “political power grab” and “wise,” “health” and “wealth” are often subjective terms too.
[Editor’s note: None of the above should be construed as criticism. The author of the Bloomberg piece, Lu Wang, consistently produces quality, informative articles. O’Rourke’s missives are on my daily reading list and I would highly and happily recommend them to anyone.]
A couple of things come to mind. First of all, the assumption that government spending is less efficient than private markets is not a given. Especially when one takes into account externalities and the existence of public goods. I have worked in the private sector my whole life and I have observed plenty of unfair and wasteful spending. Given that we just went through a pandemic public health seems like a great use of money to me. Even if it was only “75%” efficient- is it less beneficial than a 100% efficient expenditure on fast food and sugary drinks which has been shown to cause ill health if eaten frequently? I beleive education while not physical infrastructure is absolutely infrastructure. A more educated population is generally happier and more productive- and isn’t labor a factor input, just like land and capital?
“But considered in a vacuum, there is nothing inherently “right,” “wrong” or “unwise” about delivering a windfall to corporates and rich people.”
Perhaps not, but I’m a Sagittarius and I can’t stop myself from making judgments about “fairness,” and those tax cuts weren’t really necessary nor were they fair. And the opinions that generated the excuse for those cuts could be easily interpreted as mean-spirited at least.
One of the interesting things that can be seen in the reported minutes of the Wannsee Conference which planned for the Nazi “final solution” was the machinations the group had to go through because at least one important member was part Jewish, and several members had important friends with Jewish relatives. So the details of the final plan had to be gerrymandered in complex ways to end up with the preordained solution in a way that didn’t bring harm to any team members. I somehow get the feeling that much legislation in recent years is created with that same process, as in — well let’s see if we do this or that, Joe gets screwed and we can’t do that so let’s put in this loophole … We all know who gets screwed these days.
I think if we are to be honest the simulation has been running for over a century. Central banks setting interest rates is not a market mechanism, governments intervening in the economy in any way (other than enforcing contracts) is not a market mechanism.
The simple fact is government intervention began because of market failings and the instability of market processes. It was seen to be unacceptable to have wild swings in economic activity and the social costs of that. For most of the last 100+ years policy has been adjusting the scope and depth of intervention.
The period from 1980 onwards represented a modest roll back of the scope of the simulation and the pandemic the opposite. But saying the ‘simulation’ is new occurrence demonstrates how effective the previous ‘simulation’ was at making people believe it was free market rather than a managed market economy. The most recent changes merely manage it more, but it has not been free in anyone’s living memory.
Markets have not run freely since the barter system. Governments and markets have always been hand in hand.
Indeed, however I am thinking more in terms of the paradigm of macroeconomic management, ‘driving the car’, as opposed to microeconomic rule-setting ‘eg making sure the vehicle works smoothly’. The former has only been a systematic endeavor in the past 100 years or so.
I think power grab begs a more precise definition before debating what it is or isn’t. One can certainly say utilizing a populist right wing movement to predominantly award the wealthy and large corporate interests in a country which has also dubbed money speech could be considered an attempt to consolidate political power at the expense of those who gave you the democratic mandate. That might arguably fit a reasonable definition of a power grab. If one is utilized democratic political power to reward constituents that may be wise or unwise but it isn’t changing the fundamental power dynamics. Gerrymandering as another example of utilizing democratic power to undermine its future potency.
And out of curiosity… how much of the detachments of equities to near-term profits is that of the big tech darlings and how much is assigned to the small caps?? So that if there was a correction would the affect the Apple, Amazon and associates felt be a higher percentage of net worth than the smaller fry??