All stock-market moves are controversial, but this rally is outright mystifying to many. The strength has certainly surprised investors, although some of the strength may be due to perspective. The S&P 500 is up 11% off the Nov. 15 post-election low, but it is now up only 3% vs. the 1460 level it marked for much of the autumn.
(As an aside, the markets once again proved that you cannot ignore history. In September I analyzed the historical post-election stock market performance, noting that the market usually rallies as the uncertainty is removed. That analysis looked wrong for the first week after the 2012 election -- but, since then, the pattern has emerged once again.)
When I am unsure about the causes or durability of a rally, I fire up FactSet, start Excel, and try to see what data support or refute the rally. Keep in mind that only a handful of factors can drive a rally. Consider that a stock (or index) price is simply earnings multiplied by the price-to-earnings multiple. For the price to go up, either the earnings or the multiple, or both, must be rising. So what is happening now?
Earnings: Profit growth is clearly expected in 2013. Of the 500 names in the S&P 500, 420 are expected to grow earnings per share this year, based on Thomson Reuters estimates. Average EPS growth is expected at 20.5%. Only 80 names are expected to show an EPS slide, with the average decline pegged at 14.5%. If we combining all the EPS growth estimates, we get per-share growth of 12.5% for the whole index -- not bad.
There is a "but," though. The problem is that the market is a discounting machine, and it has known about the year-over-year EPS growth since this rally started. To justify a higher index price, one would assume that the earnings outlook is better now than it had been two months ago. Is it?
Actually, the earnings outlook for 2013 is deteriorating. Over the last two months, 296 of the S&P 500 stocks have had their 2013 EPS estimates revised downward. 195 were revised higher, and only nine are unchanged. The expected per-share profit for the overall index is now 2.5% lower than it had been two months ago.
Fact one: Over the two months that the S&P 500 has rallied, 2013 earnings expectations have gotten marginally worse.
Multiple: The weighted average P/E multiple for the S&P 500 is currently at 17x the 2013 EPS; 153 names are above this number, and 346 are below it. Two months ago, the index was trading at 15x the expected 2013 EPS. A change of 2 multiple points constitutes meaningful valuation expansion, especially considering that this hasn't been supported by accelerating earnings.
Fact two: The market is more expensive now, indicating the presence of "animal spirits" and the expectation of better results.
Since this is strictly a valuation-based rally, the next step of the analysis is to consider whether a higher valuation is justified. What might justify a higher multiple?
Interest rates: The multiple typically expands when interest rates fall in U.S. Treasuries, and it contracts when rates rise. The multiple behaves like a bond price, adjusting the earnings yield to the current "going rate" in the market. Falling rates would justify a higher P/E. However -- and this has been barely noticed by stock market investors -- interest rates have been steadily rising since the summer. The chart below shows how the 10-year yield bottomed in August at 1.4%, and how this bond is now yielding around 2% -- a 43% increase.
Fact three: Interest rates have been rising, not falling, at the same time that the market multiple has been expanding.
Better economic conditions: A higher multiple could indicate that investors are anticipating eventually higher earnings in 2013, driven by strong economic conditions. Is the economy strengthening? Here are some data points:
● U.S. gross domestic product contracted in the fourth quarter. However, the private economy was OK -- the contraction was driven by government spending and inventories. Consumption and business investment grew.
● The Conference Board Consumer Confidence Index unexpectedly fell to a 14-month low of 58.6 in January, when 64 had been expected. December Consumer Confidence was 66.7.
● The Kansas City Federal Reserve survey turned negative in January. It posted a minus 2, when plus 1 had been expected.
● The working and middle classes -- in other words, the consuming classes -- just suffered a 50% tax increase with a 6.2% payroll-tax hike.
● A recent Chamber of Commerce small-business sentiment survey was unfavorable. 82% of businesses surveyed felt the economy is on the "wrong track," and 54% expected worse business conditions in two years.
● Housing prices are strong. In December the median new-home price was up 14% year over year. The closely watched Case-Shiller index was up 5.5%, November, its most recent data point -- the most substantial rise since 2006.
● Housing volume is OK. Not seasonally adjusted, the 26,000 new homes sold in December -- an 8% increase over December 2011.
Goldman Sachs, which tracks the direction of macroeconomic surprises, has noted a strong pattern over the last three years: Indicators tend to surprise to the downside in the spring and summer. If the pattern holds, the new flow of economic news could become more negative in the coming months.
Fact four: The latest economic indicators are mixed. Housing is clearly strong, but many forward-looking sentiment indicators are flashing warning signs.
Technicals: We all know that sometimes a good chart can beget an even better chart. Jeff Saut, an excellent market strategist at Raymond James, recently commented on the technicals:
"On the bullish side, we began the year with back-to-back 90% Upside Volume Days, a feat that has not been seen since 1987 when the D-J Industrial Average (INDU/13895.98) was beginning a rally that would carry it 24% higher into April. Interestingly, year-to-date this is the best beginning of the year rally since, you guessed it, 1987! Also recall that the history of back-to-back 90% days is for the SPX to be higher an average of 6.8% one month later 83% of the time and 12.8% higher three months later 100% of the time."
Fact five: Technical indicators, most notably the 90% upside days in early January, indicate a high likelihood that the rally will continue for at least a couple more months.
Contemplating these facts, I find that caution is warranted. The rally is being driven strictly by multiple expansion, which seems unsustainable in a rising-interest-rate environment. The economy seems OK but mixed, with pockets of firmness but not across-the-board strength. As a result, I cannot make a case for gusty tailwinds pushing up earnings, especially since the seasonal patterns would suggest downside surprises in the months ahead.
I do put credence in the 90% upside indicator. Ignore history at your own risk! I also find it interesting that this indicator is tracking 1987, as we all know how that year ended. Just as a reminder: That year, the market rallied hard on P/E expansion in a rising-interest-rate environment, similar to what's happening now. If rates do not turn south again, earnings acceleration will be required to keep the rally going, as multiple expansion may soon run out of steam.