Investors must heed volatility, despite strong rebound

SERIOUS MONEY:THE CYCLICAL uptick in stock prices rolls on and the more than 90 per cent jump in the major market indices from their lows less than two years ago has caused many of a bearish persuasion to relent in the face of the powerful upward momentum.

The perpetual bulls are back in charge and continue to advocate heavy allocations to equities, given ultra-accommodative monetary policy alongside a lean and mean corporate sector that boasts a near-record rebound in profitability from its recent cyclical low.

However, valuation multiples are back in nosebleed territory, having spent just nine months below their long-term mean, and investors must believe that trend earnings have experienced an upward shift such that near-record profit margins can be sustained indefinitely – even though no such previous once-off transition in earnings to a higher level can be gleaned from almost 140 years of historical data.

Thus, just as Prof Irving Fisher of Yale believed that “stock prices have reached what looks like a permanently higher plateau” in the autumn of 1929, today’s investors must also believe that the current earnings cycle is truly different.

The previous earnings expansion began during the spring of 2002 and corporate profits more than doubled in real terms by the summer of 2007, but the subsequent contraction proved to be particularly brutal as nominal GDP dropped in 2009 for the first time since 1949 and at the fastest rate since 1938.

The near-60 per cent decline in real earnings during the 27-month long downturn to levels first reached more than three decades earlier, ranks among the most punishing profit declines in history.

The magnitude of the contraction during the “Great Recession” is exceeded only by the 87 per cent drop in earnings from their 1916 war-inflated peak to the 1921 low, and the 67 per cent decline registered from 1929 to 1932, as the go-go economy of the “Roaring 20s” slid into the “Great Depression”.

Corporate earnings bottomed during the third quarter of 2009 and have since more than doubled to levels that are just 12 per cent shy of their all-time high. The strength of the rebound has been a pleasant surprise and particularly so given the notable absence of robust revenue growth until the most recent quarter.

Aggressive cost-containment efforts through the downturn allowed margins to bottom almost two percentage points above the previous trough registered during the fourth quarter of 2001. The focus on cost structures has persisted through the upturn to date, such that total expenses, both financing and operating, are only marginally higher than the level registered at the 2007 peak of the previous earnings cycle.

The incessant focus on costs has seen profit margins jump to within touching distance of an all-time high and robust top-line growth alongside the favourable impact from operating leverage is expected to push earnings past their 2007 record high during the first half of next year.

This is undoubtedly an impressive development compared with previous profit declines of a comparable magnitude. Indeed, the 1916 peak was not revisited in real terms until 1955 – almost four decades later, while the earnings level of 1929 was not reached again until 1948 – almost 20 years later.

This episode will see the corporate sector recoup all the lost ground in just five years.

As favourable as the current earnings expansion has proved to be, investors should not lose sight of the fact that earnings growth, profit margins and profitability are all mean-reverting variables.

Real earnings for example, have oscillated around a trend growth rate of 2 per cent through time and the historical data reveals that there has never been a one-time upward shift in the corporate sector’s per-share earnings power.

This means that the further the level of current earnings from trend, the more violent the subsequent change in direction proves to be.

Current earnings are 10 per cent above trend using dubious operating numbers and almost 25 per cent using more reliable reported data. Expectations call for increases in earnings in 2011 and 2012 to levels that are far removed from trend, such that the next earnings downturn is almost certain to be at least as brutal as the 2000/2002 contraction of more than 30 per cent.

An event that appears to be some way off may be considered irrelevant by some investors, but the key message is that it’s not simply the level of earnings that matters, but also their volatility. The fact of the matter is that the two large profit downturns experienced since the peak of the technology bubble have caused earnings volatility to increase to levels that have not been seen in more than 70 years.

Against this background, investors should pay below-average multiples for a unit of trend earnings and not the 20 – 21 times seen today. Paying high multiples for peak margins has always proved costly and this time will ultimately prove to be no different.

charliefell.com