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Market recovery – valuation assessment

One should expect global EPS growth to be significantly lower than what was expected at the end of last year. Still, global equities have strongly recovered from their March 2020 lows, while at the same time PE valuations have retreated. The question of “Is the market irrational?” is therefore warranted.

Clearly, to justify valuations, we could explain and develop valuation principles here for each industry, sector, and economic player. Key ratios and fundamentals can explain much, but not all. It is therefore worthwhile taking a look beyond principles of standard valuations in order to explain and understand current market valuations.

In the aftermath of the financial crisis of 2007/2009 and the subsequent QE, star investor Warren Buffet was asked how much money he had lost as a consequence of the FC. The normally very subtle investor from Omaha responded: “I had 10,000 shares of Coca-Cola before, and I still have 10,000 shares of Coca-Cola now.” What was he trying to say? Probably that he sees the valuation of a company not in nominal terms, but rather in terms of what the company produces and owns and in terms of being a fractional owner of the infrastructure. The external valuation given to these investments is therefore a question of mathematical appreciation. And that brings us to the point.

Let’s assume the following: you buy a bottle of Coca Cola for USD 1 before a market event. To cover for a liquidity crisis, the central bank increases the monetary base by 10%. This in turn devaluates your 1 dollar to 91 cents. However, let’s consider the value of the bottle of Coca-Cola. Theoretically, your bottle of Coca Cola should sell for USD 1.10 (because the consumer will pay with a denomination that is worth 10% less).

In practical terms, this is called inflation, and in monetary management language, it is referred to as debasement. By debasing their currencies, governments believe they can meet their financial obligations more easily or have more money to spend on infrastructure and other projects. Debasement holds negative consequences for citizens, as the risk for uncontrolled inflation rises. This further benefits the government by making government debts easier to pay off.

Now, let us shift from this theoretical point of view, back to reality. Debasement – along with some nascent but potentially groundbreaking technologies and the integration of new applications for our day-to-day lives – caused market valuation to grow to present levels very rapidly. The market did not move because of “value companies,” but rather because of promising new innovations that offer growth and sustainability for the future.

Example: the truck company Nikola (NKLA) is valued at an astonishing $23.1 billion. This is because of their hydrogen technology. However, they have not yet manufactured a single truck. In comparison, Ford is valued at $25.7 billion, but it works and produces cars with a technology that will be redundant in a few years. The technology NKLA develops is paramount and if successfully pushed to the market, will be groundbreaking. The present valuation therefore represents a fraction of the future, and as investors, we are willing to invest on the future outcome of an undertaking. 

This and companies in areas like artificial intelligence (AI), the Industrial Internet of Things (IIoT), 3D printing, drones, automation and robotics, and big data are already providing a real glimpse of the future. In the wake of these new technologies, and together with debasement, the entire market was propelled very quickly to today’s high but still reasonable valuations.

On the back of a potential quarter percent rate cut, the S&P 500 closed at another record high on 26.07.2019.

Market sentiment isn’t just driven by the interest rate direction, but corporate fundamentals do guide to market too. In fact, company earnings outlook is clearly bottom up, while the interest rate outlook is top-down. With the second-quarter earnings season now halfway through, we retain the following:

·         Overall S&P 500 earnings growth for the quarter is below previous forecasts, most of which is due to Boeing's 737 Max grounding. Earnings growth for the median company in the S&P 500 is on pace to be just over 4%. Sixty-nine percent of companies are beating earnings forecasts, and by a wider margin than average.

·         US consumer spending grew at a 4.3% real annualized rate in 2Q and is consistent with comments from the banks and results from large consumer companies such as Coca-Cola, Starbucks, and McDonald's. E-commerce, internet advertising, enterprise IT spending, and aerospace also remain solid. Finally, there are some indications that global oil and gas spending is picking up.

·         After a speedy 2018, Semiconductors are exposed now to a mature market.

·         We see also mature market conditions for automobiles sales (new car sales as well as second hand), this is generating a larger impact throughout the divers supply chains – remember that about 1/3 of the global GDP is related to the automobile industry.

For now, earnings growth is sluggish, but we expect trends to improve based on supportive leading indicators: favorable access to capital, very low new claims for unemployment insurance, and a recent improvement in capital goods orders to a new high. Also, the negative base effect this year from the 2018 fiscal stimulus and the lagged impact of prior Fed rate hikes, which are likely weighing on results, will begin to dissipate, especially in 2020.

For 2019 and 2020, we continue to expect S&P 500 earnings growth of 1% and 7%, respectively. The expected reacceleration in earnings growth should support further market gains, and we are overweight US stocks. But we expect second-half returns to be lower than in the first half.

The Fed will decide on its interest rate policy on Wednesday. The ECB's decision-makers will also meet in Sintra for the conference.

Very recently, both ECB and FED have hinted at a easing of monetary policy; the situation is particularly true for Europe where the expected rate of inflation is well below the historic average.

Meanwhile, US investors are already expecting interest rate cuts this year. The risk, however, is that such expectations could trigger a downward dynamic if they are not realized. Two years ago, the President of the European Central Bank had already caused fierce reactions on the markets with his speech in Sintra. So watch out for the comments in-between the lines.

- Central banks have turned dovish, which is a key difference with last year. Keep in mind that the market correction last Fall was primarily caused by fears of a too hawkish Fed leading the US into recession.

- Smart money has viewed the rally with skepticism since the beginning of the year, hence a “flow-less” bull market.

- US productivity has been accelerating recently, so that unit labor costs have remained quite muted. This is good news for US corporates’ margins and EPS.

- The current tensions should not lead to a global economic recession, even though the level of business confidence is more depressed than in March last year when Trump initiated the trade war. The protectionist measures taken to date should cost around 0.5%-pt to China this year and next and around 0.2%-pt to the US. The environment remains tough for manufacturers but, albeit mixed, the latest data are still consistent with an orderly economic deceleration rather than with an outright recession.

In interesting chart from PriceStat about inflation

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