Following two days of heavy selling, U.S. stocks are rebounding on Tuesday, with the benchmark S&P 500 (SNPINDEX:^GSPC) and the Dow Jones Industrial Average (DJINDICES:^DJI) (DJINDICES: $INDU) up 0.98% and 0.76%, respectively, at 1:20 p.m. EDT.
This labor market trend could puncture stock valuations
Yesterday, Matt Busigin, the engineer-blogger turned portfolio manager, published an excellent new article on valuation and growth of the S&P 500. While much of the financial media is currently tracking on the day-to-day (or hour-by-hour!) impact of the Brexit fiasco on stock prices, Busigin's piece takes a longer-term view -- five years out, in fact. His conclusion is sobering: "[L]ittle upward optionality seems available in the purchase price of the S&P 500."
To get there, he starts from a foundational observation: that "[a]sset returns can be considered a function of the differential between expected real earnings growth, and realised real earnings growth." That's a formal way of saying stock returns are determined by the relationship between stocks' future earnings stream and the initial price you pay for that earnings stream (which price implicitly reflects your view on estimated earnings growth). That sounds reasonable enough.
With an econometric model (what did you expect -- he's an engineer), Busigin shows the long-term data support that observation before using the model to back out the growth rate in earnings-per-share that is baked into the current S&P 500 price:
[W]e can impute market expectations for EPS growth at 6.34% compounded annually. (The historical average is very similar -- 6.39% compounded annually.) This would put S&P 500 EPS at $149 by the end of 2021.
All well and good, but how are we going to get to $149? That's the question Busigin tackles by analyzing economywide profits as a function of two factors, stating that "[w]e can describe the growth in profits as the growth in nominal national income, combined with the shift in profit share of national income." A second model that expresses that relationship produces the key insight of the article:
We immediately are struck by how much more significantly change in profit capture explains variability in profit growth than NGDP ... Thus, in judging the veracity of valuation-implied EPS growth, our time is far more productively spent analysing the aggregate relationship between labour and the corporate sector than economic growth.
In other words, in trying to determine whether the market-implied earnings growth rate for the S&P 500 of 6.34% is realistic, you're best off focusing on how the income pie is being split between companies and workers. Which is what he did:
[T]o get to our 6.34% EPS growth, we need [companies'] profit share of GDP to rise around 84bps.
[Note: 1 bps, or 1 basis point is equal to one hundredth of a percentage point.]
And there's the rub:
[T]he profit share of GDP is falling, and precipitously -- from its peak of nearly 11% in 2012, it has fallen to almost 9%. Buying equities here is essentially a bet that on the reversal of this trend toward increased wage capture of GDP.
As the labor market tightens, workers achieve more bargaining power regarding wages; the odds of a reversal look slim. In fact, with "the wage share of GDP is gaining about half a percentage point per year -- and this appears to be accelerating," it's companies' share buybacks that have prevented the falling profit share from showing up more clearly in earnings growth figures.
But even that buttress could be starting to crumble: Yesterday, Reuters reported that "U.S. companies have announced $291.7 billion worth of buybacks so far this year, about one third lower than the $432 billion announced for the same period last year," citing research from Trim Tabs Investment Research.
Follow-up: Soros bets against Deutsche Bank
In yesterday's column, I looked at the way three billionaire investors, including George Soros, were thinking about Brexit. Soros Fund Management had previously disclosed a bearish option position on U.S. stocks and a bullish option position on gold at the end of the first quarter.
Bloomberg reported today that the family office sold short shares of German lender Deutsche Bank AG (NYSE: DB) as the Brexit tsunami hit markets on Friday, to the tune of roughly 7 million shares (or half a percent of the bank's shares outstanding).
As The Wall Street Journal's "Heard on the Street" column remarked in today's paper, the market capitalization of Deutsche Bank, which once had ambitions to compete with Goldman Sachs and JPMorgan Chase, was lower than that of SunTrust Banks on Monday morning -- despite having more than 10 times the assets.