Investors seem increasingly optimistic. But should they be?

The market has repeatedly hit new all-time highs over the past several months, a surge the media has referred to as the “Trump rally.” An additional explanation out there is that the market's run is powered by newly discovered “animal spirits.” I expect we'll continue to hear more about animal spirits as long as the market rises, so I want to make sure we're clear on what "animal spirits" are. Here's the description of animal spirits given by economist John Maynard Keynes in his 1936 book The General Theory of Employment, Interest and Money:

“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” (Emphasis added.)

 

Is this an accurate description of what we're seeing in the current market? Perhaps, but I'm skeptical.

I'm not conviced that what we're seeing is the result of “spontaneous optimism.” There are, after all, mathematical expectations embedded in the valuation of the market at all times. Those expectations are easy enough to track and can give us a reference point to how today’s market valuations compare historically. In determining how much of the optimism we see embedded in the market is spontaneous, it’s worth looking at a longer term than just the last two news cycles.

The table below shows the Wall Street consensus analyst earnings expectations for the S&P 500. There's a lot here, so bear with me. The different columns whos estimates for the "year ahead" over the past six years, what the earnings ended up being, where the market was at the time, and what the multiple on the expected earnings was. So for March 2012, we’re looking at what the published earnings expectations for the S&P 500 was (per each S&P 500 “share”) in the first quarter of 2012 for the year ahead — i.e., the 12 months ending December 2013.

Obviously, making a prediction for 500 companies a full two years forward is not going to be done without errors. We’re not expecting analysts to nail these estimates down to the penny, but still, what can we learn from looking at the results?**

Date

Year Forward Estimate

Price of S&P

Forward P/E

       Actual Earnings

Mar-12

$117.91

1408.47

11.94

       $107.31 (2013)

Mar-13

$124.73

1569.19

12.58

       $113.01 (2014)

Mar-14

$137.19

1872.34

13.64

       $100.45 (2015)

Mar-15

$135.03

2067.89

15.31

       $106.61 (2016)

Mar-16

$135.93

2059.74

15.15

               ?

Mar-17

$148.35

2363.64

15.93

               ?

I’ll make a couple of points from this chart. Bear in mind that these estimates and actual earnings are for operating earnings, not “as-reported GAAP” earnings, and so are consistently higher by about 10%-12% than GAAP (Generally Accepted Accounting Principles) earnings.

1. As I’ve written before, analysts are reliable more in their unchecked optimism than in their realized accuracy. Here it is at the beginning of 2017, and the S&P 500 still hasn’t reached analysts’ consensus estimates for 2013. For the most recent 12 months, at $106, earnings are still a cool 10% away from where analysts thought they’d be over three years ago. It should be noted that 12-month trailing earnings peaked at $114.50 in the third quarter of 2014, which was reasonably close to the 2013 number – but, of course, nine months later and still short a bit. Referring back to Keynes’ quote, the optimism we are seeing today is not spontaneous so much as continuing when it comes to what analysts think is right around the corner.

2. While it may be true that there is always embedded optimism in analysts’ forward-year numbers, the levels expected next year set new records in that department. Expecting earnings per share to improve nearly 40% over two years is a pretty low-percentage bet. Remember, the earnings numbers we’re looking at today aren’t at some depressed low. The economy in 2016 was very healthy, if not quite as profitable on a per-share basis for the S&P 500 as in 2012-2013. The decreased aggregate profitability is almost totally attributable to the collapse in oil prices. The energy sector was highly profitable before 2015, and though 2016 was better than 2015, both years showed losses for the energy sector as a whole. The rest of the market showed fairly normal earnings growth throughout 2014-2016.

3. As optimistic as analysts have been, investors have been just as much so, pushing the P/E on increasingly optimistic forward operating earnings numbers up from 12 to 16. If that 12 P/E from 2012 seems too low to you, remember, that was on a forward expected earnings estimate for 2013 that still hasn’t been achieved. If a forward operating earnings P/E of 16 seems reasonable to you, remember to check how likely the actual estimate is to be realized. As a counterargument, permanently low interest rates from now into the future would absolutely justify P/E multiples higher than historical averages, when equities had to compete with more profitable expected bond returns.

4. How likely are operating earnings to take that huge leap up over the next two years? At first glance, it would seem extremely unlikely, given that earnings per share historically compound at no better than 5%-6% a year. The market is pricing in corporate profitability growth of an unprecedented magnitude. However, the current administration (the one the “Trump rally” is named after) absolutely has put forward certain proposals that are unprecedented. Getting rid of, or choosing not to enforce, wide swaths of regulations regarding the financial sector and the environment, to name just two possible areas to be affected, would inevitably help business profits in the short term, whatever their long-term costs. Reducing business taxes by roughly half, again, comes with significant costs to the deficit but directly improves business profitability. The United States government is the most powerful entity going – if it chooses to fully support business interests, that cannot help leading to significant profit growth for businesses. We’ll see what actually gets achieved in the legislative realm.

It’s easy enough to attribute the move up in the stock market since the election to business and/or investor-increased “animal spirits,” but those spirits are also part of a longer narrative – an almost uninterrupted spirit of significant optimism about the future profitability of business that has defined the past five years. Perhaps now is the time earnings will actually improve, but whether they do or not, the market seems to have already rewarded itself for that possibility, and the hard work of achieving those levels of profits remains.

(** Note: The hypothetical example is meant to demonstrate a basic compounding principal. It does not represent or predict the performance of any investment and does not take into account taxes, fees or charges associated with an investment. Securities in the Funds do not match those in the indexes and performance of the Funds will differ. It is not possible to invest directl in an index. Estimates are inherently limited and should not be relied upon as an indicator of future results. Past Performance Does Not Guarantee Future Results. There can be no guarantee that any strategy will be successful. All investing involves risk, including potential loss of principal.)

 

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