The financial media is nothing if not predictable. Barron’s didn’t even wait for the ink to dry on the Dow Jones Industrial Average’s 20,000 print before declaring in a new cover story: “Next Stop Dow 30,000.” Barron’s argument is that “[t]he Dow hitting 20,000 was no fluke. Today’s stock prices are well supported by corporate earnings and economic growth. In fact, if President Trump can avoid stumbling into a trade war – or a real war – the Dow could surpass 30,000 by the year 2025.”
Leaving aside that this National Enquirer-style headline is little more than a desperate attempt to pump up readership and is followed by an extremely thin article lacking any analytical substance whatsoever, let’s take a serious look at Barron’s claims that corporate earnings and the economy are strong. You can wipe the rear end of a cow with these claims.
Then, let’s take a look at the one sector that hasn’t bought into the hype – and how you can profit.
The Dow Frenzy Ignores These Very Real Numbers
Corporate earnings were weak the last two years. According to Factset, the estimated non-GAAP earnings growth for S&P companies in 2016 was a paltry +0.1% (and GAAP earnings growth was sharply negative). Revenues were up roughly 2.0%, which is zero growth once you back out phony government inflation data and negative if you use real world inflation. In 2015, S&P 500 earnings declined year-over-year on both a GAAP and non-GAAP basis. But even this doesn’t really tell how poorly businesses are performing because GAAP and non-GAAP earnings are inflated by low effective corporate tax rates, low interest rates on the money borrowed to buy back stock and pay higher dividends, and low wage growth. In reality, US corporations are more leveraged than they were in 2007 on the cusp of the financial crisis, a condition disguised by record low interest rates that are now rising. And most of the money they borrowed wasn’t used to enhance their businesses but was paid out to shareholders in stock buybacks, dividends and M&A.
With almost half of companies reporting so far, the full year estimate for 2016 S&P 500 non-GAAP earnings are $108.66 and S&P GAAP earnings are $97.98 This puts the market multiple at 21.1x trailing non-GAAP earnings and 23.4x GAAP earnings. This is just below the 24x P/E that prevailed during the Internet Bubble. .As Peter Boockvar points out, non-GAAP earnings grew by 10.7% in the last four years beginning in 2013 while the market multiple expanded by 47% (from 14.4x non-GAAP and 15.9x GAAP earnings in 2013). The reason for this is that central banks reduced the price of money to zero through QE and ZIRP (zero interest rate policy), radically affecting the discount rate used to calculate the price at which equities theoretically should trade. Rather than being supported by earnings, stock prices are levitated by cheap money and an absence of intellect on the part of investors. Money is becoming less cheap but investors are not becoming smarter, a potentially deadly combination.
As for the claim that a strong economy justifies not only Dow 20,000 today but Dow 30,000 in eight years, Barron’s overlooks the fact that fourth quarter GDP sputtered to 1.9% and kept full year 2016 growth at a disappointing 1.6%, the slowest since 2011 and down sharply from 2015’s 2.6% pace. Last year marked the 11th consecutive year that America failed to reach 3% growth, the longest period since the Bureau of Economic Analysis started reporting GDP. And remember, this growth didn’t happen without eight years of zero interest rates and trillions of dollars of QE; without this support, growth would have been negative. Claiming that a growing economy supports higher stock prices is nonsense.
The whole Dow 20,000 frenzy is an exercise in chasing one’s tail. Like many things that capture the popular imagination, the Dow Jones Industrial Average is not what it seems. As economist extraordinaire David Rosenberg points out, if the eight companies that were replaced in the Dow since April 2004 had remained in the index, we would be reading about Dow 12,886, not Dow 20,000. Also, as a price weighted index, moves in certain stocks have an outsized impact on the Dow. For example, moves in Goldman Sachs Group (GS) have eight times the impact on the Dow as those of General Electric (GE). Tracking the Dow may make for good financial television (actually, nothing makes for good financial television today, but that’s a topic for another day), but it is comparing apples and oranges and means little analytically.
Barron’s May Be Ignoring The State of Our Economy – but Retail Isn’t
What Dow 20,000 does accomplish is getting investors all stirred up that they are missing a rally. But trees don’t grow to the sky even in an era where a new president is actively undoing the economic and foreign policy damage caused by his predecessor with flurries of executive actions. We are still a long way from adoption of the type of pro-growth tax reform needed to revive American growth. And federal debt already exceeds 100% of GDP and is likely to keep growing at more than $1 trillion per year unless the new administration aims straight at serious entitlement reforms. Cutting domestic spending without touching entitlements will do little to stem the rising tide of debt suffocating growth.
In the meantime, however, investors are caught in the dream of a new era of government. Last week, the Dow Jones Industrial Average finally breached the meaningless 20,000 mark, rising 1.34% to close at 20,093.78. The S&P 500 rose 1.03% to finish at 2294.69 while the Nasdaq Composite Index added 1.9% to end the week at 5660.78. The yield on the benchmark 10-year Treasury ended the week at 2.49% and the US Dollar Index (DXY) ended the week little changed at 100.56. The stock market rally has all the hallmarks of a burgeoning bubble, at least to my eye. Wall Street strategists are busy concocting rationales for higher P/E multiples with little substance behind their reasoning. And the worst stocks such as Tesla Motors Inc. (TSLA) keep rising despite little fundamental justification, a sign that investors are living in a post-P/E era where valuation is irrelevant. This is the same phenomenon we saw during the Internet Bubble, and it ended very badly. This rally will end badly as well for stocks trading at valuations that have no relationship to reality.
Investors are showing some signs of intelligent life when it comes to the retail sector, however. The stock of Sears Holdings Corp (NASDAQ:SHLD) fell to new lows last week (and dropped further on Monday) after Fitch Ratings did the kind of deep dive into the dying retailer’s financials that is rarely done by Wall Street analysts whose employers are fighting to extract fees from the companies they cover. Fitch warned that Sears is facing annual losses of $1 billion (confirming what I’ve been saying at Zenith Trading Circle) and is running out of family jewels to sell to fund these losses. Last year I wrote that Sears was likely seeing its last Christmas outside of bankruptcy, and it appears the stock market is coming to a similar conclusion. If you’re a Zenith subscriber, you can get my very latest SHLD recommendation (released yesterday) here.
In any case, I suggest you buy long-dated puts on SHLD (about a year out), as well as on other struggling retail stocks like Macy’s Inc. (NYSE:M). The retail carnage is only going to get worse from here on out.
Several struggling retail chains had tough holidays and are on the verge of collapse including Wet Seal, Eastern Mountain Sports, Bob’s Stores and Gander Mountain. While these are minor players, their troubles are indicative of the steady erosion of mall-based stores and the structural changes that are eating landed retailers alive. There are too many stores and too many malls and we are going to see a lot more blood spilled in store aisles in the coming months and years.