Stock Prices Becoming More Reasonable

by Mark Bern, CFA

Stocks are near record highs.  Over the last few weeks stock prices have been almost flat.  Over the same period, companies have been reporting double-digit earnings increases.  The result is that multiples like the P/E ratio have been contracting bringing stock values down from nose bleed levels closer to the long-term average.  Interest rates are still historically low, justifying higher than normal valuations.  Inflation is heating up a little but not getting out of control.  Economic growth in the U.S. remains strong and wages are beginning to rise at a better clip.  These are all good signs.

The trade war worries may be overblown, especially when considering the impact on the average U.S. household may eventually rise to around $300 per year.  Even if the President decides to raise the tariff on all goods coming out of China to 25% instead of 10%, the additional cost to the average American household is likely to be about $600 per year.  For perspective, that would approximately equal the impact a rise in the price of gasoline at the pump in the range of $0.35 – $0.40.  It is manageable.  I am not trying to say that the ride will be painless or that U.S. companies will not suffer.  It’s just that the direct cost is not likely to be that much for the U.S. consumer, contrary to what we keep hearing on the news. 

The indirect cost will be higher and is much more difficult to quantify.  But I am certain that the total cost is likely to be much greater to the Chinese economy than to the U.S.  Again, I am not condoning the tactics of the Administration.  I am just trying to put the whole thing into better perspective.  With the U.S. economy growing strongly there may not such a good time to press China into negotiations on trade again for many, many years. 

Now, back to the valuations.  There are a lot of articles in the news about how the improving profits being reported by U.S. companies this year are almost entirely the result of tax reform.  Truth is: that’s hogwash.  It varies greatly from industry to industry and company to company, but there I am seeing evidence that as little as half the rise in earnings is due to corporate tax cuts.  The rest is mostly due to rising sales, higher capacity utilization and greater efficiencies. 

On the other side of the equation, wages are rising faster now than they have in several years.  If that trend is sustained, and I see no reason why it won’t be, consumption should rise leading to higher sales and still more jobs.  The employment participation rate is also on the rise which means that people who had previously given up on finding full-time employment (and therefore were not counted as part of the workforce) are rejoining the economy.  This is very positive as the trend had been down for the better part of the last decade.  That also points to more sustainable growth for the economy.

It also points to higher revenues for U.S. companies, especially for those that generate the majority of sales domestically.  But investors must remain cautious and selective as there are several industries for which growth in earnings may be difficult to maintain.  Industries that rely heavily on debt will have two negative headwinds to overcome: higher cost of debt (and total cost of capital) with interest rates rising and the loss of deductions for interest expenses that exceed 30% of earnings (due to a change in the tax law).  For such companies earnings may either stall or even fall even though revenues may be rising.  Among the industries that could be affected negatively are utilities, R.E.I.T.s and some industrials. 

Not all companies in those industries are in the same boat; some carry much higher debt levels are, therefore, more susceptible to feeling a negative impact.  A high dividend yield may not be sustainable and if a dividend is cut to conserve cash for operations the result will be a much lower stock price.  So be very careful and be sure to check the cash flow statements for indications of a company’s ability to cover interest payments, capital expenditures and dividends before investing. 

Companies with less debt are always something I prefer, but in the current environment of rising interest rates it becomes even more important, in my humble opinion.  That said, I still see more growth in sales and earnings that should extend at least through 2019.  And forward P/E ratios could continue to become more reasonable.  The only thing I see on the horizon that could change that (other than a black swan event) is for stock prices to rise as fast as or faster than earnings.  So far, in 2018, that has not yet happened.