TGIF – What’s Too High?

This week, the 3 major US indexes: the DOW, S&P 500 and NASDAQ all hit fresh, all-time highs. It’s been a theme pretty much all year. What’s made things more surprising to the masses is this rally has continued while turmoil has increased in Washington and beyond. We emphasized in our 2017 Outlook that earnings are the primary driver of stocks and earnings were set to accelerate this year. So far, that’s been the case. We just completed the busiest week of the Q2 Earnings Season, and the numbers look pretty solid.

All About Earnings

Just over half of the S&P 500 companies have reported earnings. 73% of them beat expectations. The S&P 500 is on track to earn roughly $130 per share this year. That would be a new record by a long shot. Even more importantly, 71% of the companies have beaten on revenues. This is way above the long-term average of 59% revenue beats. This statistic is critical because earnings can be engineered to an extent with methods like cost cutting and stock buybacks. Revenue is the purest sign of demand growth, and demand is growing. That’s very important.

Naturally, with the Stock Market at all-time highs in a maturing Bull Market with increasing risks around the globe, people are worried that a correction is in order. We share those concerns and are prepared for a healthy correction. We actually are looking for one to clear out the excesses and test this uptrend before it continues higher. But we’ve heard a growing perspective that the Stock Market is “too high”.

What’s Too High?

Sure, the DOW and S&P have never been this high. But S&P 500 earnings have never been this high either. There’s nothing negative about new highs. It’s the opposite, it’s very positive. That said, stocks do get overbought and need corrections. There have been many within this 8-year Bull. There are certainly many more high Dollar stocks today. You don’t see stock splits like you used to. For whatever reason, companies are letting their stocks run well over $100 and even $1,000, without splitting the shares. It makes it hard for smaller investors to buy the stocks and gives the impression that they’re expensive. That can be very misleading. There are plenty of cheap high Dollar stocks as well as many expensive low Dollar stocks. The key is how the stocks are valued, looking at various metrics like price-to-earnings, price-to-sales and how fast they’re growing. Currently, the S&P 500 is trading at 19X this year’s estimates and 17.5X next year’s. That’s definitely not cheap. But when you consider low interest rates and the current earnings yield of 5.25%, it’s still attractively valued. A 6% earnings yield has provided strong support throughout this Bull Market, while 4% has triggered selloffs. It’s right in the middle today.

Rising Price, Shrinking Supply

Another important thing to consider is the fact that there are far fewer stocks in circulation today. The S&P 500 is considered the US Stock Market, because it represents the largest 500 companies and is the primary benchmark for investors. However, the Wilshire 5,000 is the Total Market. It consisted of 5,000 stocks when it was introduced in 1974. It ballooned to over 7500 stocks in 1998 but has been cut by more than half to just 3,600 stocks today. This is a result of acquisitions, defaults, and companies deciding to stay private. There just aren’t as many stocks to own anymore.

Even the stocks in circulation don’t have as many shares available. Corporate buybacks have been a theme for years, retiring shares. The float is the actual number of shares a stock has available for trading. A company like GE, over 100 years old and an original DOW component has nearly 100% of its shares floating. However, Amazon, founded in the 1990’s has only 83% of its shares outstanding available to investors. When you combine strong investor demand with limited supply, you get higher prices. Amazon has been a monster mover this year even with today’s selloff. No surprise, Founder and CEO Jeff Bezos owns 17% of the shares outstanding which made him the richest person in the world this week for a few hours.

Ready For Defense

As Earnings Season comes to an end, the Market will no doubt start paying more attention to the political and geopolitical issues at hand. The situation in North Korea is quite concerning as is the divisive activity in Washington. We are gearing up for a defensive position in anticipation of another correction. It’s been well over a year since the last 5% selloff, which is rare. It’s only a matter of time. Price action was abnormally choppy this week. But we certainly don’t think this Bull Market is coming to an end and we don’t think the Stock Market is too high. Demand for US stocks is still very strong. We remember investor angst last November and into the New Year. We were bullish and it certainly wasn’t consensus. Earnings are supporting the rally and should continue to do so. It just won’t continue in a straight line.

The Survey Says…

Thank you to everyone who responded to my unscientific survey last week! I received a whopping 86 responses. The tally was, 48% read last week’s TGIF on a PC (which includes laptops), 31% read it on their phone and 21% read it on a tablet. Also of note, Apple devices were by far the most popular. I’ll have to try one of these again…

Have nice weekend. We’ll be back, dark and early on Monday.


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