Mr B - what's in your LTM earnings growth leading indicator. and have you built an N12M model? (less focussed on the number, more trying to capture the scope of likely future revisions / rate of change etc)
the leading indicator is a multi-factor macro model designed to forecast earnings growth in the next 12mos, so in that sense it is an N12M model already. historically the model is better at turning points and trajectory than precise growth outcome, but for markets turning points and direction (ie rate of change) are far more important than growth level.
in a past life i did spend time trying to forecast margins for specific sectors/groups with only a little success...in the end i found getting the big picture right was more valuable. that said...its probably worth a revisit.
Yup. Compression in margins is a consensus call and seems to be creeping into FY23 via the shape of EPS revisions that are compressing much more briskly than sales/share, especially in tech (and that’s without analysts I think explicitly pricing SBC in as a future cash expense)…. So i don’t think its controversial that this is the next shoe to drop. But the extent of that margin compression?
There I can see scope for downside surprise, and im trying to get my head around where the pain trade in this is. When I look top down I just cant reconcile why margin expectations are so high. Strip out int expense, pretend D&A is flat, and it still feels to me that market expectations for gross margins being materially higher than they were in 2019, whilst absorbing all of the sticky input cost inflation and wage inflation, that doesnt make sense to me.
(i mean, obviously SPX revs x gross margins, plus a guess on D&A - int - tax = EPS gets you most of the way there, but have you tried intuiting gross margins from leading indicators at a market or sector level?)
Can you explain a bit more on how you come to the calculation of 5yr average dividend yield of the spx and your input in to come to the conclusion for the 20% lower target? Currently studying finance and trying to learn as much as possible and where to find the info. Thanks again for your help.
can read about gordon growth model, this approach is very similar. discounting current cash flows by cost of capital to provide a measure of “fair value”. given we are assuming no growth of cash flows here it likely represents more of a floor valuation rather than central tendency…but useful nonetheless
A quick valuation question: would it be wrong theoretically to use a div yield adjusted for buybacks (which as we know are very important in the US mkt) in your wacc ?
This would lower your grid values which are already some sort of floor values as another reader below rightfully says. But ok the other hand, how to add a terminal growth rate for earnings to be less conservative on the numerator side?
fair considerations. in my opinion valuation models are directionally correct and precisely wrong. i don’t think of the values as explicit targets as much as gravitational pull.
need to think about buyback yield and the appropriate inclusion. i would also suggest that A rated yield probably better reflects quality of S&P today.
so again, directionally right but precisely wrong. best to evaluate valuation gap relative to its own history
Have you considered some more longer term right tail hedge for the possible bear market rally? Maybe, just maybe a proper bear market rally could take some more time to develop? I mean, it did take from June 16th until July 19th for the previous downtrend resistance to be broken in ES1 Index.
it could and maybe that’s how it evolves. for now i think it’s a short term phenomenon rather than something with duration…but getting in early offers the optionality to modify one’s view long the way. i have Oct call spreads and Nov 25delta calls for my view
Given the modest rally, its concerning that some indicators are already giving intermediate-term overbought signals. That includes the McClellan oscillator (on the NYSE) and % of stocks trading above their 20-day moving average. Plenty of room to become oversold if stocks lose 2022's lows.
Love and greatly appreciate your work.... thank you very much! One comment to consider: You have a very important table in this update... the table of S&P500 values based on EPS and BBB yields. To me this table represents floor valuations, meaning the value should be a minimum of $x based on the two inputs. Rationale is that at x value of the S&P500 I (the buyer) would earn the equivalent of the BBB yield plus an average dividend yield. However, over time the earnings component will grow, which is not captured in the table of S&P values, so the values are understated.... hence my comment about these being floor values. What got me thinking about this was - due to the range of input values of the table - I couldn't see whether the table reasonably approximated the actual S&P500 values of the past or if it was low (conservative) compared to past valuations of the market. If low, then that would be consistent with my point. The ultimate point, though, is to be cautious about waiting for the values implied by the current table to materialize because they may be too conservative.
excellent, fair and appropriate comment. first, the model output is provided in the chart to the right….blue line.
second, during periods when EPS is rising your viewpoint is absolutely correct…but when EPS is falling that growth view is significantly impaired. i still agree that the values approximate a floor rather than some kind of equilibrium price at any point isn’t time.
i would also suggest that all valuation models are best judged by their richness/cheapness vs their own history rather than at a snapshot in time. on this model you can see SPX has gotten more expensive eve as prices have fallen b/c cost of capital is rising faster and EPS is flat/falling so no growth offset.
Thanks Mr B, certainly a tough market. Outlook is certainly negative but I don't want to get punched in the face by a bull or increase shorts here. I've increased positioning away from equities including shorting gold and some fx exposure in recent weeks which has worked well.
Heres hoping for a big rally so I can increase short exposure!
Do you have data to share on the relentless price insensitive buying of passive funds? Per Mike Green's research on target date funds by Blackrock and Vanguard.
Insightful discussion and roadmap for the upcoming challenging 6 months. (However I would call your Bear Bounce Call and research- both of your well written articles on the recent countertrend rally and partial reversal, a solid A, not a C+ as you mention).
Mr B - what's in your LTM earnings growth leading indicator. and have you built an N12M model? (less focussed on the number, more trying to capture the scope of likely future revisions / rate of change etc)
the leading indicator is a multi-factor macro model designed to forecast earnings growth in the next 12mos, so in that sense it is an N12M model already. historically the model is better at turning points and trajectory than precise growth outcome, but for markets turning points and direction (ie rate of change) are far more important than growth level.
in a past life i did spend time trying to forecast margins for specific sectors/groups with only a little success...in the end i found getting the big picture right was more valuable. that said...its probably worth a revisit.
Yup. Compression in margins is a consensus call and seems to be creeping into FY23 via the shape of EPS revisions that are compressing much more briskly than sales/share, especially in tech (and that’s without analysts I think explicitly pricing SBC in as a future cash expense)…. So i don’t think its controversial that this is the next shoe to drop. But the extent of that margin compression?
There I can see scope for downside surprise, and im trying to get my head around where the pain trade in this is. When I look top down I just cant reconcile why margin expectations are so high. Strip out int expense, pretend D&A is flat, and it still feels to me that market expectations for gross margins being materially higher than they were in 2019, whilst absorbing all of the sticky input cost inflation and wage inflation, that doesnt make sense to me.
(i mean, obviously SPX revs x gross margins, plus a guess on D&A - int - tax = EPS gets you most of the way there, but have you tried intuiting gross margins from leading indicators at a market or sector level?)
Thank you for a clear and pithy, holistic view of the market.
it’s the only way! thanks for the feedback
Can you explain a bit more on how you come to the calculation of 5yr average dividend yield of the spx and your input in to come to the conclusion for the 20% lower target? Currently studying finance and trying to learn as much as possible and where to find the info. Thanks again for your help.
can read about gordon growth model, this approach is very similar. discounting current cash flows by cost of capital to provide a measure of “fair value”. given we are assuming no growth of cash flows here it likely represents more of a floor valuation rather than central tendency…but useful nonetheless
Thank you Mr Blonde.
A quick valuation question: would it be wrong theoretically to use a div yield adjusted for buybacks (which as we know are very important in the US mkt) in your wacc ?
This would lower your grid values which are already some sort of floor values as another reader below rightfully says. But ok the other hand, how to add a terminal growth rate for earnings to be less conservative on the numerator side?
fair considerations. in my opinion valuation models are directionally correct and precisely wrong. i don’t think of the values as explicit targets as much as gravitational pull.
need to think about buyback yield and the appropriate inclusion. i would also suggest that A rated yield probably better reflects quality of S&P today.
so again, directionally right but precisely wrong. best to evaluate valuation gap relative to its own history
Have you considered some more longer term right tail hedge for the possible bear market rally? Maybe, just maybe a proper bear market rally could take some more time to develop? I mean, it did take from June 16th until July 19th for the previous downtrend resistance to be broken in ES1 Index.
it could and maybe that’s how it evolves. for now i think it’s a short term phenomenon rather than something with duration…but getting in early offers the optionality to modify one’s view long the way. i have Oct call spreads and Nov 25delta calls for my view
Given the modest rally, its concerning that some indicators are already giving intermediate-term overbought signals. That includes the McClellan oscillator (on the NYSE) and % of stocks trading above their 20-day moving average. Plenty of room to become oversold if stocks lose 2022's lows.
Thank you, appreciate as always your comprehensive and insightful coverage. Have a good weekend!
Love and greatly appreciate your work.... thank you very much! One comment to consider: You have a very important table in this update... the table of S&P500 values based on EPS and BBB yields. To me this table represents floor valuations, meaning the value should be a minimum of $x based on the two inputs. Rationale is that at x value of the S&P500 I (the buyer) would earn the equivalent of the BBB yield plus an average dividend yield. However, over time the earnings component will grow, which is not captured in the table of S&P values, so the values are understated.... hence my comment about these being floor values. What got me thinking about this was - due to the range of input values of the table - I couldn't see whether the table reasonably approximated the actual S&P500 values of the past or if it was low (conservative) compared to past valuations of the market. If low, then that would be consistent with my point. The ultimate point, though, is to be cautious about waiting for the values implied by the current table to materialize because they may be too conservative.
Will
excellent, fair and appropriate comment. first, the model output is provided in the chart to the right….blue line.
second, during periods when EPS is rising your viewpoint is absolutely correct…but when EPS is falling that growth view is significantly impaired. i still agree that the values approximate a floor rather than some kind of equilibrium price at any point isn’t time.
i would also suggest that all valuation models are best judged by their richness/cheapness vs their own history rather than at a snapshot in time. on this model you can see SPX has gotten more expensive eve as prices have fallen b/c cost of capital is rising faster and EPS is flat/falling so no growth offset.
Thanks Mr B, certainly a tough market. Outlook is certainly negative but I don't want to get punched in the face by a bull or increase shorts here. I've increased positioning away from equities including shorting gold and some fx exposure in recent weeks which has worked well.
Heres hoping for a big rally so I can increase short exposure!
Thanks for your thoughts as always.
Do you have data to share on the relentless price insensitive buying of passive funds? Per Mike Green's research on target date funds by Blackrock and Vanguard.
Thanks for sharing
Insightful discussion and roadmap for the upcoming challenging 6 months. (However I would call your Bear Bounce Call and research- both of your well written articles on the recent countertrend rally and partial reversal, a solid A, not a C+ as you mention).
Painful week for me.