The “Easy Money” Has Been Made
Analyzing market headwinds and tailwinds via business fundamentals may provide investors some insights into where they might be headed over the short-term.
Over the last 20 years, one of my favorite observations to use with clients (when appropriate) is that “the easy money has been made.” More recently, I’ve discovered that in some corners of the financial world, this expression is the subject of much derision. One internet meme highlights all the pundits and magazine covers that have used this quote over the past 10 years – while the stock market just kept going higher. This strikes me as odd. As someone who has said this many times in the last 2+ years, it never occurred to me that investors or market watchers would take it as an outright bearish expression.
Let’s take a step back. If there is such a thing as “easy money” in the stock market, there must also by definition be “hard money.” In simple terms, “easy money” can be made when investors have some fundamental tailwinds at their back. (In this use, “easy money” is not referring to accommodative monetary policy.) “Hard money” is when these tailwinds turn into headwinds. To be sure, equity markets can still move higher in spite of headwinds or, more significantly, lower despite tailwinds. There are no laws and markets are hardly precise.
Easy Money: Properly Defined
So what are these headwinds and tailwinds? Setting aside dividend income, which tends to be fairly stable, price gains in an equity index can be broken down into the change in earnings multiplied by the change in the price-to-earning (P/E) ratio.1 We can further decompose the change in earnings into the change in sales combined with the change in profit margins. The trend in top line sales illustrates the ups and downs of the business cycle (i.e., macroeconomic forces), while the change in profit margin illustrates the waxing and waning of competitive pressures and the ability of firms to be more or less efficient at turning sales into earnings (i.e., microeconomic forces).
All three of these factors – sales growth or trend, profit margins, and P/E ratios – tend to rise and fall, and are to some extent mean reverting over time. This is common sense. Sales are not mean reverting (they go up in line with broad economic growth), but sales do rise and fall around their longer-term trend. Years of strong growth create oversupply which eventually has to be worked off – and vice versa: Slow periods tend to be followed by periods of catch-up. Profit margins are mean reverting because high margins invite new entrants (which reduce margins), while low margins force out the least efficient firms (increasing margins). Lastly, P/Es rise until stocks are so expensive that investors begin to shun them (pressuring valuations), while conversely P/Es can fall until the valuations are too compelling to ignore.
Why the accounting lesson? Because there are some periods when these variables largely support future equity gains and other periods when they hamper equity gains. Simply put, when revenue growth has been below trend (e.g., a recession), profit margins are low, and P/Es are low, the tailwinds are at your back as earnings and multiples are spring-loaded to deliver strong future equity returns. Conversely, when revenue growth has been above trend, margins are high, and P/Es are high, the fundamental fuel for large equity gains has been exhausted. Again, this doesn’t mean return will necessarily be negative.
The Easy Money Index: Patent NOT Pending
So far, this is all mostly common sense – almost tautological. But what might it look like empirically? Using the S&P 500®,2 we created an “Easy Money Index.” This index measures the headwind or tailwind for each of our three variables: sales growth above/below trend (because the trend is not mean reverting), above or below average profit margins, and P/E ratios (because they are mean reverting). Each variable is then normalized (z-score) to put them on like terms. Our Easy Money Index is just the cumulative total of the 3 z-scores. A negative index value indicates these variables are tailwinds (easy money), and positive values indicate fundamental headwinds or “hard (to make) money.” The Easy Money Index has been plotted below against the 3-year subsequent return for the S&P 500®.
Source: Bloomberg, Morningstar, Natixis Investment Strategies Group, January 1990 – August 2018 (monthly). Past performance is not indicative of future results. For illustrative use only.
Some observations from the Easy Money Index above: It is far from perfect, but generally consistent with three-year forward returns. Easy money tailwinds are associated with strong equity returns while fundamental headwinds are associated with much lower returns.
More specifically, below average P/Es and profit margins in the early 1990s, combined with weak sales growth from the ’90–’91 recession, set equity investors up for a mean-reverting strong run for the rest of the 1990s. The same was true after the tech-wreck and 2001 recession, and in the wake of the housing crisis and ’08–’09 recession. Conversely, high valuations and high profit margins along with above-trend revenue growth in the late 1990s and 2006–07 left investors with the mean-reverting hangovers of two subsequent bear markets.
Potential Portfolio Implications
To be sure, our Easy Money Index isn’t meant to be taken literally. The embedded look-back bias in constructing the index drives a large part of its explanatory power. It simply illustrates the point that the market’s strongest future gains are generally associated with fundamental and valuation tailwinds – below trend growth that requires a catch-up and low profit margins and P/E that can expand. The market’s weakest returns come after periods of strong growth, high margins, and high valuations – all of which will eventually give in to the gravitational pull of mean reversion.
What does the Easy Money Index tell us today? The cumulative positive z-score (+2.53 for August 2018) is indicative of recent sales growth above trend (i.e., a strong economy), much higher than normal profit margins (10.8% vs. average of 7.5%) and somewhat elevated, but not exorbitant, P/E multiples. The current reading is consistent with a forward three-year return on the S&P 500® that is slightly negative. Can stocks continue to generate positive returns? Absolutely, but investors should recognize the fundamental and valuation headwinds they now face. The easy money has already been made.
1 The price-earnings ratio (P/E) or price-earnings multiple is the current market price of a company share divided by the earnings per share of the company.
2 The S&P (Standard & Poor’s) 500 Index is an index of 500 stocks often used to represent the US stock market.
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