One of the best indicators that correlates with U.S. gross domestic product is the monthly Institute for Supply Management report on manufacturing. A reading below 50 suggests the manufacturing sector is contracting. ISM has been persistently weaker since the third quarter of 2014, about the same time that earnings growth peaked for the S&P 500. Other signs of weakness in demand came by way of August's anemic U.S. auto sales numbers. That should drop the year-on-year growth in retail sales to a little more than 2 per cent, which means real (after inflation) consumer spending is running at about 1 per cent.
U.S. job growth has been very strong since 2012, growing at a monthly average of about 200,000. Population growth suggests that we should be adding about 150,000 jobs a month just to keep up with births and immigration, so the 200,000 average rate is a pretty good pace. That said, a high percentage of jobs have been part-time and so average hourly earnings have been relatively weak considering the number of jobs added and overall hours worked is down suggesting productivity is soft.
The combination of weakening demand from manufacturing and softening retail sales combined with strong job gains suggests falling profit margins. We have seen five straight quarter of falling earnings, yet the S&P 500 trades at the highest (advancing market) multiple since December, 1996, when Alan Greenspan gave his famous "irrational exuberance" speech. Of course, back then, the driving factor of Y2K pushed multiples to more than 30 times earnings before the tech bubble collapsed in 2000. Mr. Greenspan recognized at the time that the multiple was as high as it was in 1987 prior to the market crash, yet markets continued to be irrational on valuation for several more years.
So we have to ask: What is the growth catalyst now to keep markets trading at expensive multiples? One answer might be that this time is different given policies of low interest rates and big government deficits – but how long can that continue?
Looking forward at S&P 500 earnings, we likely see the sixth quarter of year-on-year declines in earnings according to Bloomberg estimates (minus 1.4 per cent). That said, forward estimates for the next few years are expecting low double-digit earnings growth. Again, we have to ask what the catalyst is for that kind of growth when we see the United States, China, Japan and Europe all struggling. I recall several top strategists in a roundtable discussion in late 2007 giving their forecasts for 2008 earnings: On average, the group was wrong by about 50 per cent – they had no idea what was coming. You have to take Wall Street forward earnings estimates with big grain of salt in the late stages of a market cycle. It makes far more sense to play defence and wait for better valuation to get back to a growth focus.
To be sure, it's not going to be easy. ETFs with covered call exposure – which serves to enhance yield – work best in sideways to lower markets, which the high valuations and margin pressures suggest is prudent. For those in higher dividend utilities (pipelines, telecoms, electric), while the sectors are not cheap by historical measures, the BMO Covered Call Utilities ETF (ZWU) is a lower volatility way to get a 7-per-cent-plus yield. It has about 40 per cent lower historical volatility than the broad S&P/TSX, but it is much more interest-rate sensitive. Back in 2013 when the market was worried about Fed rate hikes, it sold off aggressively. I mentioned a few weeks back that I like the BMO Covered Call Europe CAD-Hedged ETF (ZWE) as a way to get a 7-per-cent yield in Europe and the BMO U.S. High Dividend Covered Call ETF (ZWH) as a way to get about 6 per cent from the U.S. markets. Covered call strategies won't eliminate the downside, but they will likely enhance your portfolio yield until valuations and margin pressures improve.
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.