Covenant Weekly Market Synopsis as of March 31, 2017

April 3, 2017

Friday marked the end of a solid first quarter for risk assets. Although gains in March were fairly muted for domestic stocks, year to date the S&P 500 is up 6.1% (inclusive of dividends). Meanwhile, higher beta international equities (as measured by the EAFE Index) and emerging market stocks (MXEF Index) accelerated past domestic equities in March, recording gains of 3.4% and 2.5% bringing year-to-date performance to 7.9% and 11.5%, respectively. Despite some intra-quarter volatility, bond yields were relatively unchanged, though the yield curve flattened slightly as measured by comparing the quarterly change in yield on the 2-year bond +0.07% vs. the 30-year bond -0.06%. Precious metals were also flat in March, though year-to-date gold has risen 8.9% and silver 14.7%. On the back of rising rig counts in the U.S., WTI Crude gave up gains earned over the first two months of the year to close the first quarter down 5.8% at $50.60 per barrel.

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.


Engineered Higher – The stock market rally since 2012 has been impressive. The Russell 3000, representing a broad swath of corporate America, rallied 79.3% (ex-dividends) in the five years ending 2016. Typically, equity moves of that magnitude are accompanied by improving corporate profitability as investors are willing to pay higher prices for stocks when earnings streams are growing. However, the Bureau of Economic Analysis’s most recent release of total corporate profits for 2016 (after tax and with inventory and capital consumption adjustments) shows a strikingly different picture. Indeed, annual total corporate profits have remained relatively flat for the last five years, declining by approximately $8.1 billion, or -0.5% from 2012 to 2016.



Earnings per share (“EPS”), on the other hand have risen approximately 17.6% over this timeframe from $51.15 in 2011 to $60.13 for the Russell 3000 Index. How do earnings per share rise in spite of flattish profits? Financial engineering.

Financial engineering of corporate balance sheets includes share buybacks and mergers that reduce the number of outstanding shares and the denominator in the formula EPS = Earnings / Shares Outstanding. In a simplified example, assume fictitious company ABC had 100 shares and total profits of $100 in 2012, meaning that the EPS is $1.00 per share ($100 profits divided by 100 outstanding shares). Fast forward to 2016 and assume that total profit remained the same at $100, but that management had approved and implemented a share buyback program that reduced total shares by 5% (i.e. the repurchase of 5 shares). Even though profits were identical to that of five years prior, the EPS equates to $1.05 per share ($100 profit divided by 95 shares outstanding) giving the illusion that profits grew by 5%.

Financial engineering alone does not explain the impressive rise in equity index prices over the last five years. In fact, a large portion of the market’s appreciation can be explained through expansion of the Price to Earnings (P/E) ratio. That is, investors have been willing to pay ever-higher prices (the “P”) for each unit of earnings (the “E”) per share. For the Russell 3000 Index, the PE Ratio increased by 52.5% from 14.5 at the beginning of 2012 to 22.1 by the end of 2016. Applying this actual multiple expansion to our fictitious company ABC, the stock price which was $14.50 per share in 2012 (=$1.00 EPS x 14.5 P/E multiple) would have been worth $23.26 per share by the end of 2016 (=$1.05 EPS x 22.1 P/E multiple) – an increase of 60.4% due entirely to financial engineering (reduced share count) and multiple expansion. Real versions of this hypothetical example have played out across stock market since 2012.

Of course some companies have increased actual earnings since 2012, but as the data above illustrates, on an aggregate basis Corporate Profits are at the same level as 2012. The stock market’s rise over this timeframe is, in large part, courtesy of extraordinarily accommodative monetary policy from the Fed and other central banks that provided fuel for both financial engineering and expansion of the P/E multiple. There is nothing inherently wrong with that, and in fact, it was an implicit (if not explicit) goal of the Fed to stir “Animal Spirits” through accommodative policy that would increase asset valuations, make people feel richer, and in so doing encourage consumers to spend money to grow an economy that is 70% consumer based. Yet, financial engineering and multiple expansions cannot continue indefinitely. Companies do not possess infinite cash for stock buybacks and there is a long history of cycles in which the P/E multiple expands and contracts.

Stock markets are inherently forward discounting mechanisms, meaning that they are priced today based on expectations of future events, including cash flow available from earnings. It’s clear from both the rise in the market over the last several years, and the current P/E multiple, that investors are expecting better earnings growth than has been realized over the last five years. Time will tell if investors’ expectations will be validated. Given the recent history of actual earnings and the high expectation levels (i.e. the P/E multiple), it would seem prudent to avoid putting all of one’s financial eggs in passive, domestic equity index ETFs and mutual funds.

Be well,