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INVESTMENT INSIGHTS ARCHIVE
Originally posted in September 2017

Headlines like these have become far too regular of late. In fact, when we ran some statistics for how many companies’ share prices in the FTSE 350 had seen more than 15% declines from their early 2017 highs and are still down, 180 companies were below the red line. That’s over 50% of the index, with some of them down 80%. No wonder even the legendary Neil Woodford’s fund is falling fast.

However, all the actual indices, the FTSE 100, FTSE 250 and FTSE 350 are up, 3.2%, 8.6% and 4.1% respectively. Clearly, there must be some companies doing very well. Regular readers will know that I believe stock valuations are very overpriced currently, but before we argue that this is just a case of the half-full, half-empty glass, we should understand that the observation is just typically what the technical analysts of the stock markets call ‘breadth’. Breadth can be measured in many ways, but the eventual analysis should focus on whether the ratio of stocks going up, versus down, signals a potential strong or weak market in the future. Declining breadth, where the number of companies making new highs versus lows, is usually a sign of wider spread weakness ahead.

We know that in the UK stock indices, just like the SP500 in the US, there are some huge companies potentially ‘holding’ up the index, which is not a particularly good sign, especially if these companies are not seeing strong earnings. In the UK, for example, the huge size of Unilever, at almost 5% weighting of the index, means that the stellar 40% stock price rise this year is responsible alone for an index move of 2%, over half the actual 3.2% year to date rise in the FTSE 100. In the US, we have the well-known FANGs stocks – Facebook, Amazon, Netflix and Google ¬– almost dictating daily SP500 movements with their high market capitalisation weightings.

Neither a huge difference in returns across companies in the preceding periods, nor a small number of very large companies driving the index returns, is a great sign of a stable and strong market.

However, much more important are the stock price increases or decreases in these companies that relate to an increase or decrease in actual earnings, or are much more to do with the expansion or contraction of the price/ earnings multiple itself. Unfortunately, it would appear that far too many of the price advances of rising stocks in the last few years are multiple expansion, rather than earnings growth. Persimmon is one of the few winners this year that demonstrates a ‘good’ story. It is up over 40% this year, but its P/E ratio still only trades around 11 because its earnings per share keep rising.

One of the outcomes we shouldn’t want is for all companies with declining stock prices to have earnings that are also declining with still relatively high price/earnings ratios and most companies with increasing stock prices to have negligible earnings growth with very high price/earnings ratios. Again, that appears to be where we are today.

Unilever, the stand out big cap performer of 2017, has earnings per share just back to the 2013-2050 period, but with a P/E of 24.6. For a company Unilever’s size, the earnings growth they ought to see to justify such a high P/E is very hopeful indeed.

A recent research piece by Goldman Sachs showed that the typical SP500 index stock trades in the US at the 98th percentile and the overall index at the 87th percentile relative to the last 40 years.

The advocates of Exchange Traded Funds for equity indices – passive investing, as it is often known ¬¬– are enjoying their moment in the sun. Even the super hurricane season in the US is unable to touch the bulletproof main stock market index. A recent comparison against Neil Woodford’s active stock-picking is there for all to see, but the smug cheering may be short-lived.

With extreme valuations, dropping breadth is often compared to kicking table supports away, leg by leg. Eventually, gravity wins out.

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