Quarterly Market Update
Equity Market Turnaround Highly Dependent on Third-Quarter Earnings
Because conditions may be such that downward earnings revisions estimates have gone too far, we could see some positive surprises this reporting period.
Fears of a slowdown in China pushed broad equity market stock indexes into correction territory in the third quarter for the first time since the 2011 “summer correction” when the European debt crisis roiled global stock markets. U.S. markets had their largest one-day drop during the quarter, and the VIX posted its highest close in August since 2011. (A correction is defined as a loss of 10% or more from a recent peak.).
The initial and primary catalyst for the market roil was the People’s Bank of China’s (PBOC) devaluation of its currency on August 21, signaling the central bank’s concern about the pace of its economic growth. Subsequently, the fact that the Fed “blinked” in response had unintended consequences. The Fed’s decision at the September policy meeting not to raise rates came across somewhat as a vote of no confidence, and came close to sending the market back to retesting the lows of late August. The surprising announcement that Volkswagen had put software on their cars that circumvented EPA emissions standards sparked speculation about the actual strength of corporate balance sheets. Finally, exogenous events including House Speaker Boehner’s announced resignation and the prospect of yet another U.S. government shut down contributed to general uncertainty and negative sentiment.
As events accumulated, market sentiment shifted such that every new data point was viewed through a negative lens, and all news became bad news. While the selloff cannot be entirely attributed to the sentiment shift as the global growth slowdown bears monitoring, particularly in China, a soft drum roll of negativity has been building for some time. The correction was classic in the sense that there was no place to hide. During periods of high risk aversion, the riskier the asset class, as measured by historical standard deviations, the greater the asset class will trade off. Accordingly, U.S. markets were down the least, while emerging markets were down the most.
Figure 1. All broad U.S. equity index returns are in negative territory for the year-to-date.
Investors Place Higher Risk Premium on Assets
The S&P 500 Index was the quarter’s top performer, down -6.44%, followed by mid-cap stocks, down -8.01%. Small caps brought up the rear, posting a loss of -11.92%. The MSCI EAFE was down -10.22% and the MSCI Emerging Market Index was down -17.80%. China’s primary index, the Shanghai Composite Index was down -29.71%. International stock returns, as measured by the EAFE, continue to lead year-to-date, but within the U.S. the leadership changed as large-cap stock returns pulled ahead of small- and mid-cap stocks indicating the higher risk premium investors are now placing on assets.
Earnings were down for the second quarter in a row for the first time since the financial crisis began in 2007, and financing conditions in the corporate bond market tightened. Earnings have been trending lower across nine of the ten GICS (Global Industry Classification Standard) sectors in 2015, with Telecommunications being the only exception. The forecast for the third-quarter earnings calls for a decline of -4.2% year-over-year, 11.6 percentage points lower than estimates at the start of the year.
While trending downwards across the board, valuations remain high by historical standards, but are closer to their long-term averages following the correction. Prior to falling into correction territory, the S&P 500 traded at 18.2 times the past year of earnings. The index now trades at 16.97 times the past twelve months earnings, compared with its 10-year average of 16.51 according to Factset.
The degree of bearishness in the stock market has mushroomed to the point that it could potentially be a bullish contrarian indicator.
Our outlook for the fourth quarter continues to be cautiously optimistic. Fundamentals remain in place and favorable central bank policy can support the continuation of the latter couple of years of a bull market, albeit one characterized by more modest returns relative to the last four years. After the four- year rally, the U.S. stock market was long overdue a correction in valuations. The market is repeating the pattern of the summer crash of 2011 when things were going well right up to the time of the correction. Fortunately, indices were not down as sharply as then, but neither is the market likely to rally 20% before year-end as it did following the 2011 correction.
While fundamentals do not support a huge market rally, neither does there appear to be a catalyst for a leg down. Certainly there are signs that the economic data is slowing given the downward revisions to both earnings and payroll gains, but there are no signs of a U.S. recession, and we would not anticipate a significant leg down without one. The economy is projected to expand at a modest but healthy 2.5% annual rate this year, after growing at a much faster pace than initially estimated in the second quarter of the year. If the U.S. economy sustains decent growth, the consumer discretionary, consumer staples, healthcare, and financials sectors will continue to grow. Sectors that are affected by global growth including materials and industrials will likely continue to struggle. Global markets can stabilize if the U.S. economic data continues to display even moderate improvement as the rest of the world needs for the U.S. to be a goldilocks economy – not too hot and not too cold.
Figure 2. P/E ratios are closer to their long-term averages following the summer correction of 2015.
Earnings and Sentiment Critical Factors
Negative earnings revisions have been a problem since late 2014. Should the slide in earnings continue, either multiples must expand – highly unlikely in the face of ongoing global weakness – or equities will continue to struggle into 2016. The question is how well are companies actually doing from an economic standpoint? Will the revisions continue, or will companies stabilize and resume a modest growth path? We would hope to see greater recognition of strong companies and strong sectors relative to weaker ones going forward.
Much like the September Fed policy meeting, this will be a highly scrutinized earnings season. As companies are reporting, whether missing earnings or beating them, it will be important to determine what is behind the numbers – U.S. strength, U.S. weakness, impact of a stronger dollar, etc. Earnings announcements will be torn apart – a company may announce a headline “miss” or “beat” in terms of earnings expectations, and investors will demand to know the root cause. Investors will scrutinize sales – is the company truly experiencing a slowdown due to problems in China, or are they deliberately underestimating earnings? Investors will closely examine any forward guidance to divine the future direction of the market.
A strong equity market turnaround is highly dependent upon the third- quarter earnings beating expectations. Investors need to see some positive earnings surprises even if it is that earnings decline less than expected. And, because conditions may be such that downward revisions have gone too far, we could see some positive surprises. Indeed, internationally corporate earnings are so depressed that the earnings do not need much support in order to surprise. A market turnaround will also depend on a sentiment shift. The degree of bearishness in the stock market has mushroomed to the point that it has become something of a bullish contrarian indicator, and bad news could become good news.
We also need improvement in the data out of China, not necessarily a reversion but some degree of bottoming out and marginal improvement. China does not want to be the poster child for taking down the global markets, so policymakers are certain to use every tool at their disposal to turn the economy around.
Volatility Brings Opportunity
Some degree of volatility will continue for the balance of the year as investors brace for the October and December Fed policy meetings at which the fate of short-term interest rates will be decided. Many forecast that Chairwoman Janet Yellen will raise interest rates. The VIX has remained above its long-term average of 20 since late August, indicating that investors still anticipate volatility.
Once the Fed begins a course of fed funds rate hikes, the U.S. financial markets will no longer be supported by the rising tide of looser monetary policy. We anticipate that volatility will increase around these events, whenever they occur. The associated volatility will create buying opportunities. As investment professionals, our job is a relative one where we attempt to determine where the best risk/reward is and where the relative value amongst the choices are. We believe this remains in the equity arena.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).