Quarterly Market Update
Pressure Builds on Earnings
It is difficult to look at a market and say with complete confidence that if valuations are high and earnings growth is slowing that it is time to sell.
Pressures are mounting on three components of earnings – margins, profitability, and productivity. There has not been a significant increase in U.S. productivity, a measure of economic efficiency, in a number of years. According to the Bureau of Labor Statistics, productivity decreased to 105 Index Points in the first quarter (the most recent available) from 106 in the fourth quarter of 2014. The all-time high reading was 107 reached in the third quarter of 2014, but the largest production gains came during the 10-year period from 1995 to 2005 when the Index moved by roughly 25 points to just under 95. Technological advances and inventory control systems were credited with much of the increase. Although companies are benefiting from low commodity prices and a lack of wage inflation, the fact is that these positive trends for earnings may be approaching an end. Without productivity improvement to offset rising costs, such increases will diminish corporate margins and profitability.
After the financial crisis, companies drastically reduced expenses to maintain margins. With cost savings and expense reductions exhausted, increases in revenue growth must kick in at some point. Multiple expansion (meaning the stock price becomes more expensive relative to the company’s earnings) has driven stock returns since the market bottomed in March 2009. We are not in a profoundly high valuation market – as of 6/30/15 the trailing P/E on the S&P 500 Index was approximately 18 and the forward P/E was approximately 17 – but neither is the market cheap. The modest growth environment suggests multiples are unlikely to expand much further.
The lack of inflation also pressures earnings. Without modest inflation – with little to no wage expansion and little to no pressure on the prices of goods and services – achieving healthy economic growth is a challenge. A lift from an inflationary standpoint is necessary to grow earnings and those critical year-over-year estimates. The inflation rate has trended below the Fed target of 2% for more than three years although the U.S. Treasury yield curve steepened this quarter – yields on long-term bonds rose faster than on short-term bonds which telegraphs the expectation of higher inflation in the future. (See the Fixed Income Outlook that follows for a more complete discussion.)
Wage inflation is one of the Fed’s most closely watched metrics. Jobs growth has been a bright spot, but an even more positive sign of a healing labor market occurs when payroll gains fuel wage increases. Average hourly earnings, the best-known measure of workers’ pay, were up a scant 2% in June over the past year, according to the Labor Department’s most recent release. Wage gains are stuck in a somewhat two steps forward, one step back pattern – average hourly wages trend up for a couple of months and then fall back.
Certainly factors other than earnings affect future equity market performance. Investors ask if markets will sell off if earnings are down. There is no clear answer because it is about expectations. What do investors expect the market to do? What is investor sentiment about the market? What are the alternatives for cash, where else can investors go? Such factors are more challenging to quantify but are nonetheless critical.
It is difficult to look at a market and say with complete confidence that if valuations are high and earnings growth is slowing that it is time to sell. Trends can stay in place for a very long time, and it is hard to predict what catalyst will bring about its end. For example in China, even after the recent correction, PE valuations are still 31 times earnings according to Bloomberg estimates, compared to around 18 in the U.S.
Earlier in the year, investor sentiment was more bullish, but the pendulum has now swung into bearish territory. Short sales in June were at their highest level since 2009, according to Bloomberg. And, after years of gobbling up stock and bond mutual funds, individual investors appear to have lost some of their appetite. Investors favored bond funds from 2010 to 2012, but preference shifted to equity funds as confidence in the U.S. economy improved. According to Lipper, assets under management by stock and bond funds more than doubled to $13.7 trillion (through June 17) from $6.9 trillion at the end of 2009. But year-to-date inflows for the period dropped by 36%, or $143 billion, compared to a year earlier.
We tend to take a somewhat contrarian view of sentiment extremes, but when there are examples of extreme positive or negative sentiment, it pays to be aware that such levels can sometimes lead to a strong market reversal.
U.S. Stock Market Flat For the Quarter
Major stock indexes ended the second quarter essentially flat after reaching record highs in May, primarily due to Greece defaulting on its debts and corporate earnings and economic growth disappointing at home. The Dow Jones Industrial Average was negatively affected by the energy component and defensive stocks. Defensive sectors have not done as well even when markets have sold off because valuations are expensive, and many of the companies are multinationals whose earnings have been impacted by the strong U.S. dollar. Dividend-paying stocks have lagged this year due to the threat of interest rate increases as investors may increasingly shift from “bond substitutes” to traditional fixed income.
The S&P 500 Index performance was helped by the consumer discretionary and healthcare sectors. The fact that The Affordable Healthcare Act appears here to stay has provided some clarity for business models given the increasing degree of confidence that the rules are not going to change at any given moment. This also translates to more Americans covered by health insurance able to receive medications and have access to doctors and treatments in greater number just as the population of the U.S. is aging. An additional contributor to the robust performance of healthcare, biotech stocks, appears to encapsulate the exact ingredient necessary for growth: innovation. The lengthy cycle of the past for these companies to bring new drugs has improved considerably as efficiencies in R&D are shortening the pipeline to market while enhancements in the FDA approval process have assisted in the trend.
The NASDAQ Composite benefited from a growth and small-cap orientation. The Index reached the level of its previous nominal high posted in 2000 during the dotcom bubble before falling back a bit.
Figure 1. Equity valuations around the world appear to be fully priced.
Outlook: Investors are Still Addicted to the Fed’s Easy Money Policies
Equity market performance for the balance of 2015 should mainly be driven by earnings. However, sentiment, expectations, and the Fed will likely play an important role as well.
We have a somewhat muted outlook for equity returns for the next six months based on earnings expectations. Estimates for the second quarter earnings growth have been revised to -4.5%. The bounce that was originally expected after some of the variables that constrained the first quarter earnings came later and was not as robust as was expected. (The negative number does not mean an actual loss, but rather that earnings were 4.5% lower than 12 months ago (YoY).) However, analysts are prone to understate estimates. The first quarter earnings estimates were around -6.0%, but earnings came in close to 2.0%. Nonetheless, pressure is intensifying on the rest of the year’s earnings performance, although fourth-quarter comparisons should be easier as we anniversary the collapse in oil prices.
The corporate earnings outlook must be weighed against sentiment, expectations, where the Fed stands, and against the overall economic backdrop. Investors are clearly still addicted to the Fed’s easy money policies. A big part of the market does not want to see rates go up given the turmoil in China and Greece and sluggish growth in the U.S. Should the Fed raise rates in September, we could see an equity market pullback if economic growth and inflation expectations are not at a level investors feel is sufficient to withstand even a small increase in the fed funds rate. However, given that there has been so much discussion about the possible negative impact on stocks of rising rates, the actual reaction could be more muted. Instead of seeing a pullback in equities, we could see flows diverted from bond funds into the stock market. Historically, equity markets continue to rally for several quarters after the first rate increase as economic improvement is usually significant at that time.
Figure 2. The Nasdaq Composite is currently the only one of the three indexes above with double-digit returns across the one-, five-, and ten- year periods.
The earnings outlook is one reason we prefer small- over large-cap stocks. Given the headwinds for large-cap companies who face a strong dollar eroding their revenues coupled with potentially slower global growth, it makes sense to allocate assets to U.S. focused companies versus multinational ones. Currently only 18% of the revenues of small cap companies are generated abroad. Small caps are not particularly cheap in terms of valuation, but we focus on relative value, as nothing is particularly cheap. We see value in small cap U.S. stocks versus large cap stocks for these reasons.
We are also still focused on growth stocks, specifically growth at a reasonable price – quality, consistent growth, over value stocks. We do not see any sudden large cyclical upswing in economic growth above the level of the past few years. Such an environment makes the consistent returns typically generated by growth-oriented stocks more attractive. Indeed, so far in 2015, growth is outperforming value across all market capitalizations.
We are also more favorable towards international stocks relative to U.S. large-cap multinational ones. We are of the belief that as investors, “one does not fight the Fed,” and the U.S. economy is improving to a point that the Fed will be able to raise interest rates. The most dramatic improvement in equity prices will probably come in Europe where, given the level of the ECB’s monetary easing programs, and if the EU can manage their geopolitical issues and the fiscal issues around Greece, member countries can maintain some modest growth and have the potential for a better bounce in equity returns. The returns have lagged for so long that international stocks are due a reversion to the mean performance. Eurozone activity is currently much weaker than that of the US. This is a reminder of the fact that the market is often times a discounting mechanism; it is not necessarily the current situation that drives markets but more often expectations for the future.
Finally, in another example of reversion to the mean, we anticipate that volatility will continue to pick up, especially given the problems in Greece and China. In 2014 the CBOE Volatility Index (the VIX) was depressed, averaging 14, but now the measure of volatility is returning to its 10-year average of 20. It feels more painful than it really is simply because we saw depressed levels of volatility last year.
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