Skip to content. Skip to main navigation.


Quarterly Market Update

Equity Outlook

Earnings Enter a Phase of Heightened Scrutiny

Faced with the potential for the first four-quarter streak of declines since the financial crisis, earnings are under not only heightened scrutiny, but some are even questioning how earnings are being presented.

Besieged by fears that the avalanche of bad news from China would pull down the global economy and push the U.S. back into recession, the S&P 500 Index experienced the worst start to the new year in history. Investors responded by pulling $39 billion from equity markets, as measured by outflows from equity mutual funds and ETFs in the first quarter of 2016. But much like the faithful tortoise, the U.S. economy continued to evidence broad strength and, after troughing on February 11, markets resumed an upward trajectory, proving once again that even slight economic improvements are still sufficient to boost equity returns.

Financial markets frequently go beyond what makes rational sense, whether to the upside or to the downside, and that has certainly been the case in the last year as the seven-year stock market rally struggles to stay alive. Faced with the potential for the first four-quarter streak of declines since the financial crisis, earnings are under not only heightened scrutiny, but some are even questioning how earnings are being presented. Sell-side analysts appear to be employing an “earnings micro- management” approach, pushing down expectations almost to the extreme. By sharply reducing estimates, it is easier for the market to view a lower earnings number positively simply because the number turns out to be better than expected.

Such a practice deemphasizes the true degree of decline, and somewhat negates the appreciation that the numbers are still down. All too frequently, in the face of plummeting expectations, earnings end up beating historical averages. This was the case in the fourth quarter of last year, when despite the doom and gloom that companies communicated to the street, earnings beat their historical averages.

As a result, many companies have stopped issuing EPS guidance altogether – currently only about 20% of the S&P 500 companies continue the practice. Of the 119 companies that issued guidance for the first quarter, 93 were negative and 26 were positive. Companies which have eschewed the practice of issuing guidance contend that the practice detracts from a longer-term view of the business model, and can make the stock price more volatile.

Analysts’ expectations for the first quarter earnings season, which begins a few weeks after the close of the first quarter, again push expectations to the extreme. Roiled by a continuation of factors that have hampered earnings in recent quarters including a strengthening U.S. dollar, falling oil prices, and anemic consumer spending, FactSet has projected year-over-year earnings will decline 8.7%, compared to the gain of 0.3% projected at the beginning of the quarter – a 9% decline in expectations within the quarter alone.

Obviously a big driver is the energy sector. For first quarter, FactSet is projecting year-over-year (YOY) earnings for the sector to be down over 99%. In comparison, the materials sector’s earnings are expected to be down 22% YOY. Telecom is expected to post the strongest earnings growth with a 13%, followed by consumer discretionary earnings with a 10% YOY rise.

Economic Outlook

In a second example of “earnings micro-management,” GAAP (Generally Accepted Accounting Principles) vs. non-GAAP comparisons are under scrutiny. Under this scenario, one-time events that a firm determines to be outside the scope of its normal business, such as the sale of a division or litigation expenses, are being stripped out each quarter. In 2015, 20 companies in the Dow reported non-GAAP earnings that were 31% higher than their respective GAAP earnings. The difference was 12% higher in 2014, so the spread continues to widen and has since the financial crisis began in 2007.

For the first quarter, most U.S. indexes were up slightly. Emerging markets, driven by the boost in oil and commodity prices the last seven weeks of the quarter, did the best. REITS, U.S. mid-cap stocks, and U.S. large cap stocks followed with single digit returns. U.S. small cap stocks which were down 1.5% before the February 11 trough and, along with the EAFE, which was down 2.7%, brought up the rear.

Economic Outlook

Economic Outlook

Outlook

There are a broad range of possible outcomes, but in our opinion, going forward macroeconomics stemming from global events will drive stock market returns.

The first quarter failed to shed much light on how the year may play out. Indeed, there are a broad range of possible outcomes, but in our opinion, macroeconomics stemming from global events will drive stock market returns. In the summer, Great Britain’s referendum for the country to determine whether or not it will remain within the European Union is set to take place. Great Britain is the largest economy in the EU and if it leaves, the exit will set a precedent for others, calling into question even more the lack of political and fiscal union among member countries. Certainly the events leading up to the vote have the potential to create temporary, if not longer, market angst.

At home, the upcoming presidential election may contribute to short-term market volatility until the two parties choose their political candidate. Historically, things settle down once the candidates are known, and the market typically has a decent experience for the balance of the election year. But should there be a contested GOP convention, that is just one more element of uncertainty that the market must digest.

The Fed has become more cautious about the economic outlook for the remainder of the year and has reduced expectations for rate increases from four to two. This gives the market some confidence that the Fed is not going to raise rates too much, too soon, a positive in comparison to the outlook three months ago. The Fed’s dovish stance sets the stage for stock prices to move upwards and for more multiple expansion if there is not supporting earnings. If multiple expansion once again becomes the norm, then the market is susceptible to even greater volatility, a continuation of the vicious cycle experienced in 2015.

The U.S. economy continues to move in the right direction, although not at an accelerated pace. Corporate earnings should improve in the second half of the year. Indeed, if companies cannot beat the currently incredibly ratcheted down expectations, then the bull-market rally may become a memory, although this is not an outcome that we are ready to concede. Certainly, events experienced in the first quarter will not relieve the pressure on earnings. Equity prices have bounced back in a reversal of extreme negative sentiment, but investors still need concrete evidence in the form of better data and improving earnings.

We are not in a horribly expensive market, but certainly not a cheap one either. Valuations came down decently with the selloff, but then moved right back to where they began the year. The snap back was not unexpected but nonetheless, the quick pace of the quarter’s recovery puts us back in a vulnerable position should we again have some bad economic news. The declines in earnings have further stretched valuations, and investors need tangible proof that these companies are healthy and that the move up is warranted, or the gains could evaporate. According to FactSet, at the quarter-end, the S&P 500’s forward price-to-earnings (P/E) ratio was 16.6%, compared to its 10-year forward average of 14.2%.

We remain positive on U.S. large cap growth stocks because in a slow- growth environment, investors reward companies that have above average growth with a premium stock price. International stocks should at some point outperform the U.S. given the additional economic stimulus announced by the ECB during the first quarter and the fact that they are relatively cheaper, although it has not happened yet.

The challenging financial market and economic environment continues to support the case for professional management.

Economic Outlook

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

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).