The Road Not Taken

The first two months of 2016 have been a challenge. Stock prices started the year in free-fall and didn’t let up until February 11.  At that point prices were down an eye opening 10.3%, measured by the S&P 500.  Over that 28 trading-day span, prices fell on 16 days or nearly 60% of the time.  Worse, on a staggering 13 of the 16 down days, prices fell by more than 1%.  Market corrections of 10% or more are not uncommon, in fact they tend to occur every 18 months on average.  This correction was sharp and unexpected.

Interestingly, oil prices also fell on 19 of the first 28 trading days of the year, and they also bottomed on February 11th – down an astounding 29.2%.  The correlation between stock prices and oil was nearly perfect in January, higher than any time since 1990.  Then suddenly, blue sky reappeared on the 12th, and prices began to rebound recovering more than 50% of their respective losses by month end.

The hope is the 18 month collapse in global oil markets has stabilized. One of the most damaging aspects of the plunge in oil prices has been the impact on earnings – both for the energy sector and the S&P 500 as a whole.  According to FactSet Research, earnings estimates for the energy sector fell from $2.97 to $0.20 during the first two months of 2016.  Interestingly, at the start of 2015, the Q1 estimate for energy was $8.38.  The point here is earnings from energy companies have effectively gone away.  At this point, I think there is reason to expect a substantial rebound in earnings forecasts for the S&P 500 as we move into 2016.

Separate from the energy patch, the bottom up earnings estimates for the S&P 500 have been falling – for the last four quarters. We have been grinding through an earnings recession.  Based on FactSet Research data, this is the first time S&P 500 earnings have seen four quarters of year-over-year declines since the period Q4 2008 through Q3 2009.  This has caused a drag on the market dating back to mid-year 2015.  A popular topic in the news is a global recession, but the slow-drip erosion in earnings has been nagging stock prices, primarily energy, materials and industrials, for the last nine months.

Amidst this backdrop, the market’s fundamentals are sound (measures such as earnings yield, price to earnings ratio) making the 10% correction in prices look very disconnected. When the emotions clear and speculative traders have exhausted themselves, the baseline valuation of the underlying stocks once again becomes the imperative.  According to FactSet Research, the 12-month forward P/E ratio for the S&P 500 is 16.1x based on the recent 1993.4 price level and forward earnings estimates of $124.  This is underpinned by a generally constructive domestic economic outlook.

The recent bounce in prices has brought a welcome tail-wind to our favored asset classes: stocks, corporate and municipal bonds, REITs and oil and gas pipelines (MLPs). Out of respect for the market’s recent directionality, we will hold an overweight position in cash, though I expect the recent bump in prices to have a somewhat calming effect. Our baseline measures of growth, valuation and dividend distribution remain firm.  If the stability holds, we will look to put more excess cash to work. 

Just as in Robert Frost’s well know poem “The Road Not Taken”, we are faced with something of a divergence. Many investors have shifted their portfolios into lower growth value stocks, including consumer staples and utilities.  They are seeking temporary shelter.  The transition occurred at the end of last year, as though a switch were flipped.  The path we have chosen is, “the one less traveled,” anchored by higher growth names we expect to outperform the broader market, over time.  These are investments that require a little more research and conviction, but have the potential to deliver attractive rates of return.  I expect some patience will be required, as we allow our growth oriented and strong free-cash flow based stocks to regain their position of dominance. 

As the damage from the storm passes, I suspect we will be proven right. Of course, time will tell.  In the meantime, please feel free to call if we have not been in touch recently.  When the markets are volatile, it’s often useful for us to connect.  

Bruce Hotaling, CFA

Managing Partner