After starting out the year with two extremely challenging months, March gave investors a big lift and some emotional respite. Stock prices, measured by the S&P 500, rebounded 6.6% in March, the biggest jump in monthly prices since last October’s dramatic 8.3% run-up. Dividend paying stocks have begun to stand out, as have value stocks, particularly small caps and mid-caps. Utilities, consumer staples and telecom stocks have led the way while financials and health care stocks have been notable laggards.
The S&P 500 started the year at 2,043. From day one (January 4th was the first trading day of the year), prices fell. They hit their lowest point on February 11th (possibly the new March 9th 2009?) when they closed at 1,810. In only six weeks, prices had fallen 10.27%. A 10% drop in prices is the generally accepted definition of a market correction. I think this utterly shocked investors. Most were evaluating how they intended to reposition their portfolios, not how they were going to execute triage.
In today’s world, there is a spectrum of issues dominating the emotional backdrop: unconventional presidential candidates, global warming, refugee crises and ever more incidences of terrorism. The year started with a contentious Fed rate hike and a resurgence of fear the global economy was spiraling into a recession. In my opinion, amidst all this noise, the critical component remains the outlook for US corporate earnings. The earnings recession we are in (I’ve mentioned in past letters) remains a cloud over markets. My expectation is for it to resolve.
According to FactSet Research, with the anticipated earnings drop in Q1 2016, it will be the first time the S&P 500 has seen four quarters of successive earnings declines since Q4 2008. The energy sector remains the culprit. If we overlook the anticipated 101% drop in earnings from energy stocks, the earnings decline for the S&P 500 would be 3.7%. At the present time, earnings forecasts are for declines in Q1 and Q2 of 8.5% and 2.5%. Analysts are calling for a turn-around in the second half, with positive earnings growth of 3.7% and 11% in Q3 and Q4.
Since the financial crisis in 2008, labor costs have been low, employment has recovered smartly (in spite of an aging work force) and corporate profit margins have improved dramatically. Things have been going well, but now revenue and earnings are decelerating. Today, growth in Europe is intact, it’s slow here at home, and middling around the rest of the world (China, Japan). With this backdrop, earnings improvement is not a given.
Critical factors in the expected second half earnings recovery are a normalization of oil prices and a continued fall in the value of the US$. Oil prices look to have stabilized and possibly put in a bottom. Airlines are reported to be purchasing oil hedges out 2-3 years. As earnings from the energy sector have evaporated – even a 50% recovery would be a nice bump to the S&P 500’s earnings. On the currency front, a further weakening of the US$ could provide an even bigger bump to earnings. According to JP Morgan, a 10% drop in the trade-weighted US$ could lift earnings as much as 5%. Oil and the US$ could be the differentiators this year.
Stock valuations are not unreasonable. If the price/earnings (PE) ratio remains constant, and earnings pick up, stock prices are likely to rise. According to FactSet Research, stocks are currently priced at a PE of 16x the next 12 months expected earnings. I am hopeful continued mean reversion in both oil prices and the US$ are enough to catalyze earnings going forward and anchor higher stock prices into next year.
The style shift I discussed in last month’s letter has not changed. Stocks correlated to a recovery in oil, unloved sectors (industrials, transports, materials), have begun to lift. The crowded sectors such as consumer staples and utilities have been safe places to hide but are all very expensive to buy. I continue to believe a second half earnings recovery will return the spotlight to quality growth companies in the technology, consumer discretionary and health care sectors.
Please feel free to call if we have not spoken recently. Now that the typically busy tax season is behind us, we can put renewed focus on portfolio positioning and other issues more central to your long term needs.
Bruce Hotaling, CFA