The stock market, in the face of some high levels of skepticism, continues to befuddle investors who thought they understood what was going on. Stocks, measured by the S&P 500, finished the month of May at the 2,096 level, up 1.5% for the month. Stocks are now up 3.6% year to date. After a rocky start to the year, when prices fell relentlessly for two months, stocks have recovered 8.4% since the end of February.
The market made an abrupt shift to value stocks with the start of 2016 and looked to be committed to that path. Oil prices were in total free fall the first 6 weeks of the year, leading to uncommon correlations between asset classes and immense levels of fear. Investors drank the Kool-Aid and began to unload all the favored growth stocks of the last few years, hoping to ride out the storm with dividends and low valuations.
Then, growth stocks woke up in May. Not all, to be sure, but enough to raise the level of doubt that the newly proclaimed value regime had legs. Stocks with ties back to the energy complex have strengthened with the recovery in oil prices. Industrials, some transportation stocks and a range of materials stocks have shown solid earnings strength and price improvement. The financial stocks, banks in particular, after a difficult start to the year, have also been coming around. This reflects the market’s anticipation of a more friendly yield curve, and some relief that loan losses from the oil patch are manageable.
At a time of year when things tend to simmer down, there are some sideshows looming. Brexit may bring some added volatility when the UK’s “should I stay” referendum takes place on June 23rd. It’s interesting that roughly half of Britain’s exports go to the EU, while only about 6% of the EU’s exports end up in the UK. The unknowns surrounding this question are weighing on the UK financial markets and currency. The UK, on its own, is in the top 10 US trading partners.
Brazil is host to the 2016 Summer Olympics (Rio 2016) this August. This year’s competition will include rugby sevens and golf for the first time, at the expense of baseball and squash. The issue is the mosquito-borne Zika virus. It is largely symptomless and no current vaccine exists. This has led athletes from several countries to withdraw from competition. It’s not at all clear how this will develop, but the situation harks back to the Ebola scare during the fall of 2014. When fear raises its ugly head, all rational thinking goes out the window.
As I have discussed in the past, we have been slogging our way through an earnings recession. The earnings decline for 2Q 2016 will mark the fifth consecutive quarter of quarter over quarter earnings decline since Q3 2008. The anticipation of weak earnings was likely the prime factor in the milquetoast returns to stocks in 2015 (the year of the FANG stocks). The market was discounting a prolonged earnings recession due to the expanded fallout from the implosion in oil prices.
In my opinion the market’s current lift is both a reflection of a slowing rate of decline and an expected recovery in the second half of 2016 and into 2017. The most significant change is the recovery in the energy space. According to FactSet Research, the energy sector actually recorded an increase in the bottom-up earnings estimate of 1.8% (to $1.10) over the first two months of the quarter. During this time the price of crude (WTI) has increased 28% to $49.10.
According to FactSet Research, the CY2017 bottom-up earnings forecast is for $135.42. With the S&P 500 currently in the 2,090 range, stocks are trading 15.4x next year’s earnings. Stocks are not cheap. At the same time, they are discounting an earnings recovery or a return to earnings growth which we have not seen for some time.
As is the case, things will develop that destabilize the markets, temporarily. The stock market corrects on average once a year. It corrected in September ’15 and February ’16. I think the evidence supports small steps toward an improving market and looking for higher returns for stocks in the second half of the year. Please touch base if you would like to review.
Bruce Hotaling, CFA, Managing Partner