We are sitting in the front row seats, mouths and eyes wide open, hearts racing, gripping the arm rests. We’re watching the stock market equivalent of a Zombie – it’s barely moving, arms outstretched, lumbering forward, and it’s somewhat terrifying to watch. Something bad must be about to happen, but it’s not clear what. This is how many investors are experiencing their participation in the stock market today. Fear is on the rise but it’s not clear yet whether it’s an illusion (created by the media) or real and we should be looking for someplace to hide.
For the month of June, stock prices fell 2.1%. This was the third time in six months stocks have produced a negative return for a .500 batting average (below their .667 historical average). For the first half of the year, stocks measured by the S&P 500 returned a scant 1.2%. This is not much reward for taking on all the risk that typically comes with owning stocks. In fact, according to Bespoke Investment Group, the first half of 2015 will be the first time ever the S&P 500 has not been either up, or down, more than 3.5% at any point, during the first six months of the year. In years past when the market has been this passive, the average returns for the second half of the year have been around 6%.
The good news for you is our stock portfolios are well positioned to take advantage of the sub-tendencies in this market. Growth stocks outperformed value at every capitalization level. High P/E and low dividend yields outperformed. Sectors we are overweight remain health care, consumer discretionary and increasingly the financial sector. They are all generating excess return. We expect financials to work well if the yield curve begins to shift upward and retains a positive slope. The other sector we are attracted to is technology. There are many innovative companies we own with an emphasis on the internet of things, and emerging technologies. We are underweight energy, consumer staples and industrials. Materials are of no special significance and we simply do not own utilities.
For the most part, the recent news flow has been little more than media contrivance. Greece, whose economy is similar in size to the greater Miami (according to Paul Krugman) is not going to destabilize the US stock market. Reported declining growth in China, a controlled communist economy, is suspect. We do not invest in Chinese companies. The US companies we do own make their own decisions as to the degree to which they deal with China. Apple, for example, produces and sells vast quantities of product in China. I believe the events that ultimately validate investors’ fear, the black-swans, will surprise all of us. I also believe Russia remains the greatest possible source of near term market disruption – far more than Greece.
More importantly, we are just entering 2nd quarter earnings season. Strong 2nd quarter earnings will be supportive of even stronger 3rd and 4th quarter earnings, and thus positive for earnings revisions. As we have discussed in the past, the stock market is an effective discounting mechanism. Today’s stock price tendencies are reflective of what we should expect in the future. Stock prices are primarily driven by future earnings expectations. The stock market’s Zombie-like behavior to this point in time could be signaling some reticence with respect to earnings for the second half of the year.
According to FactSet Research, the P/E ratio of the S&P 500 for the forward 12 month period is 16.5x. For some context, this is above the 5-year average of 13.9x and the 10-year average of 14.1x. Current bottom-up earnings expectations for 2015 are $119.5 a share and $133.72 for 2016, a 12% rate of growth. This would be the index’s highest growth rate since 2011. I expect the market to recognize this forecasted rate in earnings growth, and for stocks to behave accordingly in the second half. To be clear, if it looks as though the growth is unobtainable, then it could be the Zombies are more real than illusionary. If that is the case, we will want to consider selling some stocks, and de-risking your portfolio.
Until that day, if the fear becomes overwhelming, please call so we can discuss the best next steps for you. Of course, it may be time to simply turn off your television and enjoy the beautiful summertime.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.