Hard to be Patient.
“A man who is a master of patience is a master of everything else.”
Yes, we are still in a bull market for stocks. Stocks, measured by the S&P 500, remain about 3% below the May 20, 2015 record high. After correcting in late summer – early fall 2015 and again in early 2016, stocks have challenged the record highs only to fall back to technical support levels. Through last week, the S&P 500 index was up 0.65% for the year and 2.79% below the year-ago level. Volatility, although not approaching the correction levels of August – September 2015 has remained historically elevated. The major negatives of last year and into early February have lessened but not disappeared. China has regained some traction in its transitional economy, oil is up 70% from its February 11th low, and the US dollar is down about 8% from its highs. Economic data on balance remains positive with little or no chance of a recession on the horizon. But the economy, measured by real GDP, continues to grow annually in a 2.0%-2.5% range, close to the 2.2% annual average since the end of the 2007-2008 recession.
While many short- term uncertainties remain, there has been progress on a number of fronts. Among these are:
Stability and Emerging Markets (EM) – Raw material prices have risen recently and for many EM countries this has been translated into higher equity prices. Even with the slowdown in China, many EM countries were in better financial condition to withstand a substantial decline in exports. In addition, the weakening of the US dollar has alleviated pressure from the dollar-dominated sovereign debt issued during the boom years. Stock markets have reflected this turn of events as the MSCI Emerging Market Index rose 6.1% year-to-date through April.
Oil Bottom – While it is impossible to determine the magnitude and short-term direction for crude oil, the February 11th rally off of the $26 a barrel crude price seems certain to hold. There is reason to question that at $45 this rise has been too much too fast. Inventories remain high and production is off only marginally. Demand continues to rise, but is nowhere near equilibrium. The fires in Alberta and the war in Libya may have temporarily kept prices elevated, but this has been more than offset by increased production in Iran.
China Improvement – Data are mixed but there are signs that the transition to a consumer economy is gaining momentum. Most recently the Chinese PPI bottomed. This indicator has historically shown a high correlation to Chinese GDP. Also, the increase in the Baltic Dry Freight Index from 300 to 700 indicates a movement of raw materials and most certainly including China.
Fed Policy – The most recent employment data will most likely push any interest rate increase back into early fall. Thus far current quarter economic data do not give any clear indication of acceleration in overall growth. Manufacturing remains positive, but only marginally, and one of the more robust sectors, Autos, looks to be topping.
Earnings season is near completion and the results have not provided a catalyst to raise stocks above the record highs of 2015. According to FactSet, with 87% of the S&P 500 companies reporting results for 1Q2016, 71% had earnings above estimates. Revenues for these companies were only 53% above forecasts. At the sector level, Materials (84%), Consumer Staples (83%), Consumer Discretionary (82%), and Healthcare (81%) had the highest EPS beat rates. With the exception of Healthcare, companies in the other three sectors have outperformed the S&P 500 Index year-to-date through May 6th. The blended earnings decline for 1Q2016 is -7.1%, making it the first four consecutive quarterly year-over-year decline since 4Q2008-3Q2009. Also, the 7.1% decline is the largest since 3Q2009 of -15.8%. There is little reason for optimism in the current quarter. Analysts are forecasting a 4.7% drop in S&P 500 earnings for 2Q2016. Should oil prices and the dollar remain near current levels the 2Q numbers appear too low. FactSet reports that for 3Q2016 and 4Q2016 earnings are estimated to increase 1.4% and 7.5% respectively. Revenues are forecast to follow a similar trend, turning positive in 2H2016.
Disappointing data for New Home Sales and Starts have put in question the strength of the US housing recovery. New Home Sales have been lackluster, missing expectations in March by 1.7%. Single unit starts are up 22.2% in 1Q2016, maybe warmer weather, but most likely a reaction to low inventory. A shift back to a more balanced single unit/multiunit ratio may be evolving. The trend in rental housing over homeownership seems to be reversing as indicated by an increase in rental vacancy rates to 4.5% in March 2016 from the lows of 4.2% last summer. Housing demand is highly dependent on household formations. According to the most recent Housing Vacancy Survey, the average annual household formation increased from 450,000 in 4Q2015 to 540,000 in 1Q2016. As more millennials moved through their 20’s and into their 30’s, the demographic transition will drive household formation and homeownership. The slow but increasing trend in wages, 2.5% in 1Q2016 preliminary GDP Report, will support this transition from renter to owner.
Our investment policy is less cautious and should move toward outright optimism as the economy and earnings reflect our outlook for 2H2016. The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.