Stocks, as measured by the broader averages, had a banner July, sending the Dow, S&P 500 and NASDAQ clearly into positive territory for 1H2016. The July rally was led by Technology as higherthan-anticipated earnings and M&A fortified prices. Energy, which had been a leader since the bottom in crude prices early in February, was the weakest S&P sector in July, falling 2%. The fall in energy stocks reflects a steady 20% decline in crude oil prices in July. For year-to-date, the Energy sector is up 12%, but once again the bears are claiming the drop in oil is a sign of impending economic slowdown. The 1.2% rise in real GDP for 2Q2016 added confirmation to this assertion. In reality, the decline in oil prices reflects a seasonal cycle, although for much lower levels than historically. Oil prices regularly rise through the spring as gasoline production increases in anticipation of summer driving season, peaks in early June and falls into late October. After all the attention given to oil volatility over the past year, in a slow news environment attention is refocused to the dangers of another freefall.
Corporate Profits and GDP
It was almost immediately reported in the media and echoed by market analysts that GDP data released by the Bureau of Economic Analysis (BEA) on Friday confirmed a weakening economy. The lower real GDP then estimates was ascribed to a larger-than-expected decline in inventories at the finished goods level. Had inventories remained stable, GDP would have been up 2.4%, in the range of most estimates. Low inventory numbers in this instance do not positively impact corporate profits to the extent of the adjustment back to normal levels. As we have written on numerous occasions since 2014 it is Gross Output (GO) that fully reflects what is going on in the economy.
Unlike GDP, GO is defined by BEA “Measures the combination of both final product (GDP) and the industry input that is purchased by other industries for use as inputs to their own production.” The criticism of GO is that it involves double-counting, as it takes into account all goods and services used in the production process to produce rather than for final consumption measured as GDP. The Go is indicative of the total activity of the entire production process. The Table below shows annual and the most recent quarterly data.
The data on the Table show the relationship of GO to Personal Consumption Expenditures (PCE) to be consistent, the private industry output tell a different story. Although not shown on the Table, the Total Output of Private Industry fluctuate quarter-on-quarter. These data show a sharp slowdown in 4Q2015 and a below-average increase in 1Q2016, an indication of inventory buildup being worked off.
Although the consumer is the lynchpin for GDP growth, when looking at the overall economy GO must be part of the analysis. Corporate profits are more reflective on total output, this is particularly the case for industrial companies producing intermediate goods for final production. A stronger US dollar, foreign trade, inventory adjustment, and productivity are outside the scope of PCE. A trend of increasing personal consumption assures growth in consumer related products, but masks of a full picture for corporate earnings. For example, dislocations, such as sharply falling energy prices, positively affects consumer spending but negatively affects energy companies and ancillary industries. In other words, a pickup in PCE, while a positive for selected equity sectors, may not be reflected in overall corporate profits.
Productivity weakness has been another factor for subpar corporate profits. Since late-2010, capital spending has trended down as capacity utilization remains below 75%. After increases in Nonresidential Investment in 2014, mostly structures, a low level of capital spending increases continued until turning negative in 4Q2015 through 2Q2016. Only the intellectual property component has remained positive but at subdued levels. Low interest rates are supposed to stimulate investment, but longer term these low rates face a lack of demand as savers are penalized without a return on investment or consumption. It is implicit that the Fed raise rates to normalize the credit cycle. The economy has not reached this point of rising unemployment but the current range of 180,000-200,000 monthly job additions may soon become unsustainable.
2Q2106 Corporate Profits
According to FactSet, with 63% of the companies in the S&P500 companies reporting earnings for 2Q2016, 71% have reported above the mean estimate and 57% have reported revenues above the mean estimate. Our proprietary research shows equal weight quarter average EPS is up 5%. At the sector level, Healthcare (81%), Information Technology (79%) and Consumer Staples (78%) have the highest percentage beating mean estimates. Morgan Stanley research shows that earnings of 312, or 74%, of S&P 500 companies reporting, 91% are at/above estimates, but only 41% with revenues above estimates. By individual sectors the leaders by percentages above estimates are; Financials (7.4%), Information Technology (7.4%), Industrials (6.2%) and Consumer Discretionary (5.6%). Energy sector earnings are 22.9% below estimates. For all sectors, earnings are 5.0% above estimates while revenues are only 0.6% higher.
Over the past three months all of the 2Q2016 earnings leading sector stocks have risen, but only Information Technology with its stocks rising 10.3% has outperformed the S&P 500 composite (5.2%). The recent stock performance shows a shift away from defensive sectors to more economic sensitive sectors. The larger tech companies, with a concentration on consumer tech have produced consistently better-than-anticipated earnings and performance. One thing these companies have in common is a continued high level of capital spending in the absence of stock repurchase plans and no dividends. Alphabet (Google) and Facebook aptly fit the conservative definition of growth companies. Amazon continues to invest heavily in its distribution infrastructure and in addition has built a cloud storage business reported to have over 50% of this rapidly growing important subsector. Google is another leader in this area but with only 5% of the available market.
Our investment policy is more optimistic and favors a strategy based on slow economic growth and improving quarterly earnings. The seasonal light volume of summer with the concentration of money in large traders (algorithmic and hedge funds), periods of volatility are to be expected; we view any selloff as a buying opportunity. The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings. The recent inventory adjustment reported in GDP is a positive for future growth. 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 and technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends. We would avoid companies deriving substantial revenues from Europe until the currency translation become favorable.