A Bumpy Ride or Correction?
Measured against historic valuations, stock prices are high at the current 17.2X 12-month forward earnings. Much of this recent revaluation can be traced to the drop in oil prices, however, there is little risk of an “earnings recession” or an economic downturn. According to FactSet, Energy sector earnings are estimated to fall 51.8% in 2015, down from a decline of 19.4% in the December 31, 2014 estimate. With the US economy growing 2.5% - 3.0%, there is more reason to anticipate continued growth than an economic slowdown. But the bear case will incorporate the “stretched” valuations as an impending sign of a longer-term earnings declines rather than a temporary anomaly. US equities remain the investment of choice, whether on merit or by default. After the slow start in January, the major averages, including the beaten down risk-on Russell 2000, rebounded into late-February. The S&P 500 is up 5.8% as of last Friday from its January month-end close, and the more volatile Russell 2000 has climbed 5.7% over the same period. The structural imbalances that require correction will not end the bull market but we expect the necessary “Wall of Worry” to elicit perma-bear wisdom as any negative economic data is reported. As the excess capacity still overhanging the economy since 2008-2009 is absorbed and unemployment approaches the 5% level, we expect growth to accelerate. For now we expect weaker-than-forecast monthly and first quarter economic data, affected by oil, a strong dollar and rising interest rates, along with weather in the Northeast and New England and the dock strike on the West Coast.
A More Cautious Short-term Outlook
As our readers are aware, we have been long-term bullish on US equities since we began publishing the Compass in 2010. During the European Sovereign debt problems in 2002 and 2010-2011 we were short-term cautious, but never bearish. Today, a combination of events are beginning to appear on our research radar that indicate that stocks may be vulnerable to a definable correction (+10%). As mentioned earlier stock valuations are at historical highs. But, in and of itself it is not a precondition for a correction. However, a number of economic road signs are now pointing in the direction of slowing economic growth, thereby limiting any possible multiple expansion. The overhead challenge from current valuations is complicated by a strengthening dollar and its effect on exports and overseas earnings. On the positive side is the “Patience” of the Fed should we enter a period of perceived uncertain economic growth. Also, the much discussed lack of consumer spending and business savings in response to lower oil prices may be premature. The full response begins after these savings work their way into the economy. As stated many times, the decline in oil prices is not a risk to the US economy, but a net positive for US growth, and in turn, US equity prices. Hopefully, our expectations will not be confirmed and the forthcoming data will be only bumpy and remain positive on balance.
Additionally, the prospect for an external shock remains high. As we have stated for years, Greece is only a problem in Europe, but today it is the Russian unbridled aggression without a noticeable reaction that could result in widespread consequences. As Putin attempts to reconstruct the Soviet Union, European financial markets will reflect Russian intransigence. Any negatives for the European Union will initially result in an inflow into US denominated assets. Potentially more troubling is the Mideast, it is a landmine. Terrorists seem to wander around unimpeded. They are well-armed and are rumored to successfully secure armaments and weapons through Turkey via Saudi Arabia. There seems no limits on their potential for death and destruction in the oil-rich desert. In the current situation with ISIS and its developing Caliphate, it is further complicated by bungled US policy, enabling Iran to complete its nuclear program. If there is a Black Swan in the future, it most likely resides in the Middle East.
With 4Q2014 earnings season drawing to a close, 75% of 443 S&P 500 companies have reported earnings above the mean estimate and 58% have beaten on revenues. Actual EPS is above the 5-year average and the revenue is slightly below the 5-year history. Uncertainty about future earnings of the Energy sector and the effect of the stronger dollar clouds the outlook for 2015. According to FactSet, for 1Q2015 and 2Q2015, consensus estimates are for S&P earnings declines of 4.1% and 1.1%, respectively. Calendar year 2015 earnings for the S&P 500 are estimated to increase 2.9%, led by Healthcare (+9.0%) and Technology (+5.9%), with the Energy sector earnings falling 51.8%. Sharply lower negative revisions in Energy dominate 2015 forward earnings without any commensurate upward revisions to earnings for Consumer Discretionary. The forward 12-month P/E ratio is 17.2X based on last Fridays closing price, this is the highest level since December 31, 2004. This current P/E is up from 16.2X at the conclusion of 2014, this outsized increase reflects a 2.5% increase in the S&P 500 stock average and a decline in earnings estimates of 3.3%. It is far too early in the year to make any rational investment decisions based on these “often changed, never right” analysts’ estimates.
Oil – “A Dead Cat Bounce?”
Markets have moved up following a volatile, but on balance, flat January. The so called “oil crises” has moved off the front pages as the rise from the mid-$40’s for Brent crude to $60 has alleviated fears of new lows. However, the world still remains awash with crude as inventories continue to build and storage is at a premium. As we discussed at length in recent Reports the potential unintended consequences “abound not only for non-OPEC exporters but for OPEC itself.” One such consequence of continued production is the amount of crude oil moving to limited storage. Research from Societe Generale shows world oil in storage rose by 265 million barrels in 2014, a relatively small amount when one considers production is 92 million barrels per day. It is estimated that 300 million barrels will be added to storage during the first half of 2015, based on overproduction of 1.5 – 1.6 million barrels per day. This translates to only about six days of inventory indicating a surprisingly limited amount of storage. Accordingly, Europe and Asian storage is at 80% - 85% capacity. Tankers are being rented for $45,000 a day to store crude in hopes of selling at higher prices at a not-to-distant future. Continued overproduction could result in a retesting of the lows as storage capacity utilization rises. The Saudi’s and OPEC have left the door open to cut quotas if high cost producers are not cleared from the market. Mid-February data from Baker Hughes reveals that despite a 37% decline since October 2014 to 1,091 rigs, the drop has been only 9% in the shale basins in North Dakota and Texas, which accounted for 80% of the increase in US oil output over the past two years. Rig productivity has increased in the remaining 63% open wells. Signs of anticipated long-term low oil prices are the lowered energy-related capital spending plans, down approximately 20%.
Our investment policy remains optimistic on Large-Cap domestic corporate equities. As the US dollar strengthens we would avoid companies highly dependent on overseas earnings, and until stability returns to the commodities markets, energy and raw material producers. In the short-term, the potential is evolving for a definable correction which will offer a long-term buying opportunity. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities.