Market Held Captive by Oil
Over the past few months we have discussed the shift in consumer spending and the challenges to corporate earnings from the collapse in oil and raw material prices, the strong US dollar, lower exports, and a deflationary impact of global oversupply. Equity prices remain highly correlated to the change in the price in a barrel of crude. China, which we have discussed at length, seems to affect our securities markets despite no clear evidence of cause and effect to the US economy. At its lows two weeks ago, crude was down over 70% from its June 2014 highs. Companies comprising the S&P Energy sector are down 42.2% over this period and earnings are forecast to decline 52.9% in CY2016, after dropping 60.5% in CY2015. Throughout this period, production, particularly US fracking, has declined but not nearly enough to lower prices in line with increasing supply.
While lower energy prices benefit the consumer, it creates dislocations much broader than the 10% representation in the US economy. That being said, the recent rally from $26 a barrel was initially attributed to short covering, although it is hard to believe shorting was a rational decision as oil fell below $30. The magic $20 a barrel, put forth by Goldman Sachs, may still be reached, but in reality will not be at that level for very long. Further complicating the investment landscape is the debt in China and the European banking sector. European banks have not rebuilt their asset base as have the US banks, despite the near-panic conditions in 2010 and 2011. European bank stocks are at recession levels and credit default swaps are approaching prices last seen in 2011. (The Europe 600 Bank Index is down 27% since the beginning of the year.) Over the most recent period, S&P 500 earnings have fallen three consecutive quarters and revenues have declined four consecutive quarters. Real GDP for 4Q2015 was a lackluster 0.7% and a below trend 2.4% for 2015, the same as 2014. While the global economy slows, estimates are for 3% emerging market growth in 2016, the US economy outpaces most developed countries. This year may be a year of upside surprise for US equity investors if price stability in oil can be achieved, but with gasoline demand slowing in China and with little likelihood of a cutback in supply, investors will have to wait for market stability in economic growth and positive quarterly earnings.
With 87% of the S&P 500 having reported for 4Q2015, 68% have reported earnings above mean estimates. Overall, S&P 500 companies have beaten year-end estimates by 0.3 percentage points. As the Table below shows the 4Q results by major S&P sector, the estimate beats are driven primarily by Healthcare, Discretionary and Technology sectors. The beat on these earnings is due, in part, to the sizeable downside revisions prior to earnings season.
It is obvious from the Table that the Energy and Material sectors are responsible for the earnings decline for the S&P 500. Information Technology (78%) and Healthcare (73%) led the increases in overall sector earnings, while Consumer Discretionary, Industrials, and Materials were slightly above (69%), the S&P 500 (68%). As of last Friday, all sectors remained in correction territory, but only Energy and Materials were in a bear market. Given the slightly better-than-expected results in the latest earnings data, stock prices do not reflect any noticeable improvements for Information Technology, Healthcare, and Consumer Discretionary. The price declines are discounting 1Q2016 estimates, where only Consumer Discretionary (+11.4%) and Healthcare (+3.5%) are currently forecast to show positive earnings growth. For CY2016 estimates are coming down quickly and although too early to fully discount these negative revisions, not until there are signs of renewed economic growth a ceiling has been placed on stock prices. On the other hand, any broad-based pickup in economic activity beyond the weak consensus will result in an upward revaluation in stock prices. Should the dollar stabilize at current levels, even with the supply/demand for oil in disequilibrium, a firming dollar will prove a positive for multinational company earnings.
S&P 500 4Q2015 Sector Earnings and Stock Prices
||High to 2/19/16
Source: FactSet, Hutchens Investment Management
Much ado about Fed policy
To a large extent, volatility in the US securities markets has been placed on Federal Reserve interest rate policy. Many argue that the Fed was behind the curve with its interest rate increase, although it’s hard to believe a 25 basis point rise could result in the panic selling witnessed this year. Previous first rate increases have rarely coincided with the end of bull markets. In fact, of twelve instances of first rate hikes since 1933, only in two was the bull market terminated in one year or less. The average was 3.1 years for a continued bull market. Since 1977, there have been five initial rate increases, with the bull market averaging an additional 3.7 years, with the shortest 3.3 years and the longest 6.1 years. We cannot underestimate market regulation that has removed the liquidity of proprietary trading.
Our investment policy remains cautious. The recent rally has not changed our outlook as it is short-term technicals (triple bottom) coinciding with a bounce from the mid-$20’s in crude oil. The problems we foresee are cyclical and not systemic, but they may continue further into 2016 than in previous post-2008 selloffs. Since late-December, there have been no meaningful rallies as buyers are transfixed on oil prices. Earnings season was in line with the lowered estimates and given the dismal earnings outlook for 2Q2016 and beyond will not positively affect current stock prices. We reiterate our strategy expressed in early January, “sit back and wait.”
The US economy will grow below trend for the first-half of the year, but with little chance of recession in 2016. Recent data confirm employment growth, rising industrial production, increasing retail sales, and an erratic housing recovery. Inflationary pressures are building in wages and housing, alleviating deflation fears. For the stock market the problems are well-documented but solutions will take time. Lower earnings will carry through the second quarter as corporations work through lower energy and raw commodity prices, a strong dollar, tighter margins, and inventory liquidation.
Expect higher volatility during early-2016 as companies shift to satisfy increased consumer demand in an environment of geopolitical uncertainty and an impending presidential election. The transition to a more consumer-oriented economy is in its early stages and 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.