Crosscurrents = Uncertainty = Volatility = Opportunity
The world outside the United States is becoming more uncertain both economically and politically. Instability from the sharp decline in energy prices, ultimately benefitting consumers worldwide, has created a vacuum for high cost producers and countries largely dependent on oil and other commodities for their economic existence. The budget shortfalls of major oil producing countries are well-documented, but less unknown is most emerging market countries have been beset with lower commodity prices and depreciating currencies against the dollar, leaving them uncompetitive in world markets. The disruption in the energy and commodity markets will be, on balance, a benefit to our domestic economy. Last week the announcement of massive bond buying to begin in February by the European Central Bank is a positive for European and US equities. This QE program with purchases of Sovereign and selected corporate debt at 1.1 billion euros is higher than had been anticipated. Results will be evaluated in terms of increased liquidity and an acceleration in inflation. Already, there is skepticism based on the US experience with QE’s. But now US growth rates are higher than Europe and a deflation spiral never approached reality. As investors, we welcome European QE, knowing that “all other things equal” asset prices will rise.
Since the beginning of 2015 the Dow has fluctuated more than 200 points on every trading day despite no major change in fundamentals. Lower oil prices, declining interest rates, and the strong dollar are a positive for equity prices. While early in the earnings cycle, according to FactSet, the first 90 S&P 500 companies reporting earnings for 4Q2014, 79% are above the mean estimate, for revenues, only 54% are above the mean estimate. Stocks are valued on future earnings and estimates are declining. For 2015, the forward 12-month P/E ratio is 16.6x and above the three most recent historical averages: 5-year (14.6x), 10-year (14.1x) and 15-year (16.1x). This rise in the forward 12-month rate reflects a drop in earnings, rather than a rise in price. The decline anticipates weakness in the Energy sector from the 50%+ decline in oil. Since December 31, the 12-month forward EPS estimate for this sector has fallen 27.3%, increasing the P/E ratio to 22.4x from 16.6x. These crosscurrents affect the S&P 500 estimates by bringing down the 2015 earnings growth rate by 40%. Assuming a 10% Energy sector earnings weight/market cap of the S&P 500, Energy is a 4% drag on overall S&P 500 earnings. Today, 2015 S&P 500 earnings are estimated at $125, a 5.9% increase over 2014. Therefore, ex-energy expected earnings growth remains close to the 10% prior level. The Table below shows the latest full-year estimates by major S&P sector.
The benefits of falling oil prices which have driven energy earnings and stocks lower should begin to show up in 4Q2014 GDP data as increased personal consumption expenditures. Over time lower fuel prices will result in stronger retail sales, but for now what has occurred is a cutback in capital spending by energy-related companies. (Energy-related capex is only 10% of total.) Although the US economy is growing faster (3%) then it had in 2010 and 2011 (2%) earnings growth is slowing. Multinational companies are adversely affected by dollar appreciation. The dollar has risen about 15% against the currencies of many of our major trading partners. Historically, currency fluctuations are treated as temporary, but a continued strong dollar will eventually result in lower share prices. Dollar appreciation negatively affects American exports and with Europe bordering on recession, China growth decelerating, South America a disaster, large multinationals have limited upside visibility.
After a weak 2014, consumer spending is poised to accelerate in 2015. The problems inherent in 2014 have mostly disappeared and the sharp decline in gasoline prices giving sentiment a boost will in turn increase discretionary consumer spending. Last year can be characterized as another retrenchment for low-to-middle income consumers. Much of the spending during 2012-2013 was by wealthy consumers’ spending patterns that followed equities higher. Anecdotal evidence shows that the spending growth of the wealthy consumer slowed in 2014. As employment continues to increase and wage and salaries grow, low and middle class consumers are reassured of a better economic and personal financial outlook. Adjusting for lower energy prices, consumers entered 2015 with growing aggregate income and declining expenses. According to the University of Michigan Sentiment Report, in December sentiment of the bottom third of the income group rose 233% year-over-year. As we move through this year, consumer purchasing patterns will become more apparent, but for now the durable goods category, particularly basic goods, are preferred. Included are used light trucks, up 13.3% in the second half of 2014 as compared with the first six months, along with audio equipment, telephones, televisions, and new domestic autos. On the services side it is motor vehicle leasing and travel.
The housing market remains range bound as investors withdraw and potential first-time and existing homeowners slowly transition into purchasers. Existing home sales remain weak and housing starts are about 50% below their historic average. Mortgage rates are back near record lows, consumer confidence is rising, affordability remains high, and recent changes at FNMA and FMAC should help first-time buyers. Inventories are low, resulting in higher prices thereby further reducing the supply for potential purchasers. As the consumer sector accepts the transition to a financially secure economy we expect a more “old normal” housing recovery.
Looking at the stock market, earnings estimates are coming down and with the crosscurrents discussed above, may track lower into mid-year. For now lower energy prices and a stronger dollar are more negative than positive. The banks are suffering under additional regulation and low net margin spreads. Low interest rates place a floor on equity prices. The dividend yield on the S&P 500 is above 10-year Treasuries, an indicator of relative value favoring equities. The stronger dollar will attract capital, keeping rates low and lower earnings growth will set a ceiling in stock prices. Over the course of 1H2015 economic data will reveal the unevenness of the economic cycle that has been heightened by these crosscurrents. Within this range there will be volatility until there is moderation in the slope of oil prices, interest rates, and the dollar. A range-bound market does not mean individual stocks will not outperform. We, as investment managers, look for value in individual companies that not only have good earnings but those that surpass expectations.
Our investment policy remains optimistic on Large Cap domestic corporate equities. As the US dollar strengthens we would avoid companies highly dependent on Europe and until stability returns to the commodities markets, energy and raw material producers, particularly those in Emerging Markets. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities.