Meanwhile Back at the Ranch
“Headlines, in a way, are what misled you because bad news is a headline, gradual improvement is not.” Bill Gates
As the headline noise created over Greece and China fades, the US economy and 2Q2015 earnings move back into the forefront. Bankrupt Greece, now in the European Union “bankruptcy court” and China’s misspent attempt at broadening its stock market yielded no contagion and left the major US stock averages near levels where these potential “disasters” began. Unrelated to this media blitz has been an internal correction of equities within the S&P 500. The S&P 500 is up 3.29% year-to-date as of close on Friday, and has not been more than 5% below its all-time highs this year. However, the average S&P 500 company is off about 15% from their highs and with only one-third of listed NYSE companies above their 50-week moving average, some are calling this a stealth correction. Recent moves to record highs in the NASDAQ 100 have been jettisoned by large-cap technology companies. This is borne out when looking at four leading tech companies and their performance during the July 1-17 period. Google (+29%), Amazon (+11%), Facebook (+10%) and Apple (+3%) have a market cap of $1.7 trillion and represent 30% of the total capitalization of the NASDAQ 100. Last Friday the average rose almost 1% while 60% of the 100 companies were down. Throughout this “upheaval” the volatility index (VIX) briefly flirted with 20 in early July but quickly settled back to below 12 last week. The VIX is an indication of upside and downside volatility, but longer term a low VIX level accompanies rising markets. Over the past 25 years, the VIX has had its highest increases in July, August and September.
Not unlike the old Western movies, which used a return to the ranch to segue into a new scene, we too believe we will soon return to focus on fundamentals that will determine the magnitude and duration of the current bull market. We cannot fully discount a potential definable stock market correction, but the resilience of equities has already been tested during the first-half 2015. An economic slowdown, weaker earnings, and perceived international chaos could not drive the broad-based market indices into correction territory. Astute longer term money managers continue to see value and growth with only minor interruptions from bears leaning on the algorithmic traders for downside support. The investment landscape is strewn with bearish strategists and economists who have called 20 of the last 0 corrections.
Looking forward to the next few weeks earnings will be front and center. Although early in the season, according to FactSet, 2Q2015 S&P 500 earnings are expected to decline a revised 3.7%, a slight bit better than the -4.5% estimate as of June 30, 2015. Energy, once again, is the largest contributor to the S&P earnings shortfall. Excluding the Energy sector, the aforementioned -3.7% would result in a 2.6% increase. With 61, or 12%, of the S&P 500 reported, 72% have beat estimates. For revenues the beat rate is 56% with the overall revenue decline estimated at 4.0%, the largest since 3Q2009. (This week 131 S&P 500 companies are scheduled to report.) The negative estimate (-55.4%) for the Energy sector are well-known and compensated for in overall investment strategy, but the 6.0% estimated decline in the Technology sector, ex-Apple, may come to many as a surprise. Despite better-than-expected earnings from some of the large-cap tech companies, overall Tech sector earnings will be negatively impacted by the strong US dollar and, to a lesser extent, a slowdown in China.
We expect the dollar to trade around current levels while Europe stabilizes. Should the dollar strengthen further it will endanger the anticipated pickup in 2H2015 earnings. But even under these circumstances US equities may continue to rise. In an increasing interest rate environment, stocks will be the alternative to bonds and with a growing economy, US stocks offer less risk than foreign alternatives. Under such conditions we would expect some multiple expansion. Although the economy would continue to improve, margins would rise on lower revenues and earnings would weaken. Energy remains a question mark as the WTI crude oil price has fallen sharply to $50 a barrel in July, after increasing from $47.60 to $59.47 during the second quarter. Prices during 2Q2015 averaged $58.02, 43.6% below the $102.96 in the corresponding quarter in 2014. This second quarter price increase explains the 7% upward revision in Energy sector estimates.
Our outlook for the US economy is for continued below-average recovery growth rates (2.5%-3.5% GDP), moderation in quarter-to-quarter GDP amplitude as the consumer sector and housing normalize. The Fed will act when the data dictate, but most likely later this year or early 2016. We would expect the bearish consensus to amp up the negative consequences once Fed policy is finalized. History has shown that the initiation and implementation of a Fed policy to increase interest rates almost always result in rising equity prices. As shown in the Table below, of the 14 instances of Fed policy initiatives raising rates, since the inception of the S&P 500 Index, only two resulted in declining S&P stock prices over the period of rate increases, and that was in the 1970’s. The average annual return for the S&P 500, excluding the down periods, was 9.4%.
Most surprising from the Table is the Fed’s ability to not upset equity markets. Granted the Greenspan Put bears some responsibility for the Tech Bubble and ensuing crash in the early-2000’s, but on balance the results no way reflect todays bearish case. Slow retrenchment from the Fed, which will lead to rate normalization, confirms to us that the economy, after more than five years on life support, is breathing on its own. One could conceivably chart the beginning of the “old normal” business cycle from this point. Bull markets do not die of old age, but rather from an impending recession. In fact, seven of the last eight bull markets ended in recession. If there is a broad consensus on the economy today, it is that there is no recession on the horizon. Recessions start on average about five years after tightening begins, but have occurred in as little as three years. Additionally, it is two years on average after wage gains of 4% and one and a half years after the yield curve inverts that the downturn begins.
Markets remain vulnerable as investors and traders assess the effects of lowered earnings amid fluctuating oil prices, a stronger dollar, and rising interest rates. In the short-term, there is potential for a selloff which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during the rate normalization process. 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. Our investment policy remains optimistic on selective large-cap domestic corporate equities.