Climbing a "Wall of Worry"
“Knowledge is an unending adventure at the edge of uncertainty.”
Jacob Bronkowski – Scientist
Volatility returned to the oil and currency markets, and in turn to equities. Many have claimed the March market volatility compares favorably with January. The recent brief uptick in volatility reflects increased uncertainty of future Fed interest rate policy, deteriorating 2015 earnings estimates, a stronger-than-expected dollar, and falling commodity prices. Most of these are the same worries that surfaced last January. Meanwhile, stock markets, measured by the S&P 500 and the NASDAQ, are within striking distance of all-time highs. Although the S&P 500 Volatility Index approached the 17 level prior to the March Fed meeting, it has fallen back to the 13 level since. In January, the Index was above 20 for the first half of the month and reached intra-day highs above 23. Despite what most analysts are saying about market volatility in March, it is more in-line with markets prior to the October 2014 selloff, rather than January 2015. This more normal level of volatility is often present during rising markets.
Among the issues creating the “Wall of Worry” are Fed policy and 2015 earnings.
- Federal Reserve Interest Rate Policy – Our position on Fed speak has long been to listen, not overanalyze. Strategists have spent undue time and effort in playing up the dire consequences of anticipated Fed policy. It began in 2009, ramped up through three rounds of QE’s, and has continued through the taper. The Fed will raise rates, but it will not be until they feel their duel mandate can be accomplished. The recent removal of the word “patient,” not unlike the prior elimination of “considerable time,” was interpreted as a clear signal of an imminent increase in rates. Traders, not learning from their prior lesson in semantics, bet heavily before the statement that markets would react negatively to removal of this single word, tipping the odds in favor of a rate increase in June.
The Fed did as traders and Fed-watchers predicted and removed “patient.” But the Fed added that the US economy had lost momentum between meetings, and that recent US dollar strength was slowing inflation and negatively impacting US exports. Currency and bond traders rushed to cover short positions and stocks rallied. The Fed statement reflected interpretation of current data, most of which was available to traders and analysts. The Fed has long-stated before the tapering began, that it is “data dependent,” and Chairman Yellen only reaffirmed this policy, but not before traders were spooked again. A further confirmation came as the bond market lowered the probability of a June rate hike to 10% immediately after the statement was released.
According to the “watcher experts” another worrisome aspect of the Fed interest rate policy is the Federal Reserve has painted itself into a corner. The premise is the Fed wants to increase rates but because of economic conditions, both domestic and international, risks a further slowing. While money has been created, it is not being spent. The consumer is back-loaded and in the best
financial shape since the 1990’s. Spending will eventually come on, but uncertainty keeps traditional spending habits on ice. Gas and other energy costs have been falling since last June, but the savings are barely noticeable in the spending data. The recent increases in gas prices only confirms the uncertainty that these price declines are short-term and better off saved than spent.
Those claiming the Fed is behind the curve for not raising rates last year would today be demonizing them for raising rates in a slowing economy. The current confluence of economic events: QE’s in Japan and Europe; a slowing domestic economy; the deflationary aspects of a 50% decline in crude oil; and the inability of wages increasing would have the “watchers” focusing on premature increases and potential inverted yield curve accompanied by declining corporate earnings. With the equities markets near all-time highs and stocks fairly valued, the economy will pick up later in the year, and despite the potential for a correction, there will be no recession, neither economic or earnings.
- 1Q2015 Earnings – The earnings results in 1Q2015 can be summed up in two words: oil & dollars. Without beating a dead horse, the 50% decline in the price of crude and its widespread impact on the energy sector is well-known, but the overall earnings shortfall from the strengthening dollar is more difficult to quantify. Already, bears have concluded we are approaching an earnings recession with equities overvalued. Any perceived further weakness in the economy will empower the bearish argument of overvaluation of stocks, with biotech and technology bubbles. In the forthcoming earnings season, not unlike last quarter, misses in revenues and on the bottom line will be severely punished. Sectors that derive more than 40% of earnings abroad will be targeted. Overall, about 46% of S&P 500 earnings are non-US, with Materials and Information Technology above 50%, and Healthcare, Consumer Staples and Industrials more than 40%.
The nominal trade-weighted value of the US dollar has appreciated nearly 22% since mid-2014. It is the rate of increase (averaging 2.3% month-to-month) that has precipitated recent downward revisions in 1Q2015 earnings. According to Reuters, 1Q2015 S&P500 earnings are estimated to decline 3.1%, the first decline since 3Q2012 (-1.0%), and the largest since 3Q2009 (-15.5%). As shown in the Table below, five sectors are projected to show year-over-year earnings growth and five showing declines.
Interestingly, the Energy sector has a 43.3% higher weighting in the S&P 500 earnings than in the S&P 500 market cap Index. This means the effect of the 63.4% decline in earnings is not equally reflected in the cap-weighted S&P 500 Index. The earnings drag of the 11.2% earnings weight in the S&P 500 is -6.5%, thereby giving an adjusted S&P 500 earnings, ex-Energy, an increase of 3.4% in Q12015.
The dollar shock will be more quantifiable after 1Q2015 earnings are reported. For the remainder of 2015, earnings estimates will increase or decrease depending on the effect of non-US earnings in the first quarter. But similar circumstances of dollar strength and earnings weakness are not without historical precedence. During the 1990’s stocks rose despite Fed rate increases and a strengthening dollar. From year-end 1991 to December 31, 1996, S&P 500 earnings rose 111%. However, earnings only rose 17.7% from January 1997 through December 2000. An earnings recession in 1997-1998 saw earnings rise 1.0% in 1997 and fall 7.0% in 1998. There was no economic recession and stocks, measured by the S&P 500, climbed 33% in 1997 and 28% in 1998. Currency fluctuations can have a measurable effect on short-term earnings, but longer-term stock valuations are the present value of discounted future cash flow and earnings surprise.
Markets may become vulnerable through earnings season as investors and traders assess the effects of declining earnings amid fluctuating oil prices, a strong dollar, and below consensus economic data. 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, there is potential for a definable correction which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during a 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 limited multiple expansion with continued upside for equities. Our investment policy remains optimistic on Large-Cap domestic corporate equities.