on Monday, 19 October 2015. Posted in October, 2015


Back on Track?

“Dear Optimist, Pessimist, and Realist, While you guys were busy arguing
over a glass of water, I drank it.”
                                                                    Sincerely,The Opportunist (Author Unknown)

As stocks move up from the double bottom experienced in August-September, most traders agree that the world is no longer ending but, as yet, the bull uptrend has not been restored. The long-term Pessimist, or more likely, the perma-bears have taken a victory lap on a 12% correction in a 200% increase in the S&P 500 since March 2009. Only a month ago China was collapsing, Goldman Sachs predicted oil below $30 a barrel, deflation was inevitable, 3Q2015 earnings reports would confirm an earnings recession leading to an economic downturn, and stocks would break through technical support levels and fall another 10%-20%.

The rally since September 30 indicates a significant reversal in investor psychology. China data, including GDP released today, are consistent with expectations in August-early September, oil prices are at the same levels as late summer, and P/E ratios are unchanged. Stock prices, measured by the S&P 500, are only about 3% off their summer highs and 4.7% below the May 20, 2015 all-time highs. No doubt the market correction was related to perceived Emerging Market and China weakness resulting in selling out of these markets and their derivatives. As we said in our September 8 Compass:

“Traders participate in both up and down markets without any regard for fundamental economic value placed on individual stocks or indices. Computer programs react to specific trading patterns which offer the best chances of success. These algorithms are limited by a finite number of profitable trades. Volatility is the key to profit and the more the algorithmic traders, the higher the volatility. In periods like those experienced in the past few weeks, markets become casinos, increasing the possibility of flash crashes and massive losses of investment funds.”

In such times the astute investor is a Realist, stepping aside as these traders dominate. As of Friday, the S&P 500 is now above its 50-day moving average for the first time since mid-August. On a technical basis this is a necessary step in reversing the downtrend. Also, seven of ten S&P 500 sectors are above their 50-day moving averages, indicating improved breadth not seen in the rally from the August lows. According to Bespoke Investment Group, 59% of the S&P 500 stocks are back above their 50-day moving averages, the highest reading since last June. One has to wonder, who are the Opportunists?

Earnings season for 3Q2015 is underway and the majority of S&P 500 companies will report over the next two weeks. According to FactSet, of the 58 companies reported, 81% beat mean earnings estimates while only 50% reported revenues above the mean estimate. We expect revenue growth to continue to slow. With US nominal GDP only growing about 3.5%, the strong dollar, and the impact of lower commodity prices, revenue increases are hard to come by. However, good corporate managers set
themselves apart from the average and grow earnings. General Electric, which released earnings last week, held their margins and reported earnings above expectations, despite declining revenues. Intel also maintained strong margins, even with a declining PC market.

Once again, the Energy sector is the largest contributor to the overall earnings decline to the S&P 500. For 3Q2015, Energy earnings are forecast to decline 64.9% and 63.5% for 4Q2015. Earnings ex-Energy are positive for both quarterly estimates. The decline in commodity prices is reflected in the Materials sector with earnings estimated to fall 19.9% in 3Q2015 and 13.9% in 4Q2015. Overall, earnings for the rest of the year should remain subdued as the unfavorable year-over-year comparisons reflect the sharp rise in the US dollar and the dramatic decline in oil and commodity prices. More favorable comparisons are anticipated in 2016 as these anomalies in both earnings and revenues are lapped.

Lower gasoline prices have begun to have an effect on consumer spending. It is not the magnitude of the decline, but only when coupled with sustained lower prices does spending directly increase Personal Consumption Expenditures in GDP. Gas prices are now traceable in retail spending. A recent report by JP Morgan found that:

“Individuals spent $.78 on every dollar saved on gasoline, with about 18% of that going to eating out and 10% to groceries, according to the study. Other big categories included entertainment, electronic & appliances, and charitable donations.”

Spending on autos has remained high throughout the decline in gas prices and is correlated more to the length of auto loans (up to 84 months) and the historically low interest rate. However, the psychology of lower pump prices has resulted in increasing sales of SUVs and pickup trucks as energy efficient auto sales have declined substantially. This trend may continue through 2016 as oil supply is forecast to outstrip demand.

Since the closing low on August 24, the price of crude has risen 29%. Based on the accepted bull market definition, a 20%+ rally following a 20% decline, crude is in a bull market. This is bull. A recent report by Morgan Stanley stated that “The addition of new supply from Iran in 2016 will likely keep the market oversupplied and defer any need to incentivize any US supply growth until 2017…almost the entirety of added supplies in 2016 will come from Iran, Iraq and Saudi Arabia.”


As shown in the Table, the annual total crude demand is forecast to rise 3.0 mb/d, or 3.8%, from 2014-2016. The total crude supply will increase 2.8 mb/d, or 3.5%, over this same period. Based on these estimates, supply will remain above demand through 2016. Taken at face value, these data imply lower energy prices into the foreseeable future. Given the potential instability of many OPEC members, it is
hard to have confidence in these data, in fact, the supply of crude from OPEC member companies could vary significantly in either direction.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Markets remain vulnerable as investors and traders continue to assess China and Emerging Markets, oil prices, a stronger dollar, and mediocre earnings. Earnings should begin more favorable comparisons in 2016 and stocks, currently 16x estimated forward 12-month earnings, are not expensive. 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.

David Minor
Rebecca Goyette

William Hutchens