Markets took investors on a roller-coaster ride to open the year, with the S&P 500 Index plunging 11% from January 1st to February 11th before turning around to head steadily higher to finish the quarter narrowly in the green. The handwringing early in the quarter centered around three issues. First, investors feared the Federal Reserve was preparing an overly aggressive plan to raise interest rates in 2016. (When markets started to gyrate, the Fed dutifully adopted a more dovish stance.) Second, the price of oil plummeted more than 20% to $30 per barrel in the first three weeks of January, and third, the Chinese markets showed stress due to slowing economic growth and ham-handed attempts by the Chinese government to tame the volatility. All in all, the whipsaw action of the quarter made it a great opportunity to make mistakes.
Even though the U.S. economy continues to chug along at a relatively steady growth rate of 2.0%-2.5% per annum, corporate America remains mired in a profits recession. The first quarter of 2016 will mark the fourth straight quarter of declining profits for the companies represented in the S&P 500 Index. Overall, analysts expect S&P 500 profits to fall by about 10% from the year-ago quarter, which, if it comes to pass, will be the worst quarter for earnings since 2009.
There are three main reasons for the profits recession and one primary reason (perhaps) that the U.S. stock market remains within just a few percentage points of its all-time highs reached on May 21, 2015. The biggest reason for the profits recession is the evaporation of earnings from the energy sector. With oil now at $41, energy companies are still a long way from being able to reach their levels of profitability in recent years—and may not reach those levels for a long, long time. Second, financial companies are also suffering due to the Federal Reserve’s low interest rate policy. U.S. banks, in particular, are not earning much interest income from their loans with rates at such low levels. Third, multinational corporations have struggled to grow profits as the U.S. dollar has strengthened against other currencies. A strong dollar means makes the goods and services that U.S. multinationals offer less competitive versus foreign offerings, and it also makes it harder to grow U.S. dollar-denominated profits—because foreign currency revenue needs to be translated back to dollars to be reported.
The irony of today’s situation (and perhaps the reason that the market has remained so resilient despite the decline in corporate profits) is that the main engine of the domestic economy, the U.S. consumer, is benefitting significantly from the three precise issues that are dampening corporate profits. (Consumers account for roughly 70% of our economic output.) Low borrowing costs continue to support consumption while low energy prices are freeing up consumers’ money for other things. The strong dollar also helps consumers. Overseas travel costs less, imported goods cost less and commodities priced in dollars also usually cost less. With stocks holding their ground, home prices rising, a decent jobs picture and wages that look to be rising modestly, the U.S. consumer is in a better position now that at anytime since the 2008-09 financial crisis.
Should the fact that stocks are nearing new highs be a concern for investors? The intuitive answer might be “yes”, but the empirical answer is “no.” Just because stocks are at (or very near) all-time highs does not suggest they are about to decline. In fact, since 1946, the S&P 500 is three times more likely to be higher one year after reaching an all-time high than lower. However, the caveat is that when a fall occurs, it is almost always at a steeper angle than the angle of the preceding increase and at a time (and for a reason) that no-one can predict consistently.
U.S. stocks now trade at about 17.5 times expected earnings for 2016, which is slightly on the high side of the market’s historical valuation range. However, investors should realize that most stocks are not particularly expensive at the moment. The very depressed levels of earnings in the energy and financial sectors are skewing the market’s price-to-earnings multiple higher. An earnings recovery in these two sectors would give the overall level of corporate profits a significant boost.
In general, the U.S. seems likely to continue on its steady but low-growth trajectory as we move further into 2016.
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