Waiting (In Vain?) For An Earnings Rebound by Worth Wray, STA Wealth Management
Inside This Edition:
Stocks Reverse Course Post-Brexit…For Now
For What It’s Worth
Weekly Technical Comment
401k Plan Manager
Features Articles & Interviews
Stocks Reverse Course Post-Brexit…For Now
Written By: Luke Patterson
CEO & Chief Investment Officer
As we see the U.S. equity market reverse course from the post-Brexit sell-off and make a renewed attempt to test its all-time highs (2,130.82 close on the S&P 500, which was hit way back on May 21st, 2015.), the question is whether this effort will prove more successful than the others we have seen over the last year. (see chart of S&P 500 below)
The big question here is whether there is any fundamental justification for equity prices sustain their current levels, let alone move higher.
Pretty much every valuation metric for the S&P 500 make the broad stock market seem fairly expensive relative to history – the forward price-to-earnings (P/E) ratio at 18x compares to longer-run average of 15x; on a trailing earning-basis, the P/E ratio of 20x compares to norms of 17x.
This week investors await Friday’s June employment report. The U.S. economy is expected to have added 180,000 jobs in June, up from the shockingly low 38,000 reported for May.
What is difficult to square is the massive rally in the government bond market, which seems to be discounting a troubled future – yet the equity market appears to be pricing in a whole lot of hope. Can they both be right?
Last week’s divergence of bonds and stocks isn’t healthy. Bonds are screaming that the world economy is slowing, and shareholders are ignoring the signals. Stocks no longer seem to be about growth, but about the desperate search for safe alternatives to low-yielding bonds.
Since Brexit, the bond driven nature of the stock market has been particularly stark. Four sectors in the S&P 500 are now higher than they were on the eve of the British vote, and none is a bet on the American economy’s underlying strengths.
The bond market has really taken the show. The 10-year U.S. Treasury note has triggered a net positive return of 8% while the 30-year U.S. Treasury bond is up almost 17% in the third best first-half performance on record.
This past week, for the first time, the entire Swiss government yield curve, out to 2064 maturity, went negative in yield. The yield on the 10-year Treasury note fell to a record low at one point of 1.38%.
Throughout this entire Brexit saga, another trillion dollars of global government debt went negative in yield, bringing the tally now to $12.7 trillion. There is another $14.5 trillion between zero and one percent. We are down to just $5.7 trillion between one and 2% and a paltry $2.2 trillion worth yielding over 2%.
Consider that for a second – 36% of global sovereign debt trade below zero and 77% in total less than 1%.
These are signals that the excessive indebtedness is constraining growth and has become even more acute. A stuck-in-the-mud economic backdrop, and nobody is going to run out and raise their GDP forecasts anywhere based on the poor economic data and heightened political uncertainty in Europe.
It’s deeply troubling to think that nearly eight years after the collapse of Lehman Brothers, the only “solution” apparently available to our continued economic travails is another dose of monetary steroids.
Brexit may have provided a further push, but the underlying causes of the collapse in global interest rates lie far deeper in sluggish productivity growth, declining global growth and the excess in industrial capacity.
For What It’s Worth… Waiting (in Vain?) for an Earnings Rebound
Written By: Worth Wray
Chief Economist & Global Macro Strategist
“Fair was she and young, when in hope began the long journey; faded was she and old, when in disappointment it ended.”
~ Henry Wadsworth Longfellow, Evangeline (an epic American poem published in 1847)
Summary
- While corporate profits staged an impressive recovery in 2009, 2010, and 2011, the vast majority of S&P 500 returns since then have been driven by multiple expansion.
- What’s more, earnings have been contracting for the past five quarters; so it’s difficult to see how rising multiples can keep supporting current prices near all-time highs with liquidity contracting and the risk of a global recession rising.
- Either earnings need to rise or prices need to fall. And the market has already been waiting a long time.
- Although an earnings rebound in the second half of 2016 is now the consensus forecast among big bank analysts, I am skeptical. All it takes is another leg down in energy prices or another leg up in the trade-weighted US dollar (among other macro risks) for the profits recession to continue and for a major correction to ensue.
- With that in mind, my colleagues and I on the STA Investment Committee believe the risk/reward of being overweight stocks is pretty unfavorable. Richly valued US equity prices could rise a little, or they could fall a lot. Meanwhile, the option value of cash and other defensive assets can fall a little, or it can rise a lot.
- Rather than pining away for a surge in earnings to revive an aging bull, we know and trust that a new expansion will eventually bring new opportunities. Until then, we think it is prudent to stay defensive and take what the markets give us.
When I was a child growing up along the bayous of South Louisiana, my grandmother used to tell me a story about an Acadian girl who spent much of her life waiting for her long-lost love under an old, mossy oak tree.
Like most folktales, there are countless versions to this story. In Henry Wadsworth Longfellow’s version, Evangeline finally finds Gabriel moments before his death. But in the version I remember, she dies alone under that tree – waiting in vain for a soul mate who never comes.
It’s one of those stories that’s imprinted deeply in my heart. And, oddly enough, it keeps popping into my mind as I think about the ongoing in contraction in S&P 500 earnings.
The US equity market, you see, has been waiting for earnings growth for quite a long time. While corporate profits staged an impressive recovery in 2009, 2010, and 2011, the vast majority of S&P 500 returns since then have been driven by multiple expansion. In the following chart, you can see that multiples have grown by an impressive 37% while earnings expanded by a slight 11%.
That shouldn’t be a huge surprise given the striking relationship between the Fed’s balance sheet and the S&P 500, but it’s difficult to see how multiples can keep rising if the US economy continues to slow and the Fed continues to sit on its hands.
This isn’t simply a question of whether relatively rich multiples can drive prices higher in the face of sluggish earnings, but whether high valuations can continue to compensate for negative earnings growth in an environment where the index is trading near its all-time high, liquidity is contracting, and a number of US recession indicators are flashing red (“American Investors & Policymakers are Totally Unprepared for the Next Recession”).
As you can see in the chart below, S&P 500 earnings have been falling for five straight quarters (assuming Q2 prints in the red, which it almost certainly will) in what has proven to be a severe US dollar (and oil) shock to global economic activity.
While much of that decline has been driven by the collapse in energy prices and the erosion of foreign profitability…
… analysts have lowered their expectations for every sector in the S&P 500 over the last two years, suggesting that something more may be happening.
What’s more, we know that investment bank forecasts – which many investors use as a crutch for gauging future price action – have been consistently over-optimistic for decades.
In addition to forecasting pick-ups in earnings growth in both 2001 and 2008…
… these same Wall Street soothsayers predicted positive earnings growth for 2015 and are now forecasting a serious pick-up in the second half of 2016.
That prompts an important question. Is the worst somehow behind us? Or is the profits recession spreading to a number of non-resource sectors right under the analysts’ noses?
Will Evangeline (the ongoing S&P 500 bull market) find her long-lost love (earnings growth), or will the index die another heart-breaking death like it did in 2001 and 2008?
I’m skeptical to say the least.
While optimistic calls for an earnings rebound in the second half of 2016 have become the consensus mantra…
…this kind of recovery largely depends on solid performance from sectors like materials, financials, and consumer discretionary – three sectors I believe are particularly vulnerable to a renewed rise in the US dollar, potential shocks from financial events abroad, and the already softening US labor market.
No one can consistently predict the future, but it is not a stretch to think earnings growth may fall well short of expectations if the oil rally falters and/or the US dollar resumes its rise.
As FactSet’s John Butter explains, “If the average overestimation over the past five years is applied to the current estimate, the index would be expected to report an actual decline in earnings of -0.5% for the second half of 2016.”
Although there have been two cases in the last thirty years where significant year-over-year S&P 500 earnings declines did not coincide with US recessions, our economy has become far more exposed to foreign shocks since the energy busts of 1998 and 1986.
Moreover, the risk of global shocks from China, Europe, Japan, or the major emerging markets appears to be rising as the US economy continues to slow. [On that note, I do expect a seasonal pick-up in Q2 growth as we have seen in 4 of the last 6 years, but that does not mean the growth slowdown is somehow ending. In fact, it appears to be getting worse as the labor market weakens and the service sector economy shows signs of rolling over.]
Even if those risks do not immediately come to bear, the fact that we are rapidly approaching the upcoming US presidential election alone introduces extreme policy uncertainty with the potential for a big fall in asset prices.
As we’ve seen toward the end of the last four two-term presidencies, all the uncertainty surrounding a major election tends to keep markets in check; but after November 8, illusions will give way to reality.
If you’re struggling to understand what all this means for your portfolio at a time when US stocks still look to many investors like a safe bet, then listen carefully to global macro legend John Burbank when he says “price is a liar.”
Markets do not accurately discount the future. They reflect consensus belief about future prices and the overall balance of liquidity in the present moment.
When markets begin to reflect aggressive upside assumptions like they do today, the risk/reward of being long becomes pretty unfavorable. Richly valued US equity prices could rise a little, or they could fall a lot. Meanwhile, the option value of cash and other defensive assets can fall a little, or it can rise a lot (especially with negative interest rates in Europe and Asia pushing yield-hungry investors into American bond markets).
Would you risk losing 30%, 40%, or even 50% of your nominal portfolio value just to capture another 5% or 10% when valuations point to a high probability of low or negative returns over the next ten years?
I wouldn’t. As far as I’m concerned, this is a time to focus on the return “of” capital rather than the return “on” capital.
As the following chart illustrates, it’s easier to lose money than to make it back. And the more you lose – which can be quite a lot when investors take unnecessary risks late toward the end of a bubbly market cycle – the harder it is and the longer it takes to recover those losses.
Source: dsohrt.com
To recover from a 20% bear market loss, you have to earn 33% just to get back to even. Lose 30% and you have to earn 43%. But after your portfolio falls 40% – as many investors did in the last two market crashes – it starts to get ridiculous with a 67% required to breakeven.
That’s why high valuations tend to drag so much on future returns. Markets move in cycles and when prices dramatically outstrip earnings – even though the market may continue to rise in the short-term – it means that earnings must rise or prices must fall.
At this point in the market cycle, I believe the greater opportunity lies in shedding risk, taking a contrarian view, and waiting for a bear market to push valuations back to more favorable levels for long-term risk taking.
That doesn’t mean you should sit in cash waiting for the market to crash, but my colleagues and I on the STA Investment Committee believe it makes sense to focus on other, potentially less exciting ways of making money while the market waits for a profits rebound that may not come.
These lovers will meet again… but maybe not until the next business cycle.
Rather than pining away for a surge in earnings to revive an aging bull market like fair Evangeline under moss covered Louisiana live oaks, we know and trust that a new expansion will eventually bring new opportunities.
Until then, we think it’s prudent to stay defensive and take what the markets give us.
-Worth Wray, Chief Economist & Global Macro Strategist
Weekly Technical Comment – DOW And S&P 500 Back Above 200-day Average…
Written By: Luke Patterson
CEO & Chief Investment Officer
Stocks ended the week on a strong note. The charts below show the Dow Industrials and the S&P 500 nearing a test of their June highs.
The S&P 500 is now trading back above its May low and its 200-day moving average. That is a sign that the breakdown in the markets resulting from the Brexit vote has probably been contained. All major stocks indexes are trading back over their 200-day lines, with the exception of the Nasdaq. A move above the 50-day average would be even more encouraging. It’s also reassuring to see the 50-day average still trading above the 200-day line.
Energy And Healthcare Clear 50-day Averages…
The chart below shows the Energy SPDR (XLE) trading back above its 50-day average. A positive correlation has existed between energy shares (and crude oil) and the market.
The chart below shows the Health Care Sector SPDR (XLV) rising above its 50-day average after bouncing off its 200-day line. Other sector ETFs are either bouncing off moving average lines or moving above them.
Volatility Index Plunges…
Another positive sign is a plunge in volatility. The chart shows the Volatility (VIX) Index plunging all the way to 15 which puts it below the level of last Thursday’s British vote. That strongly suggests that option traders are liquidating their bearish hedges. It’s important that the markets held gains through the end of the week. It would also be nice to see a pickup in trading volume.
10-year Treasury Yield Testing 2012 Low…
The plunge in global bond yields continues. Last week’s statement from the Bank of England of its intention to lower rates sometime this summer pushed the British 2-year yield into negative territory for the first time, and its 10-Year to another record low further below 1%. Treasury yields continue to follow foreign yields lower. The chart below shows the 10-Year Treasury Yield falling again this week and coming dangerously close to its 2012 closing low near 1.40%. The drop in yields is boosting dividend-paying stocks like consumer staples, telecom, utilities, and REITs. Falling yields are also boosting gold which is a non-yielding asset that attracts money when yields are low and falling.
Falling yields are also boosting gold which is a non-yielding asset that attracts money when yields are low and falling (see below).
Sector Relative Rotation Model
The Sector Relative Rotation Model shows what sectors of the S&P 500 are strengthening and what sectors are weakening relative to the index. In other words, what is driving returns versus detracting from them.
The chart below (updated through July 1, 2016) indicates relative strength (relative to the S&P 500 Index). Energy, Materials, and Small Cap stocks are leading relative to the S&P 500. Technology and Consumer Discretion stocks have lagged. Consumer Staples, Industrials and Utilities indicates weakening, and Financials and Healthcare indicate improvement in the model. Keep in mind while this model is helpful to analyze sector strength in the S&P 500, it is one tool and should be used with a comprehensive investment discipline.
Note: There are four quadrants on the chart:
- Leading (Green) – strong relative strength and strong momentum
- Weakening (Yellow) – strong relative strength but weakening momentum
- Lagging (Red) – weak relative strength and weak momentum
- Improving (Blue) – weak relative strength but improving moment
Featured Articles & Interviews
- Friday, June 24th Brexit Video
Worth Wray, Chief Economist and Global Macro Strategist for STA Wealth explains Britain’s vote to exit the European Union. It is a historic decision sure to reshape the nation’s place in the world. - Friday, June 17th – What is a Fixed Index Annuity?
What are the benefits of a Fixed Indexed Annuity? What exactly is a Fixed Indexed Annuity? How does a Fixed Indexed Annuity accrue interest? These are some Frequently Asked Questions regarding Fixed Indexed Annuities (FIAs). - Thursday, May 26th – Michael Churchill
Scott Bishop, Director of Financial Planning at STA Wealth Management hosted a special edition of the
STA Money Hour with guest Michael Churchill, CPA. Mike is a CPA and Tax Manager with ABIP CPAs that
has offices in Houston and San Antonio. Mike and Scott discuss 2016 Tax Planning Ideas to help lower
your personal and business taxes
If you have any questions, please feel free to email me at [email protected].
Luke
STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Michael Smith, President
Worth Wray, Chief Economist & Global Macro Strategist
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
Disclaimer:
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