By: Gene Walden March 31, 2016
Dr. Jekyll, meet Mr. Hyde.
Optimism overcame trepidation in the stock market during a raucous and bipolar 1st Quarter of 2016.
The S&P 500 equity index tumbled more than 10 percent through the first six weeks of the quarter before some positive economic news helped fuel five consecutive weeks of market gains through March 25 that drove stocks back up into positive territory by the end of the quarter.
The market limped into the year on a downward slide amidst pessimism regarding slowing corporate earnings growth, the slumping oil market and economic weakness in China.
But some favorable developments, such as a slight rebound in the oil industry, a strong employment report and a decision by the Federal Reserve to hold the line on interest rates propelled the market through a solid rebound in the second half of the quarter.
In a Nutshell
First Quarter Fly-Over
In Like a Lamb
Several key factors created a negative investment environment during the first six weeks of 2016:
Oil slump. After a long period of declining oil prices, the energy industry was in a severe slump with the price of oil sinking to under $30 a barrel in March.
China concerns. An economic slowdown in China caused a sudden drop in stock prices around the world in the 3rd Quarter of 2015, although most major markets recovered in the 4th quarter before declining again in early 2016.
Slower earnings growth. After several years of steady growth, corporate earnings for S&P 500 companies were projected to slow down in 2016, according to Standard & Poor’s.
Pricy dollar. Due to a long run-up in the value of the dollar versus every other major currency in the world, U.S. manufacturers faced an increasingly competitive environment abroad as the relative price of their goods continued to edge up.
Out Like a Lion
The second half of the quarter brought some positive developments that helped drive the stock market back up to the level at which it began the year.
Employment report. For February, the U.S. Department of Labor announced an increase of 242,000 non-farm jobs, as well as a revision of earlier reports from December and January that indicated that an additional 30,000 jobs had been created. The new jobs report, which signaled a healthier economy, helped bolster the struggling stock market
Fed decision brings favorable reaction. The stock market responded positively to the March 16 announcement by the Federal Reserve that the board had decided not to raise interest rates.
Drop in dollar good news for U.S. companies. The Federal Reserve’s decision to hold rates steady appeared to be the catalyst for a small drop in the value of the dollar versus other major currencies – a positive development for U.S. manufacturers who were facing competitive pressures abroad with a higher dollar.
Oil rebound. Oil prices rebounded slightly in February and March as supply and demand began to move back into balance.
China a non-issue. The weakness of the Chinese economy was not a prominent factor in the performance of the markets during the second half of the quarter.
GDP still solid while consumer spending slows. The revised “gross domestic product” (GDP) numbers from the 2015 4th Quarter, released in late February by the U.S. Department of Commerce, showed the economy growing at a faster rate than previously reported. A second revised report, issued March 25, confirmed that GDP had increased at an annual rate of 1.4 percent in the fourth quarter of 2015, which is a little below the average of the past few years.
Consumer spending, on the other hand, was weaker than the preliminary numbers had indicated, growing only 0.1 percent in both January and February, according to a March 28 report from the Commerce Department.
(GDP represents the value of the goods and services produced by the nation's economy less the value of the goods and services used up in production, adjusted for price changes.)
By the Numbers
S&P 500 dives then rallies
As the chart below illustrates, the U.S. stock market started the year in a tailspin, losing more than 10% through the first six weeks before recovering during the second half of the quarter. The S&P 500 closed Dec. 31 at 2044, dropped to a closing low of 1829 on Feb. 11, and recovered all the way to 2059.74 at the close of trading on March 31.
For the quarter, the utilities sector led all S&P 500 sectors, climbing 12.8% as investors moved to dividend-paying stocks amidst a slower earnings growth environment. The energy sector also had a positive quarter, up 3.1%, as the oil industry showed some signs of a recovery. Other sectors in positive territory included consumer staples, up 4.5%, industrials, up 4 .1%, materials, up 3.2%, technology, up 2.3%, and consumer discretionary, up 0.3%.
The losers included financial services, down 8.0%, financials, down 6.3%, and healthcare, down 6.5%.
(Source: Standard & Poor's)
Equity Earnings Projections Flattening Out
For 2016, the analysts’ consensus projection, according to Standard & Poor’s, is that S&P 500 companies will earn about $124.30 per aggregate share. We believe that projection is somewhat optimistic, and that the real earnings numbers will be slightly lower.
Earnings growth of S&P 500 companies was very strong from the depths of the recession in 2009 through 2014. Since then, earnings projections have flattened out – and, in fact, have dropped slightly in 2016.
According to Standard & Poor’s, corporate earnings are expected to decline for the first and second quarter of 2016 at an estimated rate of -8.7% and -2.4%, respectively. Year-over-year growth is expected to return in the second half of the year, with projected consensus growth rates for the third and fourth quarters of 3.9% and 9.0%, respectively. We don’t believe that growth rates will reach that level this year; in fact, we expect earnings growth to be fairly flat throughout 2016.
Forward Price/Earnings Ratios
The forward 12-month P/E ratio for the S&P 500 is estimated at about 16.4, which is above the prior 5-year average forward 12-month P/E ratio of 14.2, according to FactSet. It is also higher than the 16.1 P/E ratio recorded at the start of the first quarter.
The ratio is somewhat skewed by an extremely high P/E for the energy sector of 58.7. Despite that, we still consider the current P/E level to be fairly high by historic standards, particularly considering the slowing growth rate of corporate earnings.
(Source: Standard & Poor’s)
Equity Earnings Yield
The earnings yield for the S&P 500 has continued to linger in the range of 4.4 to 4.8% over the past 12 months, with a 4.46% yield on March 29, according to Standard & Poor’s. Although the equity earnings yield is still well above the yield on 10-year U.S. Treasuries (which is about 1.9%), it has declined steadily since 2011 when the yield reached as high as 7.4%.
Bond Market: Fed holds the line on rates
The market for U.S. 10-year Treasury bonds was active and volatile over the past quarter – and the past year:
As the above chart indicates, the market rate for 10-year Treasury bonds was 2.27% at the close of 2015. It dropped to a low of just 1.63% on Feb. 11 as investors moved to the safety of bonds in the midst of the stock market sell-off that sent the S&P 500 down more than 10%. As the stock market recovered in the second half of the quarter, bond yields moved back up, ending the quarter at 1.77%.
The Federal Reserve made a decision during its March meeting to leave interest rates unchanged.
Dollar finally slows
The Dollar finally weakened somewhat this quarter after many months of appreciation versus the world’s other leading currencies. As the above chart shows, the Dollar declined versus the Yen in the first quarter, while the chart below shows the Euro also gaining ground on the Dollar:
The Fed’s decision not to raise interest rates helped keep the Euro moving up versus the Dollar. After the European Central Bank announced in February that it would begin buying up corporate bonds to bolster the credit market, rates in Europe moved deeper into negative yield territory. In our opinion, these rates are artificially low due to extreme monetary policy, and don’t represent levels that would result from a free market environment.
If the Fed had raised rates, the dollar would probably have moved up strongly, dealing another blow to U.S. manufacturers. The rising dollar has already increased the cost of U.S. goods abroad, making U.S. manufacturers less competitive.
With the Institute for Supply Management (ISM) index slightly below 50, the manufacturing sector is already showing signs of weakness – although the most recent index of national factory activity did improve from 48.5 to 49.5 in the March report. But an ISM index reading below 50 indicates a contraction in the manufacturing sector, while a reading above 50 would indicate an expansion.
Oil and gold make a move
The chart above shows the rapid run-up in oil prices since Feb. 11, as supply and demand appeared to be moving back into balance. A couple of key factors contributed to that development: consumers have been driving more because gasoline prices have been low, and supply is declining as producers shut in existing wells and stop drilling for new oil.
In fact, active drilling rigs in the U.S. are down by about three-quarters, and are at the lowest level since the 1940s, according to Baker Hughes, Inc. That may not improve until oil prices move markedly higher.
For the quarter, West Texas Intermediate Crude Oil opened the year at $37.04 a barrel and dropped to a low of $26.21 on February 11. Oil rallied to a high of 41.45 on March 22 before flattening back out to $38.18 on March 31.
As the chart above illustrates, gold made a significant move, primarily in the first half of the quarter as economic uncertainty spurred investors to move more money into the safety of gold. After ending 2015 at $1020 an ounce, the price of gold reached a high of $1,272 on March 10 before leveling off and ending the quarter at $1,232.
Fast-Forward: Outlook for the Markets
A “show me” market
After an extended run of stock market growth following the crash of 2008, investors’ perception of the market has become increasingly cautious. It has changed from a “trust me” market to a “show me” market. In other words, investors need to see some positive economic developments before committing more assets to equities.
This skeptical sentiment is driven by several key factors – corporate earnings growth appears to be slowing, GDP growth is slowing, the energy industry is still mired in a slump, the dollar is still elevated at a relatively high level versus the world’s other leading currencies, consumer spending growth slowed to a crawl this quarter, manufacturing has dropped off, and retail sales have been soft.
Auto sales have been one of the few bright spots of the economy over the past year as consumers have stepped up purchases of the more expensive vehicles, such as SUVs and pick-up trucks, in response to lower gas prices. But the sales growth in that sector appears to be slowing.
The other bright spot has been employment. According to the February employment report by the Department of Labor, a total of 242,000 non-farm jobs were added during January. The report also revised upward the number of new jobs from December and January by 30,000 jobs.
The continued strength of the job market will be a key to the strength of the economy.
While we are not forecasting a recession, we believe that the risk of a recession has been rising. We expect the GDP growth rate this year to be lower than it has been the past few years. The consensus for GDP growth for this year is 2.1%, according to the Blue Chip Economic Indicators, but we project GDP growth at 1.4% (with a plus or minus range of 1%).
Globally, over the next 12 months, we project that China will have GDP growth of about 6.5%, Japan will have negative growth, Europe will experience growth of just under 2%, and the United Kingdom will post GDP growth of 3% or more.
The strong dollar continues to hurt profit margins for U.S. manufacturers. Profit margins for U.S. companies are projected to drop to about 8% this year, according to Standard & Poor’s, compared with profit margins of 10% in 2014.
On the international front, global trade is slowing due, in part, to declining demand for goods in China. In Japan and Europe, exports have not improved recently despite an extended decline in their currency versus the U.S. dollar.
While valuations of U.S. stocks are still generally reasonable, in the current economic environment, we see little evidence to expect strong stock market growth through the remainder of 2016.
One factor that could boost the economy – and potentially the stock market – would be an increase in borrowing to support an increase in business investment and consumer spending. Although businesses are sitting on a significant amount of cash, there has been a reluctance by both businesses and consumers to take on more debt in the current economic environment.
With 10-year U.S. Treasury rates hovering around 1.8%, investors have little to be excited about in the Treasury bond market. We believe there is about a 50-50 chance that the Fed will raise rates at its June 15 meeting. But that would likely be contingent upon a few factors – stabilization of energy prices, a strengthening of wages and housing prices, and rising inflation. Otherwise, the Fed may put off its next rate hike until later in the year. In fact, with the Presidential election coming up in November, it’s possible that the Fed will wait until the end of the year to make a move, although we believe the Fed will probably raise rates twice by the end of 2016.
Media contact: Callie Briese, 612-844-7340; email@example.com
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