April 23, 2016
Why Are Markets Going Up When Earnings are Going Down?
On April 9th, just prior to the kick off of earnings season, we made the comment, “with expectations entering the season so low, and the markets timid, we may find a relief rally coinciding with better than expected releases over the next couple weeks.” The market has rallied 3% since we made that statement, yet first quarter earnings overall are projected to decline 9% (30% of S&P 500 companies having reported). In fact, earnings for the S&P 500 have declined 14% from levels reached in the 4th quarter of 2014. Top line revenues over that period declined 8%, revealing a decline in profit margins as well as sales and earnings. All in, Q1 2016 earnings reflect the mix of lower commodity prices (bad for oil and materials companies), lower interest rates (bad for banks), a rising US dollar (bad for exporters), slowly rising wages (bad for profit margins), and overall political and policy uncertainty lowering economic confidence worldwide. So why are markets cheerful? Because maybe this is as bad as it gets.
According to Factset’s calculations, earnings for the S&P 500 will rise to $33.53 by the fourth quarter of 2017. According to Standard and Poors' calculations, earnings for the S&P 500 will rise to $35.99. With Q1 2016 earnings settling around $26, earnings are expected to grow 30%-40% over the next 20 months. Generally, analysts overestimate forward earnings by about 15% or so. Even applying that discount, earnings growth looks pretty seductive for cash hoarders. However, for the earnings growth to materialize, environmental headwinds need to turn into tailwinds. A combination of a lower dollar, higher commodity prices, slightly interest higher rates, and political resolution in November could strengthen confidence in forecasts. Can confidence be measured?
There are many ways to measure investor confidence. In past commentaries we've examined sentiment surveys, money flows, and economic confidence measures. However, the most informative indicator to validate our current market assesment might be market breadth. If investors grow confident that broad macro headwinds could turn into broad macro tailwinds, then their stock appetites should be broad as well. Contrast that with 2015 when a handful of stocks posted positive returns while the vast majority posted negative returns. Thin markets, like 2015, imply low confidence. Broad based rallies communicate broader confidence. The simplest measure of market breadth subtracts the number of stocks falling from the number of stocks rising. Across both large stocks and small (see chart above), the advance/decline measures depict broad rally participation. When participation broadens, active money managers benefit as money regains interest in specific fundamental attributes. A stock market that reverts back to being a more thoughtful market for stocks would certainly cheer up fundamentalists (like us).
As argued, a shift from macro headwinds to tailwinds does improve the odds that rosy projections get realized, but that doesn’t eliminate risk. Valuations for the indices remain well above average, potentially capping the upside potential for “the market” overall. However, should breadth remain high, many forgotten stocks have potential to catch up with indices. Many of these forgotten stocks reside in the value quadrants as the growth stocks (Facebook, Amazon, Netflix and Google) garnered all of the attention over the past few years. To wit, year to date, value has outperformed growth handily while the fabled FANG group has shed 6%. While it’s hard to get excited about buying the “stock market” heavily weighted toward large cap tech here, there is still opportunity further afield.
Bottom Line: First quarter earnings releases have been dismal. However, they may also mark a nadir brought on by the headwinds of a rising dollar, falling commodities, falling interest rates and global growth anxieties. With those trends now in reverse, optimism over future earnings is rising, pulling the “stock market” higher, and confidence in that optimism is rising as well, pulling forgotten and unloved “stocks” higher still. While valuation may cap the upside potential for the major indices, broadening breadth suggests the opportunity lies with the laggards.
Have a Great Weekend!!
David S. Waddell
CEO, Chief Investment Strategist
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