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Wall Street to Your Street
First Quarter 2016 Report: In Like a Lamb, Out Like a Lion
April 15, 2016 | Gene Walden
Dr. Jekyll, meet Mr. Hyde.
Optimism overcame trepidation in the stock market during a raucous and bipolar first quarter of 2016. The S&P 500® equity index tumbled more than 10% 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:
Slower earnings growth
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:
Fed decision brings favorable reaction
Drop in dollar good news for U.S. companies
China a nonissue
GDP still solid while consumer spending slows
Consumer spending, on the other hand, was weaker than the preliminary numbers had indicated, growing only 0.1% in both January and February, according to a March 28 report from the Commerce Department.
Note: 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
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 (Exhibit 1).
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
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 price-earnings (P/E) ratio for the S&P 500 is estimated at about 16.4, which is above the prior five-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 (Exhibit 3).
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
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% (Exhibit 4).
Bond market: Fed holds the line on rates
As the chart indicates, the market rate for 10-year Treasury bonds was 2.27% at the close of 2015 (Exhibit 5). 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 chart shows, the dollar declined versus the yen in the first quarter, while the chart shows the euro also gaining ground on the dollar (Exhibit 6).
The Fed's decision not to raise interest rates helped keep the euro moving up versus the Dollar (Exhibit 7). 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 & gold make a move
The chart shows the rapid run-up in oil prices since Feb. 11, as supply and demand appeared to be moving back into balance (Exhibit 8). 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 Feb. 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 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 (Exhibit 9).
After ending 2015 at $1,020 an ounce, the price of an ounce of gold reached a high of $1,272 on March 10 before leveling off and ending the quarter at $1,232 per ounce.
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. Consumers have stepped up purchases of the more expensive vehicles, such as SUVs and pickup 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 nonfarm 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.
Contributing to this report: Russell Swansen, Chief Investment
Officer; David Francis, CFA, Head of Equity; Mark Simenstad, CFA, Head of Fixed Income;
John Groton, Jr., CFA, Director of Equity Research; Jeff Branstad, CFA, Senior Investment
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All information and representations herein are as of March 31, 2016, unless otherwise noted.
Benchmarks Indexes are unmanaged and do not reflect the fees and expenses associated with active management. Investments cannot be made directly into an index.
The S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.
The NASDAQ (National Association of Securities Dealers Automated Quotations) is an electronic stock exchange with more than 3,300 company listings.
The MSCI EAFE Index measures developed-economy stocks in Europe, Australasia and the Far East.
The Institute for Supply Management index tracks employment, production inventories, new orders and supplier deliveries based on surveys of more than 300 manufacturing firms.
West Texas Intermediate (WTI) is a grade of crude oil used as a benchmark in oil pricing.
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