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Wall Street to Your Street
May Market Recap: Hopeful Economic Signs Nudge Stocks
June 2, 2016 | Gene Walden
Consumers may not be particularly happy that oil prices eclipsed $50 a barrel on May 26 – nearly twice the low point of around $27 a barrel in February – but the recovery in oil prices represented one of several positive signs for the overall economy in May.
After a tepid gross domestic product (GDP) report from the U.S. Commerce Department that showed GDP through April growing at a seasonally-adjusted annual rate of just 0.8%, there was some concern the economy was slowing down.
But, some encouraging economic developments helped push up stock prices during the month despite rising chances of a rate hike by the Federal Reserve within the next two months.
In a nutshell (Exhibit 1)
- U.S. stocks edge up amidst weak global market.
- Oil recovery continues.
- Shoppers are back, just not at the mall.
- Dollar strengthens.
- The Fed hints of hikes.
S&P 500 continues to edge up
The market was bolstered by the recovering energy sector, a solid retail report, healthy returns in the technology area, and continuing improvement in the employment market.
Although employment gains were not quite at the level of previous months, the U.S. Department of Labor estimated that nonfarm payroll employment rose by 160,000 in April. The unemployment rate remained unchanged at 5.0%. Wages increased by 0.3% compared to the previous month – an average of 8 cents an hour – while average weekly hours rose slightly to 34.5 hours in April, compared to 34.4 hours in March.
The aggregate retail sector has also shown some signs of strength despite the fact that many of the nation's largest department chains reported weak first-quarter earnings (including Macy's, Kohl's, Nordstrom, The Gap Inc. and J.C. Penney). According to the U.S. Department of Commerce April retail report, department store sales have declined by 1.7% over the past 12-month period.
But as department store sales sagged, online sales have surged – up 2.1% for the month and up 10.2% for the past 12 months. Automotive sales have also been strong, up 3.2% for the month, and big box retailers also appear to be faring better than the department store sector. For instance, Home Depot issued a strong quarterly financial report in May, posting earnings per share growth of 19.0%.
Overall, retail sales grew by 1.3% in April, month-over-month.
The best performing sector in the S&P 500 Index for the month was information technology, which had been the worst performer the previous month. After declining by about 5.00% in April, the sector moved up 5.60% in May. Also among the leaders was health care, up 2.20%, and the financials sector, up 2.03%. After a strong April, energy declined slightly, down 0.58%.
The table details the monthly and year-to-date performance of each of the 10 S&P 500 sectors (Exhibit 3).
Bond market: Fed holds the line on rates
The Federal Reserve again left interest rates unchanged, but comments from Fed board members indicated that there is a growing likelihood of a rate hike sometime this summer. We believe there is a very strong possibility that the Fed will raise the interest rate by 0.25% in either its June or July meetings. The bond futures market is currently priced at about a 25.00% chance of a rate hike at the June 14 to 15 Fed meeting. We believe the chances of a June hike are about 50-50. But if it does not happen in June, we believe there is a very high likelihood of a rate hike in July.
Equity earnings projections are flat
According to Standard & Poor's, forward aggregate earnings for S&P 500 companies moved up slightly in May as prospects for the energy industry began to improve. The consensus aggregate earnings for the S&P 500 moved up from $124.36 in April to $125.85 at the end of May (Exhibit 5). We believe that projection is somewhat optimistic, and that the actual earnings numbers will be slightly lower.
Forward price-earnings ratio & earnings yield
The forward 12-month price-earnings (P/E) ratio for the S&P 500 ended May at 16.75, up slightly from the 16.64 level at the first of the month and the 16.1 P/E ratio at the start of 2016 (Exhibit 6).
While the 16.75 P/E level is still within a reasonable range based on historic levels, we are skeptical of further expansion in light of the sluggish growth rate of corporate earnings and the prospects for higher interest rates.
The forward 12 months earnings yield for the S&P 500 barely moved during May, beginning the month at 6.03% and ending the month at 5.99%, according to Standard & Poor's. The forward earnings yield has declined slowly since 2011 when it reached a high of 7.40%.
What do these three fundamental factors (12-month forward earnings, P/E ratios and earnings yield) reveal about the current level of the stock market? Even though projected earnings growth is sluggish, the P/E ratio is somewhat above the historic average (14.5). While you might expect the P/E to decline during periods of muted earnings expectations, there is one factor in play that may be responsible for the higher stock price levels: historically low interest rates. While the equity earnings yield is at a relatively low level of about 6%, by comparison, it is still significantly higher than the market interest rate for 10-year Treasuries, which has been hovering at less than 2% in recent months.
While a rising dollar means cheaper foreign goods for Americans and relatively cheaper costs for Americans traveling abroad, it is a set-back for U.S. companies that market their products or services overseas. The higher the dollar relative to other currencies, the less competitive American companies can be in the global market.
Oil & gold moving in opposite directions
Oil prices rose in May for the third straight month. After ending April at about $46 a barrel, the cost of a barrel of Brent crude oil eclipsed $50 a barrel on May 26 before slipping back down to $49.33 to end the month (Exhibit 8). The recent price is nearly double the low mark for the year set on Feb. 11, when the cost of a barrel of oil dropped to slightly less than $27.
We believe the recent strength in the oil market is due to global supply moving in line with demand after many months of overproduction. Production has slowed as prices dropped, with the higher-cost producers forced to curtail production. We believe that supply and demand will likely be nearly in balance by the end of this year. With shale producers and other suppliers waiting to jump back into the market at the right price, we expect that the lid on oil prices will be at about $70 to $80 a barrel over the next couple of years.
Gold prices, meanwhile, dropped steadily over the course of the month as the value of the dollar strengthened. After starting the month at $1,295.40 per ounce, gold sank to $1,217.50 per ounce by the close of May.
The global equities market (as measured by the MSCI EAFE Index) was volatile in May as the global economic slowdown and concerns over negative interest rates continued to haunt European and Asian equities markets. After closing April at 1,693.18, the EAFE Index struggled through much of the month, finishing at 1,667.84 – down 1.5% (Exhibit 9).
Fast-forward: Outlook for the markets
The S&P 500 has made minor gains in 2016 – which is about in line with our expectations for the year in the midst of the slowing economy. Going forward, here are some of the key issues facing the market:
Headwinds: Sluggish corporate earnings continue to be a concern, particularly if wage gains accelerate and the dollar continues to strengthen relative to the world's other major currencies. If the Fed raises rates in June or July and expectations build for a second increase before year-end, we could see the dollar strengthen from current levels, putting U.S. businesses at a competitive disadvantage in the global market. Manufacturing output levels have already been on the decline this year, so a higher dollar and a slow global economy could bring continued slow times, especially if productivity does not begin to improve from extraordinarily depressed levels.
Although oil prices have improved, the U.S. oil industry is still in turmoil, and the banks and financial institutions that had helped fund some of the recent oil projects continue to face the possibility of delinquencies and defaults.
Tailwinds: Although consumer spending has been soft this year, it has begun to show signs of life, with automotive, online and big box retailers all reporting solid gains. In fact, with U.S. manufacturing at near-recession levels, the consumer has been a saving grace.
While many firms in the oil industry are still facing difficult economic times, oil prices have continued to move up, sparking a small recovery in the energy and financials sectors. The Fed once again declined to raise interest rates, although that may happen within the next two months.
Employment levels have also remained solid, with another 160,000 jobs added in the nonfarm payroll employment category. We believe the increase in the number of new jobs and the trend of more people entering the work force is a good sign for the economy, although the recovery has been slower than we expected and there remains substantial room for improvement in labor conditions.
With government bonds yielding less than 2% in the U.S. and negative rates in Europe and Japan, the U.S. equities market may still look attractive on a relative basis to many investors.
We continue to have modest expectations for the stock market and the economy for the remainder of 2016. We expect GDP growth to be lower this year than it has been the past few years. The consensus among analysts for GDP growth for this year is 1.8%, according to the Blue Chip Economic Indicators, but we project GDP growth at about 1.0% to 1.5%.
Globally, over the next 12 months, we believe that China will have GDP growth of about 6% and Japan will have negative growth. We are relatively optimistic regarding growth prospects for Europe, despite its sluggish economy. We believe Europe will experience growth of just less than 2%, and the United Kingdom will post GDP growth of 3% or more.
Overall, the economy has remained fairly stable this year despite some weaknesses.
Based on current economic conditions, we are not projecting a recession in the near
term, particularly if the job market remains strong, if consumer spending continues
to pick up, if the energy industry continues to stabilize and if China can continue
to grow its GDP at a rate of at least 6%. Even if the economy does slip into a recession,
we would expect it to be far less severe than the last one because we do not see the
excesses in the current economy that we saw prior to the recession of 2008-09.
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; Darren Bagwell, Sr. Equity Portfolio Manager; Lauri Brunner, Senior Equity Research Analyst, and Jeff Branstad, CFA, Senior Investment Product Strategist.
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