posted on 20 November 2015
by Gene D. Balas
Why Some Data Argue for Caution
As the S&P 500 rallied about 11% from its late August nadir through November 10, according to Bloomberg, why might investors have an eye toward caution? Let's discuss why the market rallied the way that it did - and why there are notable headwinds that arguably should not be overlooked.
First is the reason for the rally. The main point is that the expectations of continued low interest rates encouraged investors to take more risks, especially following weakerthan- expected data in the summer. Looking forward, we now ask, what difference does it make whether the Fed hikes the short term rates it controls in December, or March, or some other time? After all, most investors expect rates to be hiked at some point. We think at this point, potentially more informative insights can be obtained by looking beyond the timing of a possible rate hike.
There are those who have made the argument that low rates allow companies to buy back their own shares, by borrowing at low rates, and continued low rates may possibly further enable that to happen. However, in a recent post, we discussed reasons why that, too, might be coming to an end - and not necessarily because of any potential increase in interest rates. Instead, the underlying reasons relate to the fundamental aspects of equity valuation - profits and earnings multiples - along with an expectation of where revenues and profits may be headed in the future.
In that regard, first consider analysts' expectations. FactSet compiles these estimates, and analysts expect corporate profits for companies in the S&P 500 will fall 0.6% in 2015. And these results benefit from cost-cutting efforts, as revenues are projected to drop 3.3% this year, according to FactSet. Meanwhile, the S&P 500 now trades at 23 times earnings for the past 12 months, far above its 15.5 historical average and above the level of 20 hit in September, according to Birinyi Associates. Thus, the market is pricey at a time when profits are becoming scarcer.
And there is reason to believe that earnings and revenues will remain challenged for the time being. We've often written about the dollar's surge since 2014. One way to look at the effects of a rising dollar is on import prices. The Bureau of Labor Statistics reported that import prices dropped 0.5% from the prior month. Some of this was due to energy prices, but that isn't the whole story. Nonfuel import prices were down 3.2% from a year ago, and this measure hasn't recorded a monthly advance since 2014.
Meanwhile, in order to compete in sluggish economies abroad, export prices are down 6.7% year over year. Now, you may ask, what do import prices have to do with U.S. stocks? Falling import prices might cause the Fed to remain on hold longer (we'll get to that topic later), and lower costs would probably be good for U.S. consumers, right? Well, to answer that question, we need to consider whether a U.S. company competes against cheaper imports.
To the extent that there are comparable goods or services sold by a foreign company here in the U.S., a U.S. company may need to compete more aggressively on price - and that could mean lower profit margins, all other factors equal. As seen in the table below, some of the sectors most exposed to international markets may experience some of the more notable reductions in earnings growth in the fourth quarter, such as consumer staples, technology and industrial companies.
Consider how many U.S. brands that are sold on global markets must compete head on with foreign rivals. Ivory soap, made by Procter and Gamble, based in Cincinatti, competes against Dove soap, made by Unilever, a Dutch company. Boeing, headquartered in Seattle, competes against the European-based Airbus Industrie. And Ford competes against Toyota. Multiply these few examples across thousands of products and hundreds of companies, and you have many instances where a rising dollar, along with falling import prices, can make it difficult for some companies to maintain their profit margins. That, in turn, can have ripple effects through to their suppliers.
However, a potential drop in profit margins, while potentially bad for stocks, does not necessarily mean that there are major economic problems looming. Those companies that need to compete more aggressively on price may quite possibly view it as merely a speed bump. The Federal Reserve isn't particularly concerned about whether companies are a bit less profitable, certainly not nearly as investors might be. The Fed is concerned, however, whether its dual mandate of low unemployment in the context of stable prices is achieved. And for that reason, it had indicated it is closer now to its first rate hike in almost a decade.
Now we get to the market's actions since August. The rally since then was driven, in part, by signs of sluggish economic growth that could have called into question whether the Fed would indeed tighten this year. In a case of bad news is good news, the market surged when weak employment readings and other economic data were, well, rather underwhelming to say the least. Presuming that a few extra months of near zero interest rates might be sufficient to support a sustained stock rally, particularly when the potential rate increase may be a mere quarter point higher, may be a somewhat weak argument.
The October payroll report, released in early November by the Bureau of Labor Statistics, should have dispelled the notion that the Fed would be on hold into perpetuity. Aside from the report indicating that 271,000 jobs were created in October - far above expectations for a more modest increase - the unemployment rate fell further to 5.0%, now right at where the Fed believes full employment may be. Importantly, rising wages may now finally be showing signs of budding. Average hourly earnings for all workers increased by 2.5% from a year ago, according to the BLS. This is the highest rate of wage growth since mid-2009. This is good news for workers, and good news for the Fed, which had been waiting for nascent signs of wage inflation - but wages are a direct subtraction from corporate profit margins.
Hence, rising wages may mean two negatives for the market: a compression in profit margins at the same time the Fed initiates rate hikes. And indeed, following its October meeting, the Fed's meeting announcement explicitly mentioned the December meeting for a potential rate hike. And in her recent commentary, Fed Chair Janet Yellen said that a December rate hike is a "live possibility."
Precisely because the market had gone up so far, so fast, based on the (perhaps false) premise that the Fed would keep rates at zero for just a few more months are cause to wonder what might happen when the Fed possibly makes a move. Or, profit expectations, unknowable as they may be, could also present a challenge to the market's surge. So, we pose the question, could those rapid gains since August possibly be unwound, either suddenly or slowly?
For this reason, some investors may approach the market with a bit more caution, even as others are optimistic about the domestic economy and are generally more bullish. Weighing both scenarios, forecasting short term market movements is a challenging exercise to say the least. With that in mind, we invite you to have a discussion with your United Capital financial adviser to see if you're positioned appropriately for your situation - whether the market takes a tumble or surges higher.
S&P 500 Index - The Index measures the performance of the large capitalization sector of the US equity market. It is a capitalization-weighted index from a broad range of industries, and is typically viewed as a proxy for the broad US equity market.
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