Posts tagged Corporate Earnings
We are heading into the dog days of summer, and this one has a distinctly retro feel to it. Just a few weeks ago we used this space to comment on the US stock market’s having a distinct 1970s vibe to it. But the big socio-cultural phenomenon of the moment is Pokémon Go, an app which appeared out of nowhere to rival Twitter in popularity. What with Pikachu and friends roaming all over our virtual spaces, the S&P 500 setting new record highs, the prospect of a Clinton White House and even a new reality show for ex-‘N Syncer Lance Bass, we may have to revise our cultural reference markers a couple decades ahead to the late 1990s. Of course, the silly season will eventually give way to the more purposeful back-to-school month of September. This year’s ninth month could be plenty interesting and potentially tricky for investors.
Yellen and the Markets
For a first clue as to what September might have in store, we will be paying close attention to the language Janet Yellen uses to convey her sense of the state of play at the FOMC meeting later this month. The odds of any actual rate action in July are vanishingly small; at this point it would be a huge surprise, and probably not a pleasant one, for the Fed to act. But Chair Yellen and the markets need to have a little conversation. In the aftermath of Brexit, short-lived tempest though it was, market expectations on the timing of the next Fed move pushed out well into 2017. Bond yields remain near historically low levels pretty much everywhere, despite a bit of a jump this week.
But Brexit is oh-so three weeks ago. There is much less uncertainty around Britain’s near-term future as the new Conservative government of Theresa May settles into office and the identity of the key players charged with negotiating the terms of Brexit become known. Meanwhile, a new string of macroeconomic numbers on this side of the Atlantic suggests that markets may be overly optimistic in their never-never expectations on rates. There was last week’s release by the BLS with all kinds of good news about jobs and wages, of course. This week we saw a strong uptick in producer prices, suggesting that the wage-price trend of the past several months is more durable than the Fed might have thought back in the spring. Retail sales and industrial production both outperformed and capacity utilization nudged up slightly. If economic conditions suggest that the Fed’s mandate of stable prices and full employment is best served by bringing rates up, if ever so slightly, can Yellen and her colleagues still make the case for staying put? Or will she use the July meeting to reset expectations towards a September move?
Earnings Finding Bottom?
By September we will also have a good sense as to how Q2 earnings will finish out and whether, as currently expected, the growth trend turns positive again for Q3 and beyond. Even as energy, industrials and materials continue to be a drag on average earnings, consensus estimates call for strong positive reversals in key sectors like consumer discretionary, healthcare and technology. The evidence from recent market trends suggests that investors are, for the moment anyway, putting oil prices and the dollar in the rear-view mirror and focusing on a potential return to double-digit earnings growth by next year.
The TINA Syndrome
Much chatter continues – including in some of our recent commentaries – about the mixed messages being sent by stocks and bonds, with the former seeing the world’s metaphorical glass as half-full and the latter viewing it as half-empty. A derivation of this is the so-called TINA view on US blue-chip equities: There Is No Alternative. This view suggests that bond investors have become the new stock investors. With historically low or negative yields distorting whatever information the bond market is sending, high quality stocks with healthy total shareholder return programs have become the new safe haven, in the world according to TINA.
IF the TINA syndrome persists into the fall, we could be in for one of those Santa Claus rallies so beloved of investors as the year heads to a close. For this to happen, though, will still require a few things to go right; at the very least, a continuation of the more favorable earnings and economic trends discussed above, and a minimum of surprises as this very strange political season draws towards Election Day. And just yesterday, of course, we were sadly reminded once again of the persistent presence of terror with the Bastille Day tragedy in Nice, France.
All of which is to say that conditions continue to be supportive for stocks, but not without plausible downside catalysts. There will be plenty of things to focus on and prepare for as the dog days give way to a potentially busy and challenging fall.
Americans love to shop, and as our shopping habits go, so goes the economy. Such is the conventional wisdom, in any case. Consumer spending has consistently accounted for around 70 percent of our gross domestic product (GDP) for many decades now. Every so often, though, a narrative takes hold to challenge the conventional wisdom. Consumers are “going small” (1970s), or “rejecting excess” (early 1990s, pretty funny in hindsight) or “repairing household finances” (post-2008 recession). There is often a grain of truth in the contrarian narrative. Somehow, though, we just go right on spending. This week we saw both sides of the narrative. A string of Q1 earnings reports in the retail sector cast a pall over the market and sparked renewed speculation about the vanishing consumer. Then, Friday morning delivered up a new batch of data from the Commerce Department showing that overall April retail sales grew by 1.4 percent (month-to-month), the briskest pace in over a year and comfortably ahead of expectations. Is this just one outlier data point, or are rumors of the consumer’s demise greatly exaggerated?
Follow the Wages
We are generally not ones to make a big to-do about one monthly number. As the chart below shows, monthly retail sales have bounced around quite a bit over the past three years, and in recent months the pace has lagged the average for the overall period.
But an improved outlook for consumer spending habits does not strike us as surprising in view of other recent headline data. Last week’s jobs report, while underwhelming in terms of payroll gains, showed a healthy uptick in wage gains; in fact wages are growing at a notably faster pace than overall inflation. Consumer confidence indicators have also been robust; the latest University of Michigan Consumer Sentiment Index release also came out today and was well ahead of expectations. And the headline retail number was not unduly skewed by volatile sectors like automobiles or building materials; the core retail sales figure, which excludes autos, gas and building materials, was up 0.9 percent for the month against expectations of a 0.4 percent gain.
High Street Hangover
Brick-and-mortar retail outlets garner a great deal of focus during earnings season, mostly because they have long served as an easy go-to touchstone for retail sentiment. But high street retailers are not the force they once were. The multiline retail segment of the S&P 500 consumer discretionary index, which includes much-followed Macy’s, Kohl’s, Nordstrom and Target, accounts for only 4.3 percent of the total market value of all consumer discretionary segments. By comparison, the internet retail segment makes up 18 percent of the total consumer discretionary index – most of which can be ascribed to category-busting Amazon. That company’s record earnings release last week presaged the line item in today’s Commerce Department report showing that online retail sales grew by double digits on a year-on-year basis from last April.
As the economy continues to recover – and particularly as the brisk pace of job creation finally translates into the long-expected pickup in wage growth – it should be reasonable to expect retail spending to continue trending positive. In any given quarter the fruits of that pickup may be spread unevenly around the stock price performance of competitors in mainline, specialty and online retailing. Why is Gap down in the mid-twenties so far this year while Urban Outfitters, a peer in the specialty retail space, is enjoying a nice year to date return of just under 20 percent? Maybe there is something enduring about the latter’s move to further diversify and optimize its revenue mix, maybe not. Consumers may be fickle, asset markets even more so.
Over time, we expect the broad-based paradigm shift into online will put increased pressure on all business models, with a resulting competitive winnowing out among winners and losers. But the American consumer appears to be very much alive and, as far as we can see, inclined to keep spending in one form or another.
The Passover holiday starts this evening, and children in Jewish households around the world will be preparing for a traditional rite of passage in reciting the Four Questions to their elders. Investors watching the two month-long rally in equity markets may well have a question of their own: Why is this rally different from all other breakout rallies since the S&P 500 reached an all-time high of 2130 nearly one year ago, in May 2015? To put it a different way, is there anything plausible to suggest a sustained move above a fiercely resistant valuation ceiling? After the three year-plus multiple expansion rally topped out last year there have been five upside breakout attempts that have fallen short, including the current one thus far. The chart below illustrates this topping-out effect.
Tiptoeing Over the Low Bar
Much of the current focus is, rightfully, on first quarter earnings. There are two ways to interpret the results that have come in so far (about 27 percent of all S&P 500 companies have reported Q1 earnings as of today). The first is the expectations game: a number of firms thus far have managed to clear an exceedingly low expectations bar. Back in December, the consensus among analysts was that earnings per share growth would be more or less flat for the first quarter. Today, the same analysts expect Q1 EPS to decline by nine percent from their levels one year ago, when all is said and done. So all that a company has to do in order to give the market an “upside surprise” is to report earnings slightly higher than these sharply reduced expectations.
We have seen this reduced-expectations narrative play out among early reports in the financial and metals & mining sectors, two of the more beaten-down industry groups of late. For example the market takeaway from JPMorgan Chase, which led off earnings for the major banks last week, could be summed up thus: “bad, but could have been worse.” Bank stocks rallied sharply following the JPMorgan release, and were no less giddy a week later when Goldman Sachs reported a decline of 56 percent in net income from the period one year ago. If bad news is not awful news it must be good news, the convoluted logic seems to go.
Math Is Still Math
The second way to interpret Q1 earnings results is to ignore the Kabuki-like theatrics of the expectations game and point out that, however you want to frame the context, low earnings are still low earnings. Stocks are therefore still expensive. At the beginning of 2012 the ratio of the S&P 500 price index to average earnings per share for the last twelve months (LTM P/E) was 12.4 times. Investors would pay $12.40 for each dollar of average per share earnings. Over the subsequent three and a half years the LTM P/E ratio jumped from 12.4 times to 18.1 times – a “multiple expansion” rally where prices grow faster than earnings.
Today, despite two market corrections of more than 10 percent and the repeated failure to regain last year’s high water mark, the S&P 500 is as expensive as it was a year ago. It is more expensive than it ever was at the peak of the previous bull market of 2003-07. It is even dearer on a price-to-sales (P/S) basis; the current LTM P/S ratio of 1.8 times is the highest this ratio has been since the immediate aftermath of the late-1990s tech bubble.
Animal Spirits, to a Point
The fact that the market remains expensive does not necessarily preclude a breakout to the upside into new record high territory. Stranger things have happened; asset markets are the stomping grounds of John Maynard Keynes’ “animal spirits” far more than they are the purview of the fictitious rational actors of economics textbooks. The vague but often telling indicator of investor sentiment seems tilted to the upside. The question, though, is how sustainable a strong upside breakout would be in the absence of improvement in corporate earnings prospects.
We are unlikely to see the earnings math for Q1 make much of a compelling growth case. It remains to be seen whether some of the headwinds that have clipped sales and earnings prospects of late will abate further into the year – perhaps driven by a softer US dollar and a demand pickup in key consumer markets. Until then, we tend to believe that this rally is not much different from the four post-high rallies which preceded it, and that it would be a good idea to keep one’s animal spirits in check. Not in a defensive crouch, but in check.
The S&P 500 reached an all-time nominal high water mark of 2130.82 on May 21 of this year. Since then 203 calendar days have elapsed, making this by far the longest post-peak recovery gap in the past three years. The chart below shows the price performance of the benchmark index since 2013. In April of that year the S&P 500 regained the previous all-time high of 1565 set in October 2007. Since then, of course, it has gone on to set successive new all-time highs on a regular basis. As the chart shows, the recovery period following pullbacks from each new high has been relatively brisk. For each pullback of 3 percent or more it has taken about 41 days on average for the index to reclaim the previous record high. That is the context in which the current 203 day gap appears striking. It may simply be a transition to a new, more narrowly selective phase of the bull, as we have argued in recent commentaries. However, we cannot rule out the potential that it could augur something worse.
The Earnings Corridor
The current top-heavy formation of the market started to take shape after a breakout rally in February propelled the index to yet another new high on March 2. The market then entered what we have termed an “earnings corridor”. Roughly speaking, the upper and lower boundaries of this corridor are about 3.5 percent and -1.0 percent respectively from where the S&P 500 began the year. The chart below provides a close-up view of the contours of the earnings corridor and the periodic deviations therefrom.
According to FactSet, average earnings per share for companies in the benchmark index are expected to be just about flat this year. The notion that prices would settle into an earnings-bound trading range – after three years of strong expansion rallies from 2012-14 – is to us entirely plausible. It is why we didn’t panic during the August correction. Although never certain, the data at the time suggested a higher likelihood for a return to the earnings corridor than the beginning of something truly awful. While subsequent events have justified that thinking, we do have a greater than average level of concern over what we see as a composite picture of technical weakness. The source of that weakness: failure to establish a new high water mark; testing of support at the lower boundary of the earnings corridor; and repeated breaching of the 200-day moving average support.
Top-Heavy in Rough Seas
To this weak technical picture we must add the contextual variables with the potential to act as catalysts for further downside, with monetary policy divergence and commodity weakness high on that list. OPEC’s Vienna debacle last week has oil prices testing support levels in the mid-30s and setting new post-recession lows. China’s currency is in another funk, and November saw another large net outflow of foreign exchange reserves. The wildly negative reaction of many asset classes to the ECB’s modest policy decisions last week threw a number of trend-dependent hedge strategies for a loop. Much of this week’s volatility may be coming from this space, with funds unwinding or covering positions to deal with the damage incurred last Thursday. A general consensus view of below-trend holiday retail spending is also not helping to impart any holiday cheer.
These rough seas may blow over, particularly once we get past the Fed next week (at this point, a no-action outcome would in our view be far more damaging to market sentiment than the expected 25 basis point rate rise). We have not changed our most likely scenario for 2016 from the “quality rally” we have described in previous commentaries. If a few industry leaders can sustain double-digit earnings growth in an environment where growth is challenged, go there. That is our thinking. But the risk X-factors are out there, and we are not ignoring the potential for them to inflict further mayhem in the weeks ahead.
We are now one third of the way into 2015. What can we say about the state of things in the capital markets? US equities would appear to merit little more than “meh”. The S&P 500 saw out the month of April with a 1 percent drop and the Nasdaq pulled back 1.6 percent. As the chart below shows, stocks have spent most of the year so far alternatively bouncing off support and resistance levels. The longest breakout trend so far was the rally that started and ended almost precisely within the calendar confines of February. A directional move one way or the other will eventually happen, but the sluggish current conditions could persist for some time yet.
Unenthusiastic and Confused
If one could attribute human characteristics to the stock market, Mr. or Ms. Market would merit the sobriquets “unenthusiastic” and “confused”. These two attributes derive from already-expensive valuation levels, uninspiring company earnings, and a muddied picture of the overall economy in the wake of some recent soft headline numbers. At 17.0 times next twelve months (NTM) earnings, the S&P 500 is considerably more expensive than it was at the peak of the 2003-07 bull market, when the NTM P/E failed to breach 16 times. At the beginning of 2012 the NTM P/E was 11.6 times. After three years of multiple-busting expansion, investors’ current lack of conviction would hardly seem irrational.
Earnings: Clearing a Very Low Bar
This brings us to earnings. Expectations were grim as the Q1 earnings season got under way, with analysts forecasting negative growth in the neighborhood of -4 percent. That appears to have been a rather exaggerated take on the impact of the dollar, oil prices and other factors on earnings. With 72 percent of S&P 500 companies reporting, earnings per share (EPS) growth is 2.2 percent. The current consensus is for EPS growth to be more or less flat year-on-year when the results are all in (40 percent of energy companies have not yet posted, and their contribution will be largely negative). But zero percent growth, even if better than expectations, is not euphoria-inducing. The current EPS growth consensus for the full year is 1.5 percent. That’s roughly equal to the S&P 500’s price appreciation for the year to date, which may help to explain the stickiness of the current resistance levels.
Growth or No Growth?
Finally, an increasingly mixed picture of the US economy is stumping pundits and Fed governors alike. The Q1 GDP numbers released this week add another data point to the case for weak growth, joining the March jobs numbers, a string of below-trend retail sales figures, a downtick in consumer confidence, and soft manufacturing data. The question is whether this is merely a repeat of 2014 or something more enduring. Last year, an unusually cold winter helped drive negative Q1 GDP growth, but the economy snapped back nicely to grow at an average rate of 4.8 percent over the ensuing two quarters. Such was the gist of the Fed’s post-FOMC message this week: let’s wait and see what happens once the effects of winter and West Coast port problems are removed from the equation.
Since Q2 GDP will not be known before the Fed’s June conclave, we see almost no likelihood of any action on rates coming out of that meeting. That in turn will keep markets guessing for longer – potentially prolonging the duration of this uninspired “meh” market.