FMA Market Update – July 2015 Edition
July 13, 2015 | John J. Klobusicky CIO, CFA®, CAIA
By John J. Klobusicky, CIO, CFA®, CAIA
In spite of all the turmoil in Europe and concerns over China’s market meltdown, the Standard & Poor’s 500 Index (S&P 500) was still able to advance by 2.2% for the month of July and is still up 3.35% for the seven months ending July 31. The bond market continues to struggle in the face of pending Federal Reserve rate hikes with the Barclays Capital Aggregate Bond Index up only .59% for the same seven-month period. There are no easy investment choices right now. Rising interest rates, a stronger dollar, and slowing earnings growth will be near-term headwinds for the market. With no recession in sight, and barring any major unforeseen event, the economy should continue to grind along in a low inflation environment. In fact, with double-digit profit growth forecast for 2016, we see the current environment as setting up for a stronger year-end. Because we are right in the middle of earnings season, we thought it would be good to focus on corporate earnings in this month’s Market Update, and also share a few thoughts on China’s market, which seems to be causing investor angst.
Earnings Update: Setting Up for a Stronger Year-End
Second quarter earnings results for S&P 500 companies have been coming in ahead of analyst expectations, and with 354 companies reporting earnings, 73% have come in above the mean analyst estimate. While these companies have surprised on the upside, it is important to note that for the second quarter there was actually a year-over-year decrease in earnings of -1.3%. The positive? Going into the second quarter, the forecast actually called for a decline of -4.5% in profit growth, so the -1.3% decline was actually better than expected. And when you break out the negative earnings of energy companies, the remaining S&P 500 companies actually posted positive earnings on the order of 7% growth.
Market valuations remain above the long-term averages, with the S&P 500 12-month forward P/E ratio at 16.6, which is above the five-year average (13.9) and the 10-year average (14.1). And as we have mentioned in prior letters, it will be difficult to get any further expansion in the P/E, especially in the face of a Central Bank tightening phase.
Profits remain the driver. We are expecting weak earnings to continue through the third quarter, and then increase toward year-end. The good news is that 2016 looks to have a fairly solid outlook for corporate profits. With no recession in sight, a correction of 10% long overdue, and probably another weak quarter to get through, it appears the market may have to pull back to earnings reality, or take a breather until profits catch up to price—as shown in the following chart. You can see the clear divergence between price and earnings that occurred around this time two years ago.
In the case of overvaluation, price levels can provide information on the severity of the next down move, but not the timing. The same is true for undervalued assets, with price indicating the strength of the next move up, but again telling us nothing about when it will occur. Current price levels at 16 times earnings are not at bubble levels and would indicate that a normal correction of 10% or so is in order. We just don’t know when. The last correction of this magnitude was over three years ago, and we are long overdue for a market adjustment.
While the U.S. market may have some catching up to do with earnings and valuations, the gap in China is much larger between reality (earnings) and price (market levels). As you can see in the following chart, the Chinese rally was almost entirely void of profit growth. Chinese investors ignored this divergence and continued to borrow to buy shares, with no regard to valuation. Markets provide information to investors. When restrictions are imposed on who can sell shares in a down market, or when the Chinese government funnels money directly to the markets to prop up shares, the information provided is nullified, leaving even experienced professional investors in as much of a guessing game as the small, margined Chinese household retail investor. Chinese A shares have had a big adjustment, but we still think there is more volatility ahead. Even though the H shares (Hong Kong listing) are beginning to show somewhat better value, we would continue to wait until there are clearer signs of fundamentals improving in not only the Chinese economy, but also in emerging markets in general, where fundamentals continue to deteriorate.
With no indication of a recession in sight, we are maintaining our current equity allocation. For international equities and Europe in particular, we have talked in the past about the positive benefits of monetary easing, currency weakness, and cheaper energy. But these are big picture, macro tailwinds that need to translate into real growth on the ground. We are beginning to see this in better credit access for small and middle-market businesses, rising consumer spending, and consumer sentiment as the European consumer appears to be spending the energy windfall. The weaker currency has translated into a 5% increase in Eurozone exports for the first five months of 2015. With this in mind, we remain positive on international equities and in particular Europe and Japan, as Japanese equities will likely continue to benefit from strong Central Bank support, a weaker currency, and strong government-directed flows to Japanese equity markets.