The Halloween Indicator once again turned green this year, providing treats for investors that stuck out the hard, grinding months of August and September. For many indices, stocks rose +8-9% for the month – October that is, so let’s touch upon that month first and the politicking that took place. Then we can turn our attention to other recent developments that have unfolded in November (updates on China, a pending Fed hike, 3rd quarter earnings, and preliminary 2016 outlook).
October turned out to be the best month since October 2011 when stocks climbed +11-12% that month on the back of a bruising August (the S&P 500 dropped 19%) when Standard & Poor’s downgraded US debt to reflect their view “that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned.” Remember budget sequestration?
Two years later, in October 2013, the debt ceiling debate turned ugly again, this time tied to a repeal of the Affordable Health Care Act and ultimately forced a 16-day shutdown of the federal government. Thankfully October 2015 was more treat than trick and we gained back what had been lost over the previously two months.
Oddly enough, things haven’t changed all that much – there’s still way too much partisan bickering in Washington and not enough legislating for the better – fiscal initiatives to rebuild our economy and to strengthen our decaying infrastructure. This time around though we did stave off a catastrophic debt default; got a budget deal to carry us through the rest of Obama’s administration (and next fall’s presidential and congressional elections); and the Republicans united long enough to agree on Paul Ryan as the new Speaker of the House. The budget deal that was struck increases spending by $80 billion over the next two years. In the context of nearly a $4 trillion annual budget that’s a 2% increase. While not an inconsequential amount, the spending marks the end of a multi-year period of budget sequestration.
So with the threat of a government shutdown and debt default behind us, the markets rallied; the S&P 500 Index has now recovered all of the ground it lost since the mid- August correction. I would also point to signs of global stabilization, additional policy action in China, possible easing in other regions, healthy bank credit levels, a resumption of merger-and-acquisition activity, and positive surprises from corporate earnings.
As so often happens as bull markets age, they become more volatile. While October was a nice respite, we’ve one again seen unexpected and big swings in returns. The S&P 500 lost more than -3.5% the week of November 9th-13th, then last week climbed sharply, up +3.3%, posting the best week so far this year.
|Market Performance||3-year ** %|
|October 30 Level * (monthly %)||3rd Qtr. %||Yr-to-Date %||W/ Dvds & W/O Dvds|
|S&P 500 Index||2079, +8.3%||8.44||2.70||+16.21 / 13.77|
|Dow Jones 30 Indust. Ave.||17664, +8.5%||8.68||1.20||+13.54 / 10.46|
|Russell 2000 Index||2888, +5.7%||5.63||-2.53||+14.16 / 12.63|
|NASDAQ||5054, +9.4%||9.44||7.68||+20.67 / 19.15|
|MSCI EAFE ***||1772, +7.4%||7.82||2.53||+8.51 / 4.15|
|MSCI Emerging Markets ***||847.84, +7.0%||7.14||-9.17||-2.37 / -5.21|
Source: JP Morgan Asset Management, Wall Street Journal, MSCI.com
*September 30, 2015 – October 31, 2015. October returns are price only, not total return.
**Annualized Return, not cumulative. All returns represent total return for stated period (index return + dividends/distributions), and index return only.
***US $ Return. MSCI EAFE is a Morgan Stanley Capital International Index that is designed to measure the performance of the developed stock markets of Europe, Australasia, and the Far East.
S&P 500 Sector Returns, Year-to-Date (10 months, through Oct. 30th) Source: JP Morgan Asset Management
From the lows of 1,867 in late September for the S&P 500, stocks ran up to 2,116 in early November. That is a 13% sprint that rivals any rally of this bull market.
With a lot of unknowns on the global macroeconomic front, investors are sure to get worried now and then. While I hold an optimistic long-term view towards equities, I don’t think the recent straight upward trend can continue without markets taking a breather at some point – as even a bull rests.
The market recovery is somewhat surprising given that the overall economy has been slow to get going over the past few months, and to some pundits, possibly rolling over. Concerns remain over Chinese growth and falling commodity prices (which helped precipitate the most recent market sell-off). More broadly, trends in global economic conditions remain at a stalemate.
The developed world looks to be improving, broadly speaking, especially in the United States and Europe where consumer spending levels are beginning to rise. Emerging market growth looks dour, with China’s economy continuing to decelerate.
As we can see in the near graphic (Source: JP Morgan Asset Management), Chinese growth has been slowing over the past few years (after posting nearly 20 years of 9-10%+ growth year in and year out). Their government is working to pivot the composition of growth away from investment (infrastructure) spending and exports towards domestic consumption.
These economic shifts take time, but don’t underestimate China’s determination to have a more balanced, sustainable economy. They are the world’s second largest economy after all.
Looking ahead, I expect volatility will persist – be it in China, internationally, or here in the US.
Investors remain confused, uneasy and skeptical about the prospects for healing in the global economy. As the sharp summer downturn and subsequent recovery shows, financial markets are capable of moving hurriedly due to changes in sentiment while ignoring actual fundamentals, at least in the short-run.
Don’t Fight the Fed, but also Don’t Fear the Fed
It looks like 6 years of near-zero interest on the federal fund rate (the interest rate at which banks actively trade balances owed to one another on a daily basis) may end next month. I firmly believe the Fed will finally move on December 16th, for “lift off” of the fed funds rate by 0.25% (25 basis points). An OK US economy and international markets that are acting better than they were a couple of months again means investors can probably handle a rate hike.
Economists consensus (as queried by Bloomberg News as of November 9th, and shown below) place odds at 70% of a rate increase coming in December.
Seeing as odds of a rate hike happening in December has increased dramatically, the market gains of October will most likely be on hold until we get clarity on (1) if the hike happens, and (2) expectations for future hikes in 2016. Do we get a stair-step pattern of a rate hike at each successive meeting? Is the era of cheap money over?
For now, I’ll stick with the color that the Federal Reserve itself provided us – Fed Chief Janet Yellen has strongly suggested that the trajectory of rate hikes will be gradual. However, I will be looking for any signs that a more aggressive pace is being contemplated by the Fed’s smaller but more hawkish contingent.
I think most investors are prepared to have a rate hike behind us as the back-and-forth will they or won’t they volatility we’ve seen ahead of the latest Federal Open Market Committee (FOMC) meetings. In fact, I think we could see a relief rally ensue after the initial rate hike.
Lift-off will surely strengthen the US dollar as we’re one of the very few countries to bucking the trend right now. In Japan and throughout much of Europe, real rates are falling.
This has renewed strength in the US dollar which recently reached its highest level since springtime, as shown in the near graphic. (Source: Bloomberg News, November 18, 2015).
This combination of a strong US dollar and rising real interest rates crowds out investment elsewhere, be it in precious metals (gold price should fall) or emerging market countries where the reward-risk continuum looks less favorable for their economies and assets, at least historically. Additionally, a stronger US dollar can erode local gains made in international stocks, so it’s best to investigate the use of vehicles that can hedge international currency exposure.
Looking ahead, I believe the long-term prospects for global economic growth remain reasonably good as central banks remain focused on promoting growth through accommodative policies. This should provide tailwinds for equity prices, as global economic growth must strengthen for both corporate earnings and equity prices to markedly improve. I expect global corporate profit levels to advance, but not until next year when the negative effects of the rising U.S. dollar and falling oil prices having faded.
Earnings Season in Review
Corporate earnings, for the most part, beat expectations but in aggregate it was another quarterly decline. In looking at corporate earnings now that most of the companies represented in the S&P 500 have reported, I would say that earnings are in a funk right now. The hurdle rate was set pretty low, so take the number of earnings beats to expectations into account.
According to FactSet (November 13th), 92% of the companies in the S&P 500 have reported results for the third quarter. “More companies are reporting actual earnings-per-share (EPS) above estimates (74%) compared to the 5-year average, while fewer companies are reporting sales above estimates (45%) relative to the 5-year average.”
In aggregate, S&P corporate earnings are forecast to decline -1.8%, which is up from a forecasted decline of -4.2% on September 30th. Revenue for the quarter is indicated to fall by -4.0%. Growth deterrents? The strong US dollar and international sales weighed strongly on global firms, and the energy sector and commodities (picked up in data for the materials sector).
How bad was international sales? For the quarter, earnings are up 4.8% for S&P 500 firms with less than <50% of their sales in the US. However, earnings are down 10.6% for firms with more than >50% of sales outside the US, according to FactSet.
This quarter’s earnings decline marks the first time the index has seen two consecutive quarters of year-over-year declines in earnings since the second and third quarters of 2009. It also marks the largest year-over-year decline in earnings (and revenues, too) since the third quarter of 2009, which was -15%, again according to FactSet.
Of the 10 major economic sectors, 5 sectors reporting year-over-year growth in revenues and earnings, led by the telecom services, health care, and consumer discretionary sectors. 5 sectors reported a year-over-year decline in earnings, led by the energy and materials sectors.
It is important to note that the Energy sector is projected to be, once again, the largest contributor to the estimated earnings and revenue declines for the fourth quarter (-64%), and for all of 2015 (-59%), according to FactSet.
Preliminary 2016 Outlook
Luckily, the headwinds in energy and the stronger US dollar are beginning to anniversary themselves (year-over-year comparisons become more favorable).
Looking ahead to 2016, analysts expect earnings and revenue growth in all four quarters (with a forecast of 3.9% EPS growth in the first quarter of 2016).
According to FactSet, for 2016, S&P 500 revenue and earnings growth is estimated to be 8.2% and 4.5%, respectively.
Earnings and expectations of earnings play a key role in stock prices. As shown in the attached graphic (Source: Thomson Reuters), the consensus forecast suggests we’re at an inflection point and earnings will begin growing again in 2016.
Valuation-wise, the S&P equity index looks fairly valued, neither cheap nor expensive. The 12-month forward P/E ratio is 16.0 based on Friday the 13th closing price (2025.48) and a forward 12-month earnings-per-share (EPS) estimate of $126.88.
I believe forecasts for renewed earnings growth cushioned the declines of August and September, and will help shares recover from the current anxiety around the potential of our first rate hike next month.
As a related topic, the rate of US consumer price inflation (CPI) should accelerate from 0.4% this year to 2.3% next year, based on projections by Allianz Global Investors. The rise in consumer inflation coincides with a stronger labor market (U-3 benchmark unemployment currently at 5.0%), and rising wage rates in the US and other developed markets. Given these factors, Fed lift-off is at hand.
The late-summer market downturn was disconcerting, but market downturns are a necessary part of investing. We often times have a hard time hearing that response or sticking with the plan in place. Sometimes you really want to do something (in the extreme, completing changing the whole portfolio), even though best thing to do is to sit tight.
Trust me, I understand that crises are hard on everyone and that not making wholesale changes can be a difficult position for them to take, emotionally speaking. Investors often feel as though, because something big is happening, they need to be taking some sort of big action.
As an advisor, I often reiterate that it’s best to stay calm — but that doesn’t mean everyone will listen. As I often say, the best thing an advisor can do sometimes is help prevent clients from harming themselves when it matters most.
While I believe it is important to monitor various economic indicators and events that have the potential to impact various asset classes, it’s also important to filter out noise that only the shortest-term traders might find of value.
In other words, let’s put the upcoming Fed meeting into perspective. Will it really matter one year, or five years, or 10 years from now that the Fed chose to raise or not raise interest rates in December 2015? It won’t. It’s the long-term that really matters. Day-to-day or month-to-month gyrations in the market ultimately get washed out.
While roller-coaster rides can be fun for some (think of a day trader) and unsettling for others, a more mundane approach is usually the best. If I properly understand clients’ tolerance for risk, then the volatile days won’t be very unsettling. Only you know how you will react; that’s why I counsel – Investor, know thyself!
As the economist Paul Samuelson once said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” It’s why I counsel that it is sometimes best to skip the financial news channels that focus on the ever-changing crisis du jour.
While the Parisian terrorist attacks are appalling, the repercussions for the markets are usually short-lived. Stock sell-offs tend to be brief, according to Bloomberg News, in their analysis of terrorist events around the world the last 15 years. “Following the 9/11 attacks in New York in 2001, the Standard & Poor’s 500 sank 12% in in 5 days, but recovered within a month. Similar swings took place after the Bali nightclub bombings in 2002, the Madrid train bombings in 2004 and the London attacks in 2005.” And most recently, we’ve experienced the downing of a Russian passenger airliner and the worst suicide bombing in Beirut since the of the Lebanese civil war in 1990.
Investors have tended to treat these terrorist acts as idiosyncratic in nature and markets bounce back quickly. Fear often rules the day, but in the end freedom wins. It always has and always will, so keep investing with the knowledge that there will be a just ending for those that think otherwise.
To recap, reality is setting in – the first hike in 9 ½ years will likely occur on December 16th. It creates some uncertainty and short-term volatility, but it’s a hugely symbolic move and will be a sign of Fed confidence in the economy, and economic growth is a tailwind for corporate earnings.
I believe that once we have our first rate hike behind us, we’ll have a relief rally, right in time for Christmas, a welcomed Seasons Greetings to patient investors. The economic picture at this time is not much different than earlier this year when stocks made a new high in May (S&P 500 @ 2,135). Further, investors are peeking around the corner to the higher earnings estimates for 2016 which can be used to calculate higher fair values. I believe that stocks are rested and ready for a surge towards that old high of 2,135. And with a little help from Santa we could press above that to make new highs on the year, say closing out 2015 closer to 2,150 for the S&P 500.
Wishing you a Happy Thanksgiving!
Eric J. Linser, CFA