Earnings Trends

The first quarter earnings season is almost over, and it is not a pretty picture.  While 71% of companies beat estimates, the earnings declined by 7.1% compared to a year ago, making this the fourth quarter in a row of earnings declines.  According to the analysts, in Q2 the earnings will continue to decline, but will reverse that trend in the second half of 2016.  For the whole year, the earnings are expected to increase by about 1%.

As I wrote before, the “earnings recession” was driven by two primary factors: a fall in energy prices and a strong dollar.  In fact, most of the decline can be attributed to a collapse in the results of energy companies.  Fortunately, both of these headwinds appear to be abating, and, in fact, earnings for S&P500 are expected to grow by 13% in 2017.  Of course, on has to take such long term forecasts with a grain of salt.

Meanwhile, the forward PE ratio of S&P500 is at 16.6, higher than the historical average of 14.3.  The overall market hasn’t really done much over the last year and half, and may well continue to trade sideways for the next several months until the uptrend in earnings is confirmed.  In this kind of environment, it is very important to be selective and choose companies that have been and continue to grow their top and bottom line regardless of the macroeconomic conditions.  Many of these companies are familiar to you (Facebook, Google, Starbucks, etc.), but there are less known firms as well.  Their valuation may appear to be high, but it is deservingly so, and I believe they are the ones worth concentrating on.

We Had the Correction: Now What?

The third quarter of this year was a weak one for the markets.  After experiencing the first correction in more than four years, S&P 500 declined by 6.9% for the quarter in a highly volatile environment.  The index is down by the same amount year to date.

Despite strong volatility this quarter, I think that the markets actually behaved rationally over the last several months.  Back in April, I wrote, “For the next couple of quarters, earnings are expected to stay flat or even decline, and that may make it difficult for the market to advance.  While there is no bubble to speak of, we may finally get that long-awaited 10% correction.” That has proven to be correct.  The earnings this quarter are expected to decline by about 4%, driven by primarily two factors: low oil prices and corresponding crash in earnings of energy companies, and continued headwinds of strong U.S. dollar.

If we exclude the energy sector whose dismal results dragged down the overall S&P 500 bottom line, we will find out that many industry sectors (such as technology, for example) continue to grow earnings.  The euro appears to have stabilized against the dollar; in fact, I think that Q3 is the last quarter to have poor year-to-year comparisons due to currency issues.  Assuming continued relative stability of the dollar, the currency headwinds due to prior year comparisons will decrease substantially in Q4 and disappear completely by Q1 of next year.  The dollar-denominated earnings of U.S. multinationals will benefit accordingly.  As markets are always forward-looking, this should have a positive effect on share prices.

Nasdaq at All Time High Again

It took just over 15 years for Nasdaq to finally exceed its previous peak reached in March 2000.  The only comparable event in U.S. stock market history is reclaiming pre-depression 1929 high — and it took Dow 25 years to do that.  So how does Nasdaq of today compare to 15 years ago?

The short answer is, there is nothing in common.  In 2000, internet exuberance affected valuations of most companies.  Even leaders of that era, like Microsoft and Cisco, sported tripe-digit PEs, and of course many dotcoms not only had no current earnings, but no prospects of getting any in the future.  Today, while there are a number of richly valued companies, most of them are solidly profitable with proven business models.  And today’s industry leaders like Google or Apple trade at reasonable forward PE in the teens.  Investor attitude also changed markedly.  In 2000, your taxi driver or your barber was ready to give you hot stock tips.  Today, more than half of U.S. population, burned by market crashes in 2000 and then again in 2008, eschews equities altogether (missing on the gains of this six year old bull market).

With earnings season underway, the results so far are similar to those of several prior quarters: about 70% of companies that reported so far exceeded earnings estimates.  These estimates were previously reduced, however, due to strong dollar and poor results by energy companies because of the fall of oil prices.  For the next couple of quarters, earnings are expected to stay flat or even decline, and that may make it difficult for the market to advance.  While there is no bubble to speak of, we may finally get that long-awaited 10% correction.

Or maybe not.  With no inflation in sight and strong dollar, there is little likelihood of Fed raising interest rates soon, and equities will continue to be the investors’ choice to generate reasonable returns.  But it is not useful to speculate on the direction of the overall market – instead, as always, it is much more productive and profitable to concentrate on the companies in your own portfolio.

Correction? What Correction?

In January, the markets appeared to be finally heading in the correction territory, which in Wall Street speak, means 10% decline from the top.  Such corrections typically occur at least once a year, and having gone for more than two years without one, we were definitely overdue.  I was hoping it would actually happen, for two reasons: one, to be able to put the checkmark (ok, just kidding), and two, to buy some good companies at a discount.

But that was not to be.  After declining just over 5%, S&P 500 has recovered most of the losses and is once again flirting with all-time highs.  Recent earnings season supports the latest rally.  Indeed, some 71% of the companies beat earnings estimates and 66% beat sales estimates, both figures higher than average.  Earnings growth was also very robust at 9.3% compared to 6.6% one year ago.  Not that you would hear financial media cheering these achievements.  Good results are boring, it is fear that sells well.

As always, where we go from here is anyone’s guess.  We may well hit new all-time highs, or we may finally go though that long-awaited correction (I am confident that we will definitely do that at some point).  The market and economic fundamentals have been favorable to equities for quite some time and still are.  There are lots of cash on sidelines, both from individuals and from companies.  Many investors remain very skeptical of the stock market.  The U.S. economy is accelerating, and even Europe seems to have emerged from the debt crisis.  Interest rates are very low.  Even though market valuation is slightly higher than average, there are not many attractive alternatives to equities at this point.

Enjoy the Rally But Be Prepared For a Drop

As you might have noticed, the stock market is doing quite well this year.  There were no major new international crises, and even the recent debt ceiling negotiations failed to spook the market.  Accordingly, there was no significant correction this year.  Rising stock prices are great news for investors in or nearing retirement, but they are not good news for young investors.  A net buyer of anything, such as cars, milk, or stocks, would much rather pay less than more for whatever he or she is buying.  But these investors will surely get their chance.

Note that I am not predicting an imminent correction.  In fact, I believe that the market is still somewhat under-valued.  But my opinion is beside the point.  And the point is, the market drop will come.  There is no complete certainty in anything in the investment world, but this is as close as it gets.  You can be assured that the market will drop in the future as well as you can be assured that a big snowstorm will hit Sierra mountains.  It may happen tomorrow, next month, or in a couple of years — but it will happen.  This is just the nature of the beast we are dealing with.

So while we can all enjoy the market ride while it lasts, we should be mentally prepared for the decline.  When the time comes, don’t act on your emotions and don’t panic.  Instead, embrace the situation as your chance to buy great businesses at a discount.  That is how the bulk of the profits in the market is made.

Market Update

While the long awaited correction that was expected this summer by many analysts has not yet materialized, the markets seem to have at least started consolidating, and the volatility has increased.  For the last couple of weeks, the major driving force behind market fluctuations was Fed watch — namely, how soon will Fed start easing off of its stimulus program.  Never mind that such easing will happen only if the economy keeps improving, a good thing, normally, but judging by the market drop today, good actually means bad nowadays.  As always, I would suggest turning off CNBC dramas and instead looking at the real news for the companies that you own.

As has been the case this year, the actual news tend to be fairly positive.  The Fed will indeed start wrapping up its stimulus program, the only question is when — late this year or sometime next year.  As a result, the interest rates will rise gradually, bond prices will decline which will drive more investors from bonds into stocks.  Despite mild uptick in interest rates lately, the dollar actually lost ground to major currencies, even the euro, which is good news for U.S. exporting companies that report results in dollars.   Stocks are reasonably valued at 15 times trailing earnings, a midpoint of valuation range, but very attractive given low interest rate environment.  Earnings estimates going forward for the next two quarters are strong compared to last year, at 7.8% and 13% respectively.  Finally, as housing recovery gains steam, more and more people find themselves regaining positive equity — 1.7 million last month.

While the short term volatility may continue, and could even turn into a market correction, I think the long term positive trends for equity investors remain in place.

Seatbelts, please

While I still think that a compromise in fiscal cliff negotiations will be reached, the path to that agreement could be turbulent for the markets.  I see two main reasons for that.  First, year-end tax selling.  It is quite likely that capital gains taxes will be higher next year.  Therefore, it may make sense to sell some of the winning investments now, rather than in January or after.  A recent slide in Apple stock could have been caused, at least partially, by that.  This tax-gain selling, together with traditional tax-loss harvesting, could exert higher than normal selling pressure on the market in the last weeks of December.

The other reason is political.  Republicans in Congress have repeatedly stated their pledge not to raise taxes (or at least tax rates).  Ironically, the easiest way to accomplish that is to let the negotiations fail this year and have taxes increase automatically on January 1st.  Then, they will have remained true to their pledge; afterwards, it would be politically easier to negotiate for rate decrease, since both Republicans and Democrats agree that next year default tax rates are too high for majority of population.  Such political posturing will not be good for the markets.

So, if any of that comes to pass, we could be in for a bumpy ride for the next few weeks.  The silver lining here is that all of this is short term.  Just as debt ceiling negotiations were resolved in the summer of 2011, fiscal cliff will be resolved  since it is in everyone’s interest. However, possible volatility ahead may present us with some excellent buying opportunities.  Have some cash ready.

Market’s ADD Syndrome

In my previous post, I expressed an opinion that market could get some relief after uncertainty surrounding the election was removed.  Well, that did not happen.  Perhaps the traders didn’t like the fact that President Obama was reelected, but the more likely culprit for continued weakness was yet another uncertainty, this time related to approaching “fiscal cliff”.  Of course, it was well-known before the election, and so it looks like the markets have an ADD syndrome — they can only focus on one thing at a time.

Current worries about the fiscal cliff are very reminiscent of the debt ceiling debates in summer of  2011.  Then, a possibility of U.S. default, averted at the last-minute by partisan Congress, caused a more severe correction in the markets.  This proved to be a good buying opportunity: even after the recent pullback, S&P 500 is up 27% from the lows of last summer. Just like no one in the their right mind wanted U.S. to default back then, falling off the cliff is no one’s interest; some sort of compromise will be reached, and markets will reflect it — but we could be in for a bumpy ride while the talks are in progress.

The underlying fundamental and economic reports and U.S. and abroad have been fairly positive lately.  Consider:

• After declining slightly in Q3, company earnings are expected to rise 9% this quarter and 13% next year.
• Housing market continues its recovery.  Median home prices rose 11% compared to one year ago, and inventory of unsold homes continues to shrink.
• Black Friday and Cyber Monday sales were strong, setting up a possibility of a good Christmas shopping season.
• Consumer confidence index rose to its highest level since early 2008.
• After several quarters of slowing growth, Chinese economy started to accelerate again.
• It seems that the worst is over for the European debt crisis.  The yields on Spanish and Italian bonds are declining, making it easier for these nations to service their debts.  An agreement for Greece bailout was recently reached.

Given the bounce in the indexes in the last two weeks, markets are apparently starting to take notice.

This Rally Gets No Respect

Third quarter earnings season is underway, and results are not pretty.  So far, two thirds of companies that reported beat their earnings estimates, but only one third beat revenue estimates.  Both figures are below averages of the previous several quarters.  In addition, for the first time since 2009, earnings actually declined (by about 3%) compared to the year ago.  Forward guidance has been disappointing as well.  The weakness was across the board, with many prominent companies such as Apple and Google feeling the pain.

Despite these news, the correction that the market experienced was fairly mild, with S&P 500 losing less than 5% from its highs.   The silver lining here is that earnings decline has been anticipated by analysts, and the growth is expected to resume next year.  So far, the market remains in the rally mode that started in 2009.

In words of late Rodney Dangerfield, that rally gets no respect.  In a Franklin Templeton poll, 1,000 investors were interviewed about stock market performance.  Shockingly, more than half of respondents believed that the market declined in each of the preceding 3 years!  As a result of this huge disconnect with reality, many investors have not been participating in the advance.  Indeed, the flight from stock-based funds into bond funds continues: over $200 billion was taken out equities and put into bonds over the last year.  This kind of caution bodes well for the market in the long term.

Short term performance, as always, is anyone’s guess.  However, the weak earnings season is winding down, and elections are approaching.  Once someone is elected, a big uncertainty will be removed, and could provide a relief for the market next month.

Market Melt-up

Yesterday, the Fed announced QE3, a new round of “quantitative easing” designed to help the economy.  Many analysts didn’t expect Fed to act before the November elections, so this move was somewhat of surprise.  The markets loved it, and the major indexes, after advancing steadily during summer, are now sitting at nearly five year highs.

Given anemic U.S. economic growth, stubbornly high unemployment, recession in Europe and slowdown in China, is that surprising?  I don’t think so.  Despite the rally, S&P 500 is still 7% below 2007 high, yet company earnings that ultimately drive equity prices, are now 20% higher than they were at the market top.  On a valuation basis, excluding the 2008-09 collapse, equities are at lowest level in twenty years.  Indeed, we had quite a good run this year, but the markets really haven’t moved anywhere (excluding roller-coaster in between) for the last five years.  And going back even further, we are now at the level of 2000, 12 years ago.  So this is all a matter of perspective.

On a CNN Money site yesterday, I saw two headlines right next to each other.  One addressed the market rally, and another stated that investors moved $70 billion out of equity funds in 2012.  A week ago, an article in USA Today pointed out to piles of cash sitting on the sidelines, which was a subject of my previous post.  Of course, there are risks going forward, and a correction here will not be all that surprising.  However, headlines like the ones above give me more confidence in the longer term.  Market tops usually happen when investors move their cash into stock funds, and when your taxi driver asks for stock tips.  We are nowhere near that right now.