Unsettled MarketsFebruary 9, 2015 12:00 am
Classic economic theory has the stock market reflecting three things: earnings of underlying companies, stock valuations as represented by price to earnings ratios, and dividends. Much of the last six year’s rally in the stock market has reflected healthy profit margins and the gradual return of higher P/E ratios. Now profit margins are beginning to be squeezed and valuations are stretched by a number of standards.
Take it back one more step: earnings and valuations reflect the potential of the underlying economy over the longer term. Sometimes stocks can get ahead of the economy and sometimes it is the other way around. Which is it now?
The favorable story is that the U.S. economy has decoupled from the rest of the globe. We were smart – the reasoning goes – to implement easy monetary policy shortly after the financial crisis. Through quantitative easing and low interest rates we kept enough money flowing through the economy to allow consumers to cut back on debt, get out from under unaffordable houses, and ride out the labor market until businesses started hiring again. Businesses, in turn, used the time to cut costs, become more efficient and store up cash on their balance sheets until they felt more confident about investing in the future.
Friday’s strong jobs report was reaffirmation that the US economy is on the right track. The economy has created one million plus non-farm payroll jobs over the last three months – that included an upward revision of the last two months figures by 147,000. The last twelve months have shown the best average jobs increases since the late 1990’s. On top of the labor news, inflation is low, consumer confidence is high and the housing market appears to be on the mend.
But it is not so simple. In recent months the rising dollar and falling oil prices have mixed things up a bit and unsettled the markets.
The recent dramatic fall in oil prices was largely unexpected and dramatic. Declining oil prices is good for some companies (which use energy to make their products). It has been bad for others (which produce energy as their product). Expectations for the Q4 energy sector growth is -21.2% (Fundamentalis). This is dragging down S&P expected earnings per share from $136.14 as forecast last October to $119.80 today (Ned Davis Research).
The rising dollar is also taking its toll. A higher dollar impacts exports negatively by making them more expensive for foreigners to buy. Since foreign sales account for 1/3 of S&P earnings and since the trade weighted dollar is up 14% since last summer, earnings per share can expect a 4% hit for 2015 (BCA Research). Between the two surprises (oil and the dollar), earnings growth has been reduced to an estimated 4-5% for 2015 – a muted forecast (BCA and Ned Davis Research).
There is also a lot of uncertainty over the Federal Reserve’s next actions. Interest rates are scheduled to rise. The issue is when and how fast. It has been a long time since the Fed formally tightened – especially from this low of an interest rate. Markets are a bit nervous over what Federal Reserve actions might mean for stocks.
And none of this takes into account the outlook for global economies. Continued slow growth could drag down the US economic recovery. Mix in Putin’s next move along with the fragility of Middle East regimes, questions about Greece’s viability in the eurozone, and the sustainability of the European economy and, well, there are a lot of story lines the markets are compelled to follow. This has led to increased volatility, which traders feast on and investors abhor.
Thus, the outlook for the stock market is becoming increasingly complicated. Until recently investing was all about the “risk on” vs “risk off” trade. We bounced between greed (all is good) and fear (all is bad). Now the outlook is more nuanced. Investors no longer fear a relapse into recession, but they may not be quite ready to take the next step forward without seeing continued validation of a stronger US economy and less challenges from overseas. A “wait and see” perspective could give the markets the breathing room they need to feel more confident in current and future valuations of company earnings and stock prices.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.