A “deflate-gate” of sorts hit Wall Street during the final week of January. On Tuesday, January 27th, the U.S. Census Bureau reported durable goods orders, core capital goods orders, and inventories; and overall, the information disappointed. Durable goods were down -3.4%. Capital goods orders were down -0.6%. Inventories increased +0.5%. The following day, the Federal Open Market Committee (the “Fed”) released a statement which pointed out that inflation is “anticipated to decline further in the near term,” and indicated they can be “patient” regarding a federal funds rate increase, but could move quickly if economic data improves sooner than anticipated. On Friday, January 30th, economic growth was reported at 2.6%, which was below estimates. On the same day, Eurostat reported the largest decline in consumer prices in the Eurozone since July of 2009. Equity markets across the globe responded by selling off.
Add to the mix that now nearly half of the companies that comprise the S&P 500 have reported fourth quarter 2014 earnings, and an increasing number of companies are issuing guidance for lower earnings in coming quarters. Apple and Amazon produced strong results, but many companies reported misses and we are still waiting on reports from the energy sector. Many analysts responded by lowering Q1 and Q2 estimates for earnings and revenue growth rates for the S&P 500. Several of these same analysts are predicting record-level earnings-per-share growth in Q3 and Q4 of 2015, and profit margins are expected to rise to record levels.
The State of the Union
President Barack Obama made his obligatory State of the Union address in January, and he spoke of tax reform, cyber security, education reform, and he highlighted the U.S.’s economic progress since the Great Recession. The members of the Fed might agree that the U.S. economy is on better footing now, but only to a certain degree. The Fed has held the Federal Funds Rate at near zero for over 5 years now, and they’ve made it clear they will raise rates only when they have more confidence in economic growth. The economy has recovered from recessionary levels, but unemployment measures still show slack.
The State of the Markets
In last month’s newsletter, we pointed out that volatility has returned to the markets and the significance of the V-bottom sell-off. With that in mind, let’s take a look at the first 10 trading days of the year. The markets opened for the year on January 2nd, and the S&P 500 opened at 2058.90. It took only a few trading days for the S&P to drop 2.7% and close at 2002.61 on January 6th. Only a couple of trading days, later the S&P closed up 3% at 2062.14 on January 8th. A week later, the S&P closed down 3.4% at 1992.67 on January 15th. Uncertainty abounds and volatility is the result. Investors don’t seem to know what to make of global economic growth, central bank economic policy, and economic divergence – factors that are all being priced into stocks minute by minute.
One way to make sense of stock prices is to look at the price-to-earnings (P/E) multiple for the stock market as a whole. The P/E of a stock is the stock’s price divided by its earnings. P/E multiples can give us an indication of how expensive or cheap stocks are based on how many times a stock trades in relation to earnings. For example, the S&P 500 has typically traded at a multiple of 16x the trailing twelve month’s earnings. The street consensus is that S&P 500 earnings for 2014 should be around $116. Thus one would expect the S&P 500 to be trading around $1856. The S&P is currently trading well above that, and one might say that the market is trading at a level above “full value”.
So what happens if we expect earnings to decrease, which is actually what analysts are now forecasting, due in large part to a weak energy sector from the recent collapse in oil prices? When you reduce the denominator in that formula, you get a higher multiple. (Four divided by two is two. Four divided by one is four.) This means that if earnings drop and prices stay the same, the market begins to look expensive. If earnings continue to slide, then it’s only a matter of time before stock prices follow.
Historically speaking, international markets are priced right now at generally cheaper levels. The Eurozone continues to struggle with recession, so much so that on January 22nd the European Central Bank (ECB) announced plans to purchase €60b in assets per month through 2017, their own version of “Quantitative Easing”. The ECB is following in the footsteps of the central bankers in the U.S. and Japan, who embarked on QE years ago, albeit to differing results. In the U.S., we have witnessed a sustained recovery since the Great Recession, however GDP growth has left much to be desired. While the U.S. has ended its QE programs and plans to raise rates as things improve, Japan has indicated a willingness to expand their stimulus program as their measures so far have not created enough economic growth. In addition, the Greek election in January resulted in leftist leadership which might hinder the decision making process if additional stimulus is deemed necessary in the future.
The State of Crude
The ongoing collapse of oil prices continues to roil markets around the world. On January 28th, the U.S. Energy Information Administration reported that oil inventories increased by 8.9 million barrels. For context, January crude inventories are at levels that have not been seen in the past 80 years. Increased supply and slowing demand are two of the primary factors that have caused prices to plummet in recent months. Many consider oil to be “oversold.” Goldman Sachs and Morgan Stanley both see oil recovering back above $60 per barrel later this year, but mixed messages continue to emanate from the Middle East. Some Saudi officials are beginning to speak of prices being too low and how the long term outlook is highly uncertain. One week the Saudis are quoted as saying that oil will never get back to $100 per barrel, and then a couple of weeks later a different official says oil could go as high as $200. If oil prices stay low for any significant period of time then jobs in the energy sector will be lost, earnings in the sector will go down, and the markets will respond – probably by selling energy company shares. While lower prices at the pump are welcome to most of us, it means pain for many in several areas of the economy. There will be winners and losers.
Regarding the long term outlook, we are still a world whose machines run on petro-fuels. A move to alternative and cleaner energy sources will likely occur, but we are years away from finding the optimal energy source, developing efficient storage for that energy source, and then building the infrastructure to manage the change. For example, the U.S. Department of Energy reports that there are currently only 8,976 electric car charging stations in America. The vast majority of cars and trucks being built today run on gasoline, and that will not change quickly.
The oil industry is dealing with supply-demand issues, but this imbalance will correct in time and oil prices will eventually stabilize. Because there are far more energy consumers than suppliers in the U.S., and in the world for that matter, the net result for consumers will be positive in the long run. Cheaper input costs are always better long-term. However, there will be pain along the way – layoffs and suspended projects in the energy sector, for example.
Trying to decipher the Fed’s intentions is a very trying affair. The Fed’s statements and press conferences have hinted at an increase in the Fed Funds rate for the past year; however it was recently reported that Federal Reserve Chair Janet Yellen told Congressional Democrats behind closed doors that no rate hikes are imminent. With that in mind, if jobs and economic growth are not strong enough, it then seems reasonable to expect the Fed to proceed with more caution and keep rates lower longer.
Here’s where things become even more challenging for investors. When interest rates stay low, stocks are expected to outperform bonds. The current dividend yield on the S&P 500 is about 2.0%, and on January 30th the 30-year Treasury fell to its lowest yield in recorded history at 2.24%. On the same day the 10-year Treasury fell to 1.67%.
While we may not agree that the “next crisis” involves U.S. treasuries, take a long look at the chart. U.S. treasury yields have never, ever been this low – not even during the Great Depression. As we’ve said repeatedly in past newsletters, the Fed’s recent monetary policies have never been implemented before. We are in uncharted waters. “Unintended consequences” will occur. They may be bad, they may be okay. No one knows.
Deciphering Mixed Signals
The outlook for 2015 is becoming murkier by the day. At face value, most of the fundamentals are supportive for stocks, although stocks might be viewed as getting expensive by several metrics. Inflation is well contained, and the drop in oil prices has actually contributed to deflationary pressures. We’ve seen the unemployment rate fall recently, but there is a significant amount of workers who have stopped looking for jobs, which influences how the employment rate is calculated. In fact, the labor participation rate is at its lowest since the late 1970s. While low borrowing costs are good for consumers and most business sectors, the further effects of the Fed’s grand experiment of a zero interest rate policy (ZIRP) and multiple bouts of quantitative easing are wild cards, and more central banks around the world are following suit with their own versions of easing.
We have identified the fog clouds obstructing our view: weakening economic data, mixed earnings reports, faltering oil prices, central bank manipulation of rates and the money supply, and increasing levels of volatility. This heightened complexity makes investing stressful and confusing. That’s why we believe that a well thought-out and cautious investment process is critical.
We’ve found that results are optimized when a good investment plan is put in place and then all of the noise around us is ignored. The “noise” comes from various sources – the TV, the print media, and even from friends and colleagues. None of those sources have a clue what your unique goals are. Nor do they understand your family dynamics or personal circumstances. Most importantly, they don’t know how to develop a long-term investment strategy that fits your needs and matches your attitudes about risk. We encourage you to work with your advisor to revisit any issues that you think may deserve attention in light of your long-term goals for your family and your family’s assets.