Originally posted at Briefing.com
When 2014 was drawing to a close, we had our suspicions that multiple expansion was going to be harder to achieve in 2015. So far, we have been proven wrong. Multiple expansion has actually come pretty easily, only it has been driven primarily by downward earnings revisions. It is that very factor why we are lowering our return expectations for this year.
Growth Estimates Weaken
Our 2015 Market View was published on December 19. At the time, the S&P 500 was trading at 15.9x forward twelve month earnings based on an index value of 2061. Since then, the S&P 500 has increased 2.3% in price, yet the forward earnings multiple has increased by 12% to 17.9x forward twelve month earnings.
The earnings estimate revisions have been driven by the energy sector whose earnings prospects have collapsed with oil prices.
The energy sector was expected to see earnings decline 3.7% on a per share basis as recently as December 1, but today, analysts' average expectation calls for earnings to decline 54.4% on a per share basis. That's the result of a roughly 60% plunge in oil prices since last June. It is important to note, however, that the downward earnings revision for the S&P 500 isn't owed solely to the energy sector.
As it so happens, every sector has seen earnings growth estimates for 2015 get marked down since December 1.
Source: S&P Capital IQ
Dollar Daze
A soaring U.S. dollar has been an instrumental factor behind the downgrades along with the arrival of consistently disappointing economic data since the start of the year. The peculiar exception has been the employment data, which has stayed strong.
While it is true that some companies employ hedging programs to mitigate the impact of currency swings, it is fair to say few, if any, hedges foresaw the rapid appreciation in the U.S. Dollar Index that has been seen in recent months. It has risen approximately 25% since July, having increased as much as 12% over the last three months alone.
The strength of the dollar was an oft-cited factor for cautious-sounding earnings views and/or negative earnings revisions during the fourth quarter reporting period. It should prove to be the same for U.S. multinational companies during the first quarter earnings reporting period.
The latter point is gestating in the fact that the average level for the U.S. Dollar Index in the first quarter of 2015 is 94.49 compared to 80.36 in the first quarter of 2014 and 80.08 in the second quarter of 2014.
Divergence
The other nettlesome factor the market is contending with is the divergence in central bank policies. That divergence is contributing to the dollar's strength as many other central banks around the globe are still cutting rates and/or making asset purchases in an effort to stoke end demand. The European Central Bank, the Bank of Japan, and the People's Bank of China are chief among them.
They are doing so at a time when the Federal Reserve is sounding as if it is angling to raise the fed funds rate in the near future.
The fed funds rate has of course been at the zero bound since December 2008. It is no mystery that the ultra-low policy rate and the suppression of market rates have been an enduring source of support for the equity market over the same period. The low rates, in turn, have helped drive economic activity, yet they clearly haven't been the complete answer considering the U.S. economy still hasn't achieved escape velocity.
Real GDP increased 2.4% in 2014 with final sales of domestic product, which exclude the change in inventories, up just 2.3%. That followed on the heels of 2.2% growth in 2013 and 2.3% growth in 2012.
The U.S. economy is on a glide path alright, but similar to a glider, there hasn't been any engine noise.
Some think that is about to change due to the strong gains seen in nonfarm payrolls for many months now. We continue to have our doubts due to a variety of factors that include, but are not limited to, the drop in the labor force participation rate, weak productivity, tight credit underwriting conditions, the strong dollar crimping export growth, a rising personal savings rate, and economic weakness abroad.
We hold out hope, like others, that spending activity will pick up given the drop in gas prices and rising levels of employment, yet the retail sales and personal spending data so far haven't substantiated that hope.
Quite a Ride
It hasn't been an easy investing environment so far this year. There has been a lot of roller-coaster action characterized by a 3.1% decline for the S&P 500 in January, a 5.5% gain in February, and a 0.3% month-to-date decline in March.
Our expectation is that the roller-coaster action will continue in the near term as participants battle with the idea that the Federal Reserve's monetary policy is near a turning point while profit margins are at record highs, the U.S. Dollar Index is at a 12-year high, and the S&P 500 earnings multiple is above its long-term average.
Under those conditions, the willingness to pay up for each dollar of earnings and to chase returns is unlikely to be as freewheeling as it has been since March 2009. That should afford the "best in class" companies (eg. Apple) with an added measure of relative strength in a tough environment and it should encourage some bargain-hunting efforts in the "best of the worst" companies (eg. Exxon) and downtrodden international markets (eg.eurozone) that are now providing more attractive entry points for scaling into long-term positions.
Our added presumption is that the dollar's strength will continue to be an overarching theme this year. That will likely play as a benefit in general for small-cap and mid-cap companies, which have less international exposure and, therefore, less dollar exposure than many large-cap companies.
We have already seen that in the first quarter as both the Russell 2000 (+4.9%) and S&P Midcap 400 Index (+5.7%) have outperformed the S&P 500 (+2.4%) and Dow Jones Industrial Average (+1.8%). That is not what we expected entering the year, yet the rapid pace of acceleration in the dollar's strength trumped our expectation.
The exception in the large-cap realm has been the Nasdaq 100 (+5.5%), which has been underpinned by Apple's (AAPL) 16% gain and ongoing strength in the biotech stocks.
What It All Means
We aren't souring on the stock market altogether. After all, the fed funds rate is still at the zero bound, inflation is still low, and the appeal of bonds is still low with the current yield of 1.93% on the 10-yr note below the S&P 500 dividend yield of 2.1%.
The S&P 500 can still have a positive year, but the return outlook has weakened in our estimation with the decline in earnings growth estimates and the corresponding jump in the earnings multiple.
When 2014 was drawing to a close, calendar 2015 earnings per share growth was projected to be 8.8%, according to S&P Capital IQ. It is now just 1.0%.
Our return outlook could change if earnings per share growth estimates are revised higher. As of now, though, we consider the fundamental backdrop to be weaker than it was when the year began and complacency in the easy monetary policy trade to be about as strong as ever.
Related:
Louise Yamada on "Very Frustrating" Fed-Induced Bull Market
