And This Is Where It Gets Interesting…

As first quarter earnings season ends, we find ourselves in the same position as we have the last couple of years. Yet another quarter completed with a good portion of the companies in the Standard & Poor’s 500 index successfully beating analysts’ consensus earnings estimates – significantly reduced estimates.  According to S&P Capital IQ, the January 1st 2015 earnings growth forecast was initially for +5.61% increase in the first quarter. Anyone paying attention would have noticed individual company estimates falling and by the middle of April, the S&P 500 aggregate number had been ratcheted down to a 3.21% decline.

FactSet, a well-known provider of financial information, states that with nearly all of the companies in the S&P 500 index having reported so far, the data reflects an actual 0.70% positive earnings growth rate. It is the lowest since the third quarter of 2012 (-1.0%), but substantially better than the forecasts. FactSet notes that approximately 71% of the companies that have reported, surprised on the upside for earnings per share, but only 45% had positive surprises on average revenue estimates. They calculate first quarter sales growth for the S&P 500 of approximately -2.9%. The numbers have changed, but the experience is similar to this time last year. Some of the blame for the disappointing growth falls on a familiar culprit, the severe weather in many parts of the country. To this we can add: a rising U.S. dollar, falling oil prices, U.S. port strikes, and slower global economic growth.

Digging into the individual S&P 500 GICS Economic Sectors, we find a wide dispersion in year over year operating earnings per share changes. This makes sense if you consider the culprits listed above as growth detractors for some companies and either positives or non-events for others.

Clearly, the worst earnings reports came from the energy sector (-55%) which was pummeled by oil prices that declined precipitously from the second quarter of 2014, through the fourth quarter of the year. Materials, which comprises companies that discover, mine and process natural resources such as precious metals, forestry and chemicals was the only other sector that had aggregate negative operating earnings growth of approximately -0.35%. The commodity dependent companies typically have a negative correlation to the U.S. dollar and are particularly vulnerable to the strength or lack thereof of the economy since, at some level, their products are basic inputs for all other industries. For some companies, lower prices were a tailwind, for others, a headwind. The most favorable earnings growth was seen in the Healthcare companies (+17%) which continued to benefit from demographic trends, Obamacare and a robust drug pipeline for many of the biotechs and pharmaceuticals.

Although it is helpful to analyze what is in our rearview, the equity markets anticipate what lies ahead. Concerns regarding Fed policy and the effect of higher interest rates on equity securities, in combination with the lack of revenue growth in most industries has resulted in a rather meandering stock market so far this year and narrowing pockets of price appreciation. Stock market participants’ expectations of improving growth trends has produced mostly full market valuations based on those assumptions. The continuing trend of corporations assuming debt or using cash to expand buy backs of their own stock has had the effect of lowering the number of outstanding shares and increasing earnings per share growth but ultimately, does nothing to improve sales of their products. S&P estimates that buy backs were approximately $148 billion for the first quarter of 2015, with 20% of the S&P 500 index companies reducing share count by at least 4%.  For those companies, a jump of 4% in earnings per share was accomplished just from buybacks. Returning cash to shareholders through dividend increases or initiations also increased from $82 billion in the first quarter of 2014 to the current $93.6 billion. These activities raise concerns that overall, many companies are not investing in historically revenue producing assets – capital expenditures, R&D and headcount. Operating efficiencies have also been a main contributor to earnings as companies remain lean and take advantage of the historically low interest rates to restructure debt.

There are several ways to consider this apparent reluctance to invest in future growth and these will be industry/company specific:

  • Limited opportunities for growth
  • Technological improvements replacing workers and increasing productivity
  • Concerns regarding government regulation
  • Globalization effect on supply and demand
  • Lower U.S. consumer and institutional demand

 

A concerning development this year, in contrast to first quarter 2014, are the downward revisions to corporate earnings and revenue estimates for the second and third quarters – as we await signs of a pick-up in demand. For second quarter 2015, the consensus from analysts is for a decline in revenues and earnings of -4.5% and -4.4%, respectively. Currently, growth in earnings is not forecast to resume until the fourth quarter of 2015 (+4.8% EPS and -0.3% revenue) and it is expected to compensate for the weakness of the previous quarters. For the full year (for now), analysts are predicting earnings growth for the S&P 500 of +1.7% and a decrease of -1.8% in revenue growth. Comparable to this time last year, revenue growth is expected to accelerate next year.

So, this is where it gets interesting – in the short term – as nervous investors with mostly very satisfying paper gains, react to any indication that the earnings side of the price/earnings ratio will not expand as anticipated.  In a market that has baked in growth expectations for year-end and going into 2016, disappointment could very likely result in a correction. Add to that the specter of rising interest rates affecting the relative attractiveness of bonds versus stocks, and the market appears vulnerable to a pull-back. A perfectly normal occurrence that we have not seen for the past three years.

As an institutional investor, Alhambra has a responsibility to the clients that we partner with, to keep our focus on the long-term and to not be distracted by the week by week market fluctuations. Wealth preservation is an important part of meeting client goals and objectives. To that effort, we adjust our asset allocations and security selections accordingly, based on the financial environment and on a client specific basis. Ultimately, investors should take the long view on investments – and in the long run, corrections result in investment opportunities.

Margarita V. Fernandez

Vice President – Alhambra Investment Partners, LLC