“Frog in a Well” (or “Two Steps Forward One Step Back…”)

As the second quarter earnings season winds down, we appear to stand at a crossroads with investors and economic pundits alike, speculating on the real state of the global economy. Investor sentiment figures released by the American Association of Individual Investors (AAII) for the next six months (week ending August 12th) reflect this concern, showing 30.5% Bullish, 33.4% Neutral and 36.1% Bearish. For comparison, AAII’s data shows that over the long-term these averages have been: Bullish 38.78%, Neutral 30.94% and Bearish 30.29%. The poll would seem to indicate a higher level of apprehension among investors, at least in the short run. Substantiating this was the response by the equity markets to any disappointment in second quarter corporate earnings or sales figures.

In a stock market that has remained virtually range bound so far in 2015, earnings calls have been a significant factor in the day-to day price fluctuations of the major indices with large and sometimes outsized reactions in company stock prices to positive surprises (AMZN +9.8%) and to disappointments (TRIP -13%). Investors are severely punishing any misses and, with some disparity, rewarding signs of business growth. For the most part, it does not appear that upside earnings surprises without sales growth are being rewarded in a comparable manner. Revenue growth is currently a highly valued factor and investors seem to be less impressed this time around with earnings per share increases due to financial engineering and cost cutting. Unsurprisingly, dispersion is higher as earnings and revenues have taken center stage. Trading after earnings releases does appear to us to be more volatile than in the recent quarters. This is not unexpected in a six-year old bull market – especially in the rather mediocre growth environment that we have seen for the past two years. Investors appear nervous and more likely to sell (perhaps indiscriminately?) on disappointment.

FactSet estimates that the final earnings tally for the June quarter will reflect the first quarterly earnings decline since the third quarter of 2012, down -1% with a revenue decrease of -3.30%. As forecast, the Energy sector is again reporting the largest year-over-year earnings decline out of the ten sectors of the S&P500 Index, down -56.4%. Excluding energy, the S&P 500 index year- over- year earnings growth rate rises to +5.7%. As mentioned in previous reports, falling commodity prices versus a year ago bite both ways – positively and negatively, depending on what side of the production/consumption continuum a company resides. West Texas Intermediate crude is down approximately 56% in the past 12 months, additionally, gold, copper and sugar have declined 15%, 27% and 35%, respectively. Continuing the trend from the prior quarter, Health Care companies are reporting the highest growth rates in earnings, up 15.4%. Many of the companies in this sector are benefitting from demographic trends, Obamacare and their proprietary research and development efforts. We continue to see negative commentary from companies with international exposure regarding the impact of a higher domestic currency. Global currencies, for the most part, have repriced lower versus the U.S. dollar, impeding earnings and revenue growth for many multinationals.  Our higher domestic currency is impacting earnings and sales, as foreign exchange lowers profits and pressures international demand for U.S. products. This appeared to be a recurrent theme during corporate earnings calls and negative comments regarding the impact of the strong U.S. dollar on sales growth for 2015 ranged across economic sectors: Sherwin Williams (Consumer Discretionary), Conagra (Consumer Staples), Johnson & Johnson (Health Care), etc.

The debt sagas in Greece and Puerto Rico and the murkiness of China’s economic growth and securities’ market operations have presented real obstacles for global stability and investments. In the Eurozone and Japan, the monetary easing continues; however, we have yet to see consistent marked improvement in several of the underlying countries. Here in the U.S., we are bombarded with confusing economic numbers which run the spectrum from fairly dismal to possibly optimistic. The recent jobless claims report, although slightly higher than expected for the week of August 8th, was a net positive, as the report reflected the lowest level (266,250) in the four-week moving average of claims since April of 2000. Retail sales for July increased by 0.6% and the level for June was revised upward; however, department stores and electronic stores did not seem to participate – and it has been reflected in their earnings announcements. It remains to be seen how the back-to-school season shakes out. On the housing front, home prices rose 4.4% in May, as did sales of existing homes (+3.2% in June) but the data also reflected that new home sales fell to a seven month low and at least for now, fewer Americans are owning homes. Presumably, we will be seeing the level of impact that rising rates will have on housing and its satellite industries.

So returning to our title named after the hapless frog that tumbled into a well and kept falling back one step for every two steps forward on his way out – Is the U.S. economy still progressing? Are we still on the arduous journey out of the recessionary well? Will the next quarter result in a step forward? For now, analysts’ consensus earnings expectations call for another decline in earnings and revenues for the S&P 500 index in the third quarter.  Data from FactSet reveals that earnings are currently expected to come in 3.6% lower on a year-over-year basis. Revenues are also predicted to decline, but at a lower relative rate of -3%.  This would be an interesting reversal from the trend of earnings growth outpacing revenue growth (or the lack of). Time will tell if (true to form), analysts’ expectations have been set too low again and we will see overall earnings beats – so far this quarter that has been the case.

Some important questions relating to factors that could produce positive or negative bias to corporate earnings strength going into the second half of 2015:

  • Will the U.S. dollar continue to rise and how effective have multinationals been in forecasting and applying (or not) foreign exchange hedging?
  • Is the U.S. consumer feeling financially healthy and ready to spend?
  • Can Europe and Asia stage a solid rebound?
  • When will the Federal Reserve raise rates and what effect will that have on businesses, the consumer and investments?
  • Will companies become more confident about demand and increase capital expenditures?
  • Where will commodity prices go? How will this further affect Emerging Markets and the companies that do business there?
  • Will politicians initiate policies that may be perceived as detrimental to corporate America or particular industries?

Bottom-up analyst estimates provided to FactSet are predicting a strong revenue rebound for the first quarter of 2016 (+5.1%). If so, this would add some substance to the current S&P 500 index valuation which they have calculated at 16.5 times the next twelve month forward earnings – well above the historical five-year and ten-year forward price/earnings multiple averages of 14.0x and 14.1x, respectively. Keeping in mind that the S&P 500 Index component companies derive approximately 70% of their sales from North America (mostly the U.S.) it seems that another step forward is forecasted to be in the works. As we noted above, according to the AAII poll, whether that materializes is up for debate among investors.

 

Margarita V. Fernandez

Vice President – Alhambra Investment Partners, LLC