Strong rally; Now time for a breather – 3/23/2016
After considerable weakness all year, stocks have found their footing with an impressive rally of more than 10% since mid-March. Much of the fear in the market has abated, as commodities have turned up and economic numbers have generally come in better. Add in a softer FED and investors can understand why the recent price action in US equities has been so strong. Sounds like a nice platform from which to continue higher, but I will make the case that most of the gains have already been made. I’m not suggesting we are in for another drop, just that we have gone as far as we can go for now.
Below is a background model for the S&P 500 based on fundamentals including earnings strength, sales, and valuation among other measures. The current Model reading is 23.8% (0-100% scale) implying a weak fundamental picture and historically below-average returns going forward for the large-cap index. Readings had been improving recently but deterioration in the earnings outlook and valuation measures turned things lower. The S&P 500 Model is just a guide, but it is a good place to start before digging deeper.
Before I describe some of the near term reasons for caution, let’s look at some of the underpinnings of the recent rise in stocks.
What exactly turned an equity market that couldn’t get out of is own way into something akin to a house on fire? A market that has show resilience even in the face of the recent European terrorist attacks? First and foremost, it was the turnaround in oil prices which moved from $26 to about $40 where it has found a home. Oil usually has zero correlation to stock prices, but for months they have moved together a majority of the time. Commodities in general have been moving up (oil, copper, iron ore) after a huge and lengthy bear market, and the broader rally looks to be real. The recent price strength/stability is seen as a proxy for global economic growth. It has also helped with the recovery in Emerging Markets and alleviated fears of an unraveling there. The $US has weakened (Yen/Euro) and the dollar index (dxy) now sits at the low end of its year-long trading range (see Chart). This has helped strengthen dollar denominated commodity prices, as well as EPS for US multi-nationals. Profits for the S&P ENERGY and INDUSTRIALS sectors will benefit from the stronger oil/weaker dollar scenario, and as a matter of fact are necessary for an improved earnings picture for the overall market.
More telling is recent US economic data, while not great, has been better and beating expectations in what tends to be an expectations game. Autos have not shown signs of peaking (as has been the criticism) and the “problem” for housing is a lack of supply. The CITI Economic Surprise Index shows an economy underperforming for the past year but one that may finally be coming into line (Chart).
Let’s not forget the role a more “cautious” FED has played in keeping stocks moving upwards. The consensus is for 2 more hikes this year, but the less aggressive approach was welcomed by those who think stimulus is still in order.
All these positive developments have calmed things down considerably from the beginning of the year chaos. The VIX is back to normal levels after spiking in February. The mini-credit crisis which saw high yield rates jump quickly from 8% to 10% and then back down again is over. The 10yr Treasury rate is back up towards 2% after an intra-day low of 1.55%. And Gold prices are off their recent highs. Sentiment is no longer in “full panic” mode and with most measures has a more Neutral reading (see Chart).
So what is there to complain about? There is no froth to be seen, the FED is being more cautious, and there is very impressive market momentum. Someone once said “Don’t fight the FED, Don’t fight the TAPE.” But everything comes at a price, and at current levels it is too much to pay.
A PRICE TOO RICH
My main conclusion that the current rally has played out is based on the fact that market fundamentals don’t support any further advance for the near-term. Profits usually lead the economy, but right now we are getting better economic data and still waiting on the earnings picture. I’m not so sure we are out of the woods on the “earnings recession” we have been experiencing as estimates for 2016-17 continue to come down. Right now we are at the very high range on current and forward valuation measures. The chart below shows that S&P 500 Operating P/E is reaching peak levels since the valuation trough in 2011 (now above 20). The 12-Mth Forward P/E is approaching 17, considerably higher than the historical average of 14. This is coming at a time when inflation (including wages) and rates are expected to move in the upward direction, most likely resulting in P/E contraction for 2016, not further expansion. There is an argument that a 17 Forward P/E is fine when the 10 Yr is below 2%, but there is not much upside room to this overvalued landscape. Earnings may materialize but let’s not forget we are at peak profit margins (operating) on the index, so not only is multiple expansion most likely off the table but so is margin expansion. That leaves organic earnings growth to be the driver, which means continued economic expansion. The IMF already lowered estimates for US (and World) growth previously, and the FED lowered estimates again in March to just slightly above 2% for both 2016-17. Not a promising environment to be waiting for profits.
What about the positive effects the rally in oil prices and the weaker $US dollar will have on earnings as mentioned previously? There is that, but I’m not going to try and guess on the direction of either one going forward. Already there is talk of oil inventory build and the near certainty that we will reach record storage levels this year. And the FED looks like it is walking back some of the “soft talk” from a few weeks ago as things have improved, and those hikes will once again get priced into stocks. So, yes, stable oil and $US are necessary for an improved profit outlook but they look to be anything but certain.
The last thing I would like to point out is of a technical nature. The chart below shows the S&P 500 with the 50d and 200d moving averages. The chart shows the index is quite a bit above its 50d MA. Historically when this has occurred the market has underperformed for the next few months. The last time index traded this high above the 50d was back in early November and it marked the peak we have yet to reach since. Nothing magical here except that it goes along with my thesis that much of the advance is over for now and to expect some sideways movement and volatility for a bit until we get more insight into earnings, FED action, and stability in commodities prices.
Andrew Salamy, 3/23/16