Among this week’s focus in the stock market are 1) the Fed’s two-day Federal Open Market Committee (FOMC) meeting, with no interest rate hike expected, and; 2) earnings report from Apple [AAPL], the world’s most highly valued publicly traded company whose shares fell sharply this morning on weak iPhone sales.
Meanwhile, the S&P 500 is near its all-time high. If you own the broad U.S. market, [SPY], the highly liquid U.S. S&P 500 ETF, you could have been up 0.6 percent last week and 3 percent year-to-date. After a very weak start in 2016, SPY has strongly rallied 14.9 percent from its February 11 closing low and is now within just 0.09 percent of its all-time adjusted closing high about nine months ago in July based on last Friday’s close, according to Yahoo Finance data.
Yet, the latest slew of earnings and economic data do not exactly support this rosy picture investors are seeing.
S&P 500 first-quarter earnings are expected to be lower in the aggregate, down 7.1 percent from a year ago, following declines of 2.9 percent and 0.8 percent the previous two quarters, according to forecasts reported by Reuters. Case in point: Microsoft [MSFT] and Alphabet (Google) [GOOG] reported disappointing earnings dragging their stocks 7.2 and 5.3 percent lower respectively on Friday.
What might be driving the strong stock market rally when earnings and economic growth estimates are registering low expectations?
Who do you believe?
While second-quarter earnings are expected to fall another 2.3 percent, according to Thomson Reuters I/B/E/S estimates, analysts are expecting the remaining 2016 quarterly earnings to rise 4.3 percent and 10.3 percent, resulting in a yearly gain just shy of 2 percent.
This below table shows that earnings estimates are “back-end loaded”, based upon an expected pick-up in economic growth after a very weak first quarter. This “hockey stick” increase in S&P 500 projected earnings results in a 17.8 times 12-month forward price-to-earnings multiple, “the highest since 2004, according to Thomson Reuters Datastream data.” Obviously if the strong growth in second half earnings fails to materialize, then the price-to-earnings ratio will be actually much higher.
Corporate profit margins are already very high, so for earnings to grow as forecast to meet the market’s already high valuation, economic growth will need to pick up. The first estimate of first quarter U.S. GDP will be released this Thursday, with the consensus calling for a small 0.7 percent increase.
Meanwhile, the strong stock market rally since February 11 is forecasting a pickup in economic growth, which is far from clear at this time as leading indicator data still show slow growth going forward (see table).
|Earnings growth or decline||-7.1%||-2.3%||+4.3%||+10.3%||+2%|
|Average U.S. GDP growth||+0.7%||+2.4%||+2.4%||+2.4%||NA|
|Leading economic indicators||Purchasing Manager Indexes (PMIs)||The Conference Board’s U.S. Leading Economic Index in March||Composite Leading Indicators (CLIs)|
|“U.S. Manufacturing PMI eases to its lowest for just over six-and-a-half years in April. Production volumes close to stagnation amid renewed slowdown in new business growth. Weakest rise in manufacturing employment since June 2013.”||March increased 0.2 percent, after declining for three straight months, which it said “still points to slow, although not slowing, growth in the coming quarters.”||Speaking of the first, third and fourth largest economies, CLIs “…continue to point to signs of easing growth in the OECD area as a whole. The CLIs continue to point to easing growth in the U.S., the U.K., and Japan, with a similar outlook now expected in Germany and Italy.”|
Diverging expectations for earnings growth and GDP estimates. 2Q, 3Q, 4Q GDP estimates: WSJ Economic Forecasting SurveyEarnings growth estimates: Thomson Reuters
Strong markets versus scant economic growth: what gives?
So what’s giving markets the fuel to run in a direction opposite from current negative earnings and weak first quarter GDP growth expectations?
First, concerns earlier this year about China’s potential hard landing seems to have eased, as credit growth there has been quite rapid in the first quarter. But high credit growth has raised concerns about China’s commitment to moving to a new economic model away from an investment- and export-driven one, renewed real estate speculation, and weakness in its corporate bond market, leading George Soros to once again sound his warnings about a China “hard landing” last week.
In this Sunday U.K.’s Telegraph article “China’s Fresh Boom Nears Peak as Amateurs Pile In,” Ambrose Evans-Pritchard, one of the world’s most well-known economic columnists, writes: “Elite global banks have begun to warn clients that China’s latest credit-driven boom is nearing its peak and will lose momentum by late summer, dashing hopes for a genuine cycle of fresh economic growth and commodity demand.”
The market’s other source of fuel is Fed chair Janet Yellen’s dovish March 29 speech, which was music to the market’s ears, and greeted with headlines like Reuters’ “Wall Street Rises as Yellen Pleases Investors”, Bloomberg’s “Yellen Outsources U.S. Monetary Policy to the Financial Markets,” and WSJ’s “Yellen Assures Markets on Interest Rates.”
The widely watched FOMC meeting starts today, and there’s no expectations of a rate hike, which is broadly expected at the June meeting.
So with currently negative earnings growth for the S&P 500 combined with what some bears would call high historic valuations, and currently still weak U.S. and global economic growth, where are investors headed?
Are investors being primed to re-enter emerging markets?
The explicit rationale since 2010 for the Fed’s ultra-easy monetary policies (its assets have increased five times since 2007 from that of the previous nearly 100 years combined) has been to force investors into more risky assets in a search for higher returns, i.e. from very low-yielding bonds into more risky stocks and junk bonds.
Recently investors have been piling into emerging markets; CNN’s Cash is flooding into emerging markets article says the flight into riskier emerging markets is being helped by:
- Commodity prices, which drive growth in emerging markets, have risen since February after plummeting the last two years.
- The Federal Reserve now expects to raise U.S. rates fewer times this year than previously thought. Higher rates tend to attract more money. So investors are seeking higher returns in riskier markets.
- The strong dollar is losing momentum while emerging markets currencies are bouncing back from a sluggish 2015. A strong dollar also makes it hard to pay back debt owed in dollars.”
“The trend is your friend”
With S&P 500 once again very close to its all-time high and highly valued, Bank of America-Merrill Lynch took the Fed’s bait last week and recommended emerging market stocks for the first time in five years, which seem more lowly valued based on consensus analyst earnings estimates.
One quick reality check of this — and any other investment idea for that matter– is to step back and look at a long-term “big picture” of the key long-term trends.
One very simple approach is to chart the ratio of security prices. In this case, the chart looks at the ratio of the S&P 500 broad market ETF [SPY] to the emerging markets ETF [EEM] (see right vertical axis). You can do this very easily on stockcharts.com, simply by putting “SPY:EEM” into the ticker symbol box (the chart shown below also changes other chart default settings).
Click on image to enlarge.
Notice that on this weekly chart over the past five years, the ratio of the price of SPY to the price of EEM has risen more than 100 percent.
Over the last five years, this price ratio has increased 126 percent (see left vertical axis), resulting in a huge outperformance for SPY relative to EEM. The key line on the chart is the red long-term moving average, which experts say is an important trend to focus on. Directionally, it is in a strong uptrend.
Some investors may try to anticipate whether that long-term uptrend in the “relative strength” or “momentum” of SPY versus EEM is about to change, that is what BoAML tried to do last week based on fundamental estimates. But many believe that “the trend is your friend,” and that it’s difficult to try to guess in advance when it ends. One possible approach is to try to combine fundamental and technical views, and invest when they are in sync.
The star of current bull market
In each major bull market, there is usually a few dominant asset classes, determining what they are as early as possible is a huge positive.
SPY has been the “cleanest dirty shirt,” to use the phrase of Bill Gross, since the beginning of Europe’s crisis in early 2010 and the slowdown in China starting in 2011. From 2003 to 2007, the best performing asset classes were emerging markets and real estate. From 1995 to 1999, it was technology assets, like those traded on the Nasdaq.
Investors with greater risk appetite exploring emerging market investments may want to consider the BRICS Building motif, up about 2 percent on one month performance and Asian Fusion, up about 3 percent on a one-month basis. Be sure to check out our recent “BRICS building a rally” post.
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