Seneca, the Roman philosopher and renowned Stoic asked, “What is harder than rock? What is softer than water? Yet hard rocks are hollowed out by soft water.”
This statement is testament to the power of persistence, a trait investors were rewarded for this month as the S&P 500 surged during the last half of February, to end roughly flat after a 6% decline earlier in the month. Year to date, the S&P 500 is down around 5%.
If stock prices waver between past and future expectations, history in the form of Q4 2015 earnings for the S&P 500 came in sloppy. The majority of companies beat expectations, although blended earnings declined-3.3%, and revenues declined by -3.9% from the prior quarter. Full-year 2015 earnings and revenues were down as well from the prior year (-0.6% and -3.6% respectively). Adding to the sour mood, companies issued downbeat guidance on earnings and revenue.
Is there any good news in this cycle? Yes, because the market seems to understand the underlying causes of the volatility, and investors are reacting rationally and orderly in response. No crash seems imminent under any stretch. The strongest factor continues to be the decline in energy prices which has seeped into the economy and given stocks their highest correlation to oil in over 35 years.
Oil’s decline has been felt in many places, including the industrial and material sectors benefitting from the North American energy surge, and financial institutions that lent to domestic and multi-national energy companies. The oil bust has also sent a signal to investors, directing the crowd to a defensive posture in utilities, staples, and telecommunication companies.
The recent tone, however, hints that stabilization could be in sight. Energy, materials, and industrials were top performers this month in equities, and the energy sector has been a middle-of-the-pack performer over the last 6 months after a horrific stretch for the last 2 years.
Since energy was the largest contributor to the earnings decline last quarter, if excluded, S&P 500 earnings would have been up by 2.6% and revenue growth up a modest 0.3%. Similarly, the energy-heavy emerging market benchmarks have been stronger in 2016.
Stabilizing economic numbers will help too, as revised U.S. GDP puts 2015 annual growth at 2.4%, with many economists projecting 2016 growth to be in the 2.0-2.5% range.
To summarize the vital signs that we saw: healthy sector and country rotation including baby steps towards commodity-linked constituents; positive earnings growth excluding energy; and the avoidance of a U.S. recession. Persistence may just be enough to get us through.
What Else Needs to Clear?
The high-yield bond market is another area of concern. Trading volumes are down nearly 35% from a year ago, the average bid price is down at least 10%, and the average yield-to-maturity is high by historic standards at over 7.5% above U.S. treasuries. Some of this is driven by potential defaults in the energy sector, whereas even unrelated industries are feeling pressure—or perhaps an overreaction by investors— as many companies borrowed freely under easier conditions.
Volatility aside, default rates for high yield bonds remain fairly low, around 3% (1.5%, if excluding energy) and are predicted to rise moderately. This is not an ideal picture, but the markets are functioning as debt and underlying assets change hands at a discount, allowing cleaner companies to emerge with funding capacity.
We have to remember that moderate losses can help clear markets and reinforce more prudent investment. Most importantly, we recognize that the fixed-income securities at issue are mostly “vanilla,” straight corporate bonds and loans that are secured or unsecured to varying degrees. The losses here go directly to the creditor. This is not the “Big Short” with esoteric products layered on derivatives and wrapped around a housing bubble.
Bull Markets in Perspective
There is no shortage of voices calling for the end of the Bull Run. Without question, more volatility may be in store even if the direction remains positive. What these calls for destruction fail to recognize is just how much ground was already lost after two successive bear markets in the early and late 2000s.
When using 10-year “rolling returns” that average the prior 9 years into each year, we see a clearer picture: the rolling return for U.S. equities is well under its long-term average going back to 1940. Having come off recent historical lows, the recovery may not be over. In the end, stocks feed off earnings, economic growth, interest rates, and substantial amounts of sentiment, but this view captures our present state using the Panavision lens of a full 75-year history.
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The above post has been excerpted from FMA Advisory Inc market update for February 2016
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