January’s 3% decline in the S&P 500 is consistent with my observation on December 30 that “Stocks Are Expensive, Offer Mediocre Risk / Reward.” The main issues are:
- Investors and strategists have become bullish and complacent; they were far more bearish two years ago, when stocks were cheaper.
- Stocks are rather expensive versus history given that we are late in the cycle when profit growth is fairly weak. (See the Dec. 30 post for details.)
- Tighter U.S. monetary policy is somewhat negative for stocks. QE has ended and the Fed will likely raise rates later this year.
- Most foreign economies, which account for 35-40% of S&P earnings, are weak, including Europe, Japan, China and many other emerging markets (Russia, Brazil, Africa, the Middle East). The EU-Greece standoff and rise of extremist political parties elsewhere may hurt business confidence in Europe.
- The oil price plunge hits S&P earnings hard. Energy companies’ earnings (11% of earnings in 2014) will collapse this year; suppliers such as CAT also take a hit. Contrary to what some observers believe, these effects are not fully offset by the benefit that certain companies get from lower energy prices, via lower costs (notably transports) and more discretionary spending. Said differently, a plunge in oil prices transfers income from the corporate sector to consumers; consumers save some of the money and spend much of it with non-S&P 500 companies.
- The strong dollar is hurting earnings, and this may get worse. Looking at the average level of the monthly Fed Dollar Index, it was up 5.3% y/y in Q4 2014. If it stayed at January 2015’s level in February and March, it would be up 8% y/y in Q1 2015. If the dollar strengthens this year its average level could easily be 10-12% above 2014.
My impression from reading Street research is that Q4 earnings were subdued but about as expected, with Apple’s huge beat offsetting weakness elsewhere. Consult your local strategist for details. The Street is split on 2015 earnings, with some smart people still at $127 and others at only $120 (versus about $118 in 2014). Given the factors discussed above, I suspect the bears will win the argument.
There are, however, a couple of extenuating circumstances that may mean stocks can rise modestly this year despite flattish profits, much as they did in another year of commodity deflation, 1998. Energy stocks are valued on “normalized” earnings not current earnings. Investors will to some degree “look through” profit weakness caused by unfavorable currency translations, which affect reported profits but not underlying cash flows. Furthermore, dividends should grow at a double-digit pace in 2015; a 2% yield on stocks looks attractive versus bonds.
Bottom line: the S&P 500 should rise 5% this year, delivering a total return of 7%. Not bad when 10-year bonds yield 1.6%.
The Starbucks Effect
SBUX traded up 7% on in-line Q4 earnings because same store sales were stronger than feared. The bear case, which had been weighing on shares for the better part of a year, was disproved. Probably lower energy prices helped here, as consumers decided they could afford one more caramel macchiato low-foam extra hot latte. This will probably happen to other high-quality consumer companies. But avoid names, like Tiffany, that sell a lot to foreign tourists impacted by the strong dollar.
Copyright Thomas Doerflinger 2015. All Rights Reserved.