At the end of 2014 we explained why “stocks are expensive, offer mediocre risk / reward.” The weak 2.5% price rise so far this year is consistent with that call. But stocks should be stronger in the second half because profit growth will improve.
Profit dynamics are poorly understood—and not just by the media. Goldman Sachs and JP Morgan could use a tutorial as well (from the folks Deutsche Bank). When oil prices collapsed, some strategists claimed this would boost S&P profits, because energy costs would decline. That was dead wrong. The huge decline in profits of oil producers was not offset by energy cost savings in other sectors for the simple reason that energy costs are just not that important—far smaller, in most industries, than such items as labor, R&D, rent, taxes, depreciation, etc.
Because of this energy confusion, as well as the surprising strength of the U.S. dollar, Q1 2015 earnings were surprisingly weak, as was earnings guidance for Q2. With stocks trading at high valuations, weak earnings growth led to weak price performance.
Three Reasons Why Profit Performance Will Improve
- The Missing Metric
Although Street strategists do a good job of slicing and dicing S&P profits, one useful metric is being neglected: median EPS growth. S&P EPS is an index number reflecting aggregate profits of 500 companies. When giants like Exxon, Chevron, Citi, etc. post huge profit drops, it slashes overall S&P earnings. But this weakness hides decent growth at many companies that, frankly, are of more interest to investors than “big uglies” such as XOM. I don’t have the median EPS growth rate for the index, but I do have a decent proxy—the median yr / yr EPS growth rate for 40 big companies spread across most industries. Here are the figures for the past eight quarters:
- Q2 2013 5.7%
- Q3 2013 12.3%
- Q4 2013 15.0%
- Q1 2014 10.6%
- Q2 2014 12. 0%
- Q3 2014 12. 2%
- Q4 2014 11.7%
- Q1 2015 7.0%
Owing mainly to the strong dollar and weak oil prices, median EPS growth rate was much weaker in Q1 than the six prior quarters. But 7% is still a lot better than the 2% growth for the index as a whole. So the typical stock is becoming cheaper in the “sideways correction” we have had so far in 2015.
- Higher Oil Price, Stabilizing Dollar Are Positive for Profits . . .
The two key headwinds to profit growth—weak energy prices and the strong dollar—are becoming more profit friendly. Oil prices have climbed 27% since January; the dollar has declined from $1.05 / Euro to $1.11. If WTI oil stays at $60 / barrel, the yr/yr change in oil prices will improve from -53% in Q1 2015 to -44% in Q2, -39% in Q3 and +1% by the fourth quarter of this year. Similarly, if the dollar stabilizes companies will quit slashing guidance for earnings and revenues. The dollar could be up modestly yr/yr by Q1 2016.
- . . . and so Is Strengthening Growth in Europe
Europe is by far the most important foreign market for U.S. multinationals, accounting for around 15% of S&P profits. Economists expect GDP growth to accelerate from 0.9% in 2014 to 1.6% this year and 2% in 2016. This is a significant positive for profits. Arguably Grexit would be positive, not negative, for Europe’s growth; it has been a huge distraction for policy makers. It looks like the Greeks will get the depression they voted for.
As confidence in profit growth improves, so should stock prices. Using a forward PE of 17x and 2016 S&P profits of $131, look for 2200 on the S&P 500 by the end of this year, up 5% from current levels.
Skip Ip – Monetary Hubris Is the Big Risk for Equities
For the time being investors still expect low inflation which justifies high PE ratios. I don’t expect this to change in the next six months, but risks are rising. Much of the econ fraternity is in the “secular stagnation” / “debt deflation” camp, which supposedly justifies zero Fed funds seven years into an economic expansion. Exhibit A was the WSJ article by Greg Ip, “Memo to Fed: Allow the Economy to Overheat.” Mr. Ip thinks overheating would be beneficial because “it would help nudge inflation back to more normal levels, restore some of the long-term growth potential lost since the financial crisis, and boost ordinary workers’ wages more effectively than a minimum wage.” This is a great example of monetary hubris—the notion that central bankers can skillfully steer the global economy, even though the Fed’s forecasts have been wrong for the past six years. There are a few good reasons to skip Ip:
- Inflation is already moving to “more normal levels.” In the three months through May the Core PCE Deflator rose at a 1.7% annual rate, close to the Fed’s arbitrary 2% target. (CPI inflation since 1815 averaged just 1.4%).
- Weirdly, Ip forgets that inflation reduces real wages, so overheating would not “boost ordinary workers’ wages.” Commodity speculators would fare much better than workers.
- The real driver of wage growth is productivity growth, which would be hurt by higher inflation, as it was in the 1970s. It is much easier for companies to raise prices than increase efficiency.
- Overheating will cut short the expansion through A) rising inflation and bond yields, B) belated tightening by a behind-the-curve Fed, which would spook markets., C) popping of asset bubbles in venture capital, junk bonds, and elsewhere.
GOP Victory in 2016 Could Lengthen the Recovery
The economic expansion has labored under Obama’s anti-capitalistic, anti-worker, pro-DC policies. A Republican President who reforms corporate taxes, Obamacare, energy policy, etc. would boost business confidence, increase investment, and reduce inflationary pressures by expanding the supply side of the economy.
Copyright Thomas Doerflinger 2015. All Rights Reserved