At the end of 2014 we explained why \u201cstocks are expensive, offer mediocre risk \/ reward.\u201d 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.<\/p>\n
Profit dynamics are poorly understood\u2014and 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\u2014far smaller, in most industries, than such items as labor, R&D, rent, taxes, depreciation, etc.<\/p>\n
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. <\/strong>With stocks trading at high valuations, weak earnings growth led to weak price performance.<\/p>\n Three Reasons Why Profit Performance Will Improve<\/strong><\/p>\n Although Street strategists do a good job of slicing and dicing S&P profits, one useful metric is being neglected: median EPS growth<\/strong>. S&P EPS is an index number reflecting aggregate profits<\/strong> 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 \u201cbig uglies\u201d such as XOM. I don\u2019t have the median EPS growth rate for the index, but I do have a decent proxy\u2014the median yr \/ yr EPS growth rate for 40 big companies spread across most industries. Here are the figures for the past eight quarters:<\/p>\n 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 \u201csideways correction\u201d we have had so far in 2015.<\/p>\n The two key headwinds to profit growth\u2014weak energy prices and the strong dollar\u2014are 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<\/strong>. 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.<\/strong><\/p>\n Europe is by far the most important foreign market for U.S. multinationals<\/strong>, 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\u2019s growth; it has been a huge distraction for policy makers. \u00a0It looks like the Greeks will get the depression they voted for.<\/p>\n 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.<\/p>\n Skip Ip \u2013 Monetary Hubris Is the Big Risk for Equities<\/strong><\/p>\n For the time being investors still expect low inflation which justifies high PE ratios. I don\u2019t expect this to change in the next six months, but risks are rising. Much of the econ fraternity is in the \u201csecular stagnation\u201d \/ \u201cdebt deflation\u201d camp, which supposedly justifies zero Fed funds seven years into an economic expansion. Exhibit A was the WSJ<\/em><\/strong> article by Greg Ip, \u201cMemo to Fed: Allow the Economy to Overheat.\u201d Mr. Ip thinks overheating would be beneficial because \u201cit 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\u2019 wages more effectively than a minimum wage.\u201d This is a great example of monetary hubris<\/strong>\u2014the notion that central bankers can skillfully steer the global economy, even though the Fed\u2019s forecasts have been wrong for the past six years. There are a few good reasons to skip Ip:<\/p>\n GOP Victory in 2016 Could Lengthen the Recovery <\/strong><\/p>\n The economic expansion has labored under Obama\u2019s 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.<\/p>\n Copyright Thomas Doerflinger 2015. All Rights Reserved<\/p>\n <\/p>\n <\/p>\n <\/p>\n","protected":false},"excerpt":{"rendered":" At the end of 2014 we explained why \u201cstocks are expensive, offer mediocre risk \/ reward.\u201d 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 … Continue reading \n
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