Excerpted from the October newsletter from Provident Investment
As we said last month, low interest rates are consistent with underperforming economies worldwide. They are also consistent with high composite stock valuations. There could be room for stocks to rise further in 2016. Valuations, while elevated, are still within a range that is historically normal. This low level for bond yields, meanwhile, is unprecedented. For the historical relationship between interest rates and stock valuations to hold, yields have to go up, or stocks have to go up, or corporate profits have to come down.
We are seeing some evidence of higher interest rates, and stocks are enjoying a positive year. That’s two out of three. Analysts expect corporate profits to rise for the year, not drop, but we wonder whether those expectations might be a little too rosy. According to data compiled by FactSet, trailing-12-month corporate earnings peaked in September of 2014 and have declined about 1% per quarter since then. The biggest cause has been low energy prices, which walloped the earnings of energy producers and their suppliers, with additional spillover effects into the regional economies that rely on spending from energy workers.
Updated estimates now call for Q3 2016 to be another down quarter for composite corporate earnings. Analysts are banking on a strong Q4 to push full-year 2016 positive. They have some reason to be optimistic. Q4 is all about consumer spending, and conditions are ripe for people to spend, spend, spend this year. In favor of a strong consumer, we have low unemployment, low gasoline prices, low interest rates, and low levels of household debt. Bank of America CEO Brian Moynihan recently told CNBC that consumers are spending 4.7% more on Bank of America’s credit and debit cards compared with a year ago. That figure is ahead of national estimates for consumer spending growth and likely reflects a customer base that is doing better than the U.S. average, but it’s a very good number.
Two worries temper our enthusiasm. The first is spillover effects due to low energy and food prices. We track numerous retail companies who have started reporting softness in these regions. There appears to be a lagged relationship between lower commodity prices and lower consumer spending in regions that produce them. It takes time for companies to realize they need to reign in wages and cut jobs; then it takes more time for those cuts to show up in the aggregate behavior of consumers in those regions.
Our other concern is due to a long-term shift in consumers’ holiday season spending patterns. Retail sales have become less compressed in recent years, with a lower fraction of annual spending pinched into the period between Thanksgiving and Christmas. Assuming this shift continues in 2016, it will cause forecasting error in models that take last year’s Thanksgiving-to-Christmas spending as a baseline. The difference between 4% growth expectations and, say, a 2.5%-3% reality would be enormous. If the consumer blinks, Q4 performance may not be strong enough to get composite earnings growing again in 2016.
Meanwhile, low bond yields have created a mania for dividend stocks, as armchair investors gravitate toward anything that will pay them a regular income. Many reluctant equities investors are deciding that blue chip stocks may not be so risky after all. That’s what 13 good years out of 14 will do for the market. In fact, many might seem appealing at yields of 3% to 3.5%, but with little or even negative growth. Where is the threat? As growth investors, we are feeling left out in the cold because growth stocks rarely pay dividends. Yield stocks currently trade at valuations about 20% higher than growth stocks. This is the inverse of the historical relationship between income and growth stocks.
Luckily, investors don’t have to settle for the whole market. They can pick and choose companies whose earnings are growing.