Excerpted from Provident Investment’s June Investment Comments
After rebounding nicely from mid-February lows, the S&P 500 has been flat. The break from volatility has been welcomed, but investors would like to see share price gains. While there is good reason to believe the balance of 2016 will see progress, lack of earnings growth and elevated market valuation make the odds tougher for a significant market advance in the short term.
Let’s start with earnings growth. There have been several well-publicized factors that have made life difficult for companies: middling economic growth, the weak dollar, the collapse of commodity prices, particularly oil, and low productivity growth. According to FactSet, as of May 13, first quarter 2016 earnings for 91% of companies in the S&P 500 reporting to date have seen a blended decline of 7.1%. This is the fourth consecutive quarter of year-over-year declines in earnings and the largest year-over-year decline since the third quarter of 2009, when earnings fell 15.7%. With earnings in decline, any little movement in market sentiment becomes magnified, leading to two double-dip corrections since last August.
Sales growth has been a challenge a well. First quarter 2016 sales fell 1.7% for companies in the S&P, representing the fifth consecutive year- over-year decline. Slow global economic growth, coupled with the strong U.S. dollar, has made it hard for companies to get the top-line advances necessary to fuel earnings.
Declining earnings have made valuations look stretched. The forward 12-month P/E ratio of 16.6 is 15% above the 5-year average (14.5) and 16% above the 10-year average (14.3). It isn’t unusual for markets to run plus or minus 20% around averages, so there isn’t any reason to panic. However, with elevated valuations and no earnings growth, the market relies on expectations even more so than normal.
The good news is expectations point to better results. The energy sector has been a huge drag on earnings, declining 107% in the first quarter. Excluding energy companies from the S&P 500 yields a first quarter blended earnings decline of only 1.8% and positive sales growth of 1.2%. The price of oil has recently stabilized in the mid-to-upper $40 per barrel range, good news for energy companies as future earnings comparisons become much easier. Coupled with steady economic activity and a stable dollar, analysts expect growth for both earnings and sales in the second half of 2016, with earnings growing 1.4% and 7.5% in the third and fourth quarters, respectively, and sales growing 1.8% and 4.6%, respectively.
As long term investors, we advise against trying to time the market, even if valuations seemed stretched by today’s standards. Things are progressing as we had thought they would in 2016, with the strong dollar and weak energy prices both weighing down growth with a rebound likely in the later part of the year. The recent strengthening in the economy reinforces this view.