Excerpted from the April 2016 Provident Investment Management newsletter
The S&P 500 spooked investors by dropping 10% in the first three weeks of 2016. After seven straight years of positive total returns for the S&P, it looked like the jig might finally be up this year. However, the index has rallied sharply, starting in early February, and is now approximately flat on the year. Whether 2016 makes it eight positive years in a row for the S&P now looks like a coin flip. Considering the sorry state of corporate earnings, this performance is remarkable.
We often say that corporate earnings are the fuel that feeds the stock market. Lately, corporate earnings have weakened significantly, but the stock market doesn’t seem to care.…
What could explain investors’ saintly patience with the stock market? We can think of a few possibilities. The first has to do with the distribution of the earnings declines, which have been concentrated mainly in energy and materials stocks. These companies typically carry lower valuations because their performance is so volatile. Those low valuations mean that pound for pound, cyclical companies’ earnings have less price impact on the overall averages.
The second explanation, related to the first but even more arcane, is an artifact of how composites deal with negative earnings.…
A third reason is low interest rates, which support high stock valuations. Numerous central banks, including Japan’s, Switzerland’s, and the ECB, are currently imposing negative interest rates on excess bank deposits. The U.S. Federal Reserve is safely positive and recently increased its interest rate for the first time since 2006, but Janet Yellen has pointed to negative interest rate policies around the world as grounds for the Fed to be patient with future hikes.
Then there is inflation — or do we have deflation? And which one is better for the stock market? Nobody knows. Inflation is tricky. Historically, the relationship between stock prices and inflation has been a tendency for stocks to rise in anticipation of coming inflation, but then fall on the news that measured inflation has risen.
Stocks like inflation in the future, but they don’t like inflation in the present. If that relationship seems hard to process, don’t worry because it might not hold anyway in the current environment. However, if that historical relationship does hold, then higher stock valuations could signal coming inflation, which would be consistent with a variety of other data, including a strong U.S. economy, an increasing CPI, which is rising at a rate close to 3% ex-food and energy, as well as the surging price of gold — up 16% so far in 2016. There has been a mysterious lack of measured inflation during the past decade, as easy-money policies have not resulted in the higher price levels that economic theory predicts. It seems that floods of cheap money have been almost totally offset by massive consumer deleveraging (paying off debt rather than borrowing more at lower interest rates). Increasingly stringent banking regulation, a soggy world economy, and aging populations in rich, western countries all contribute to this deleveraging trend.
Finally, let’s remember that the stock market reflects expectations about the future, not the past. Maybe the simplest explanation for why U.S. stocks remain robust is that investors remain bullish on the future of the economy. That seems counterintuitive, especially with the national media currently being dominated by a gaggle of presidential hopefuls cynically complaining about the (supposedly) sorry state of our great country. Meanwhile, investors are voting with their dollars every day, and despite a rough patch for earnings right now, they continue to vote for corporate equities.