The markets are giving investors a rational reason to remain optimistic, but with investors' focus on the Fed's statement yesterday (and their interpretation of what they think it meant) seems to be clouding their vision.
The chart below shows the S&P 500's earnings per share (green line), which is what ultimately moves the stock market (blue line)higher or lower. Looking over the last three years, we've seen consistent, stable earnings growth. In early 2018, we can see the dramatic increase in earnings created by the new tax plan. More importantly, since the the tax plan went into effect, we can see a stable and steady increase in earnings has been maintained.
Source: Thomson Eikon Datastream
Interestingly, since the market peaked in late September, earnings have continued to grow, but the stock market has contracted sharply, and the S&P 500's forward PE ratio has dropped to 16 times earnings. Equity indices across the board are dropping into "corrections" (greater than 10% drop), and some are approaching bear market territory (greater than 20% drop), which is usually only experienced during a recession.
While market pundits are beginning to speak of recessions and long-term bear markets, their is nothing to support their claims. Because there isn't any economic data to support their position, many have turned to blaming the Fed, stating that the future path of rate hikeswill cause a recession and a bear market, seemingly oblivious to the fact that the Fed just communicated its belief that we are "near neutral rates,"(1) and that they have backed up their statement by announcing a reduction to their expectation of where rates should go this year.
Others are blaming a sharp drop in earnings; the problem is that earnings have not yet dropped, and are not forecast to drop. Thomson Reuters produces an earnings tracker for the S&P 500, and in their most recent data, earnings are expected to increase 15.9% in the fourth quarter of 2018 and another 5.6% in the first quarter of 2019. At first glance, the 5.6% growth in Q1 2019 may seem anemic, but considering the level of earnings achieved through the tax cuts, it's actually quite impressive. Further, growth is projected to increase to nearly 12% by the end of 2019. This is hardly the outlook of a recession or long term bear market.
Looking back over the last few years, this is not the first fear based reaction investors have been through. From July, 2015 through February, 2016, the S&P 500 was in a downturn. It corresponded with a drop in earnings that started in October, 2014. As we followed the data then, we observed that earnings we predominantly lost in the Energy Sector as oil (brent crude) traded down from more than $110 / barrel at the end of 2013 to less than $50 / barrel in 2015. Because a drop in oil prices is a natural stimulus to the rest of the economy (and stock market), the rest of the economy did well. The earnings and jobs that were lost in the energy sector were more than made up for in other sectors of the market, and both the economy and the market ultimately followed earnings in an upward path.
After a disappointing 2015, the earnings continued climbing and S&P went on to return 12% in 2016 and another 22% in 2017. The challenges the market faces today appear less challenging than what was faced in 2015. Despite various companies (and some sectors of the economy) facing headwinds from trade negotiations or other issues, earnings continue to climb.
Because it's hard to see in the chart above, we'll mention that long before the markets came under extreme pressure in October 2008, earnings began to erode, and in fact, provided more than 6 months of advance notice to the dramatic market drop in October 2008. Earnings actually peaked in June 2007 and fell steadily through the beginning of 2019.
Today, unlike 2007, we have yet to see a drop in earnings, or any other metric that would indicate a recession lays ahead. Rather, we are watching earnings climb while the stock market drops. The economic data also contradicts what the stock market is doing. Employment and wages remain strong. Consumer sentiment and consumption is strong. Consumers debt burdens are considerably lower than they have historically been prior to a crisis, and the list goes on.
Looking back to the first chart, and the impact earnings ultimately have on the stock market's price, investors who did not panic sell in February, March, and April were rewarded. We believe that will happen again. Looking to next quarter, if earnings continue their ascent, it is difficult to build an argument for why stocks would not rebound.
Please call us or email us with any questions.
