OCEAN CITY — Company earnings are an essential factor for long-term equity market performance. According to FactSet, S&P 500 companies, on aggregate, have reported two consecutive quarters of declining year-over-year growth, with the first quarter of 2016 expected to extend the streak to three. The deteriorating trend has been attributed to numerous factors, such as a lack of global and U.S. economic momentum, a stronger U.S. dollar, and falling commodity prices, and has raised concern that the equity market may be overvalued. Given this backdrop, there is reason for caution.
Yet, some contributors to the earnings weakness have begun to fade, raising hopes that this quarter will mark the trough for earnings growth. The U.S. dollar, down 4.1% year-to-date (through March 31), should give multinational companies a boost by way of currency translation of sales over the coming quarters, since non-US sales of S&P 500 firms make up about 40% of total sales. Meanwhile, commodity prices, up 0.4%, led by oil, may improve the outlook for the Energy sector, which has been a major drag on earnings.
Past performance is no guarantee of future results. Equity markets are not cheap The price-to-earnings ratio, a traditional valuation measure for the equity market, is the price level of the S&P 500 divided by its constituents’ aggregated earnings per share (EPS). It fluctuates according to investor sentiment regarding the level and certainty of profits of the index’s members. The worry is that the equity market, at nearly 19 times earnings due to the deteriorating earnings picture over the past two quarters, has become expensive. The index’s price has diverged from its earnings. The historical long-term average for the market’s P/E ratio is 16.6 times.
Earlier this year, we noted that stability in key risk areas we call “the four Cs” — China, commodities, credit and consumers — helped ignite a risk rally that continued throughout the rest of the first quarter. From the market bottom on Feb. 11 through March 31, the MSCI All Country World Index rose 13.0% and oil prices rose 46.3%, while Investment Grade and High Yield bond spreads tightened 51 and 182 basis points, respectively. During this period, markets priced in a diminishing likelihood of a recession in China or the U.S., the prospect of improving in supply/demand imbalances in oil markets, and a continued dovish stance among global central banks.
These factors imply increased confidence that earnings growth will rebound later in the year. Consequently, the S&P 500 rose 13% in the same period, increasing its P/E ratio from 16.5 times (below its 10-year average) to 18.8 times.
Low expectations set up for a beat, but will it matter? Near-term, according to BofA Merrill Lynch (BofAML) Global Research, analysts have slashed first-quarter earnings estimates by 9% since the start of 2016, more than double the typical 4% pre-EPS season cut and the most extreme three-month cut since the first quarter of 2009. The largest cuts have been in the Energy and Financials sectors. Meanwhile, the best projected earnings are expected to be in Telecom (13% year-over-year growth), Consumer Discretionary (9%), and Health Care (6%). The worst performers are forecast to be Energy (-104%), Materials (-20%), and Financials (-12%). On aggregate, firstquarter S&P 500 earnings are expected to fall 9.1%, but only 4.5% when excluding Energy. Should earnings contract in the first quarter, it would be the third consecutive quarter of year-over-year contraction. Sales growth may also be a main focus this quarter. According to FactSet, Wall Street analysts expect a slight drop of 0.3% from the same quarter a year ago and for growth to increase by 2.4% excluding energy. However, these estimates seem too low, given that early reporting companies have beaten their earnings and sales estimates 63% and 60% of the time, respectively. While the likelihood of a better-than-expected earnings season is significant, markets may have largely priced in the result, according to BofAML Global Research. What does this mean? Key to this earnings season should be the tone of companies’ earnings outlooks and whether there is more evidence that improved and sustained economic and financial conditions will translate into a rebound in sales and earnings trends in the quarters ahead.
A reversion to earnings growth would alleviate concerns of the market’s high P/E ratio, while improved economic and financial conditions would provide a clearer earnings outlook, allowing for the ratio to increase. The consensus expects these events to occur, but we see formidable risks in the outlook and, as a result, anticipate episodic market volatility. Economic weakness persists both domestically and globally.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)