According to FactSet, S&P 500 earnings will drop roughly 8.3% in the first quarter. That’ll mark the fourth consecutive quarter of declines in corporate profits-per-share. Why might that matter? There are only two occasions over the previous two decades where earnings contractions lasted longer. In both instances, the U.S. economy experienced a recession; in both instances, the S&P 500 lost HALF of its value.
Does the current earnings malaise mean that history will repeat itself? No. On the other hand, there are always reasons for a slump in profits. Those who ignored the tech sector’s warnings in 2000 witnessed their portfolios disintegrate. Similarly, those who pushed aside the financial sector’s admonitions in 2008 experienced life-altering losses.
There is another reason why the contraction in corporate profits are a troublesome omen. Historically, declining earnings weigh on corporate confidence with respect to buying back shares. Extended periods of earnings contractions have led companies to sharply reduce their acquisition of shares in the past. The average pace of share reduction was a peak-to-valley slowdown of 62 percent. It follows that with corporations serving as the only significant buyer of stock at this moment – with retail investors, institutional investors, hedge funds, pensions as well as mutual fund managers participating as “net sellers” – we may be staring at the peak in the corporate buyback cycle.
The bullish counter-argument to the notion that companies may slash their buyback activity is the new corporate bond buying program by the European Central Bank (ECB). Specifically, the ECB’s willingness to buy non-sovereign debt – their eagerness to purchase company obligations in addition to country obligations – has the effect of tightening corporate credit spreads. In English, please? The cost of corporate borrowing around the world should move even lower. And if it does so, why… how can companies resist the urge to borrow more money to buy back more shares?
There may be some validity in the thought process. After all, look at the remarkable spike in Vanguard Long-Term Corporate Bond (VCLT) in the weeks leading up to the anticipated “bold-n-creative stimulus” by the ECB. It is almost as if buyers began anticipating dramatically lower yields (higher prices) for investment grade corporate bonds. (I know that I added to long-term corporates in the week leading up to the ECB’s March decision.
Unfortunately, however, the notion that ultra-low borrowing costs alone can provide everlasting support to a bull market is false. As I pointed out in earlier interest rate commentary, there were significant bear markets – stock bears in 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%), or 1946-1947 (-23.2%) – when the 10-year yield was low like it is today. In all four instances, the stock market was a remarkable bargain by comparison, trading at HALF the valuation levels of 2016. In two instances – 1939-1942 (-40.4%) and in 1946-1947 (-23.2%) – rates were low and the U.S. economy was booming.
Regardless of whether you wish to examine recent history, where decelerating stock buybacks peaked and sharply reversed course alongside contraction in corporate earnings, or whether you look for clues in the twenty year period of ultra-low borrowing costs (i.e., 1936-1955), where stock valuations were HALF what they are in March of 2016, history does not paint a pretty picture for stocks going forward. What about improvements in the technical picture? Hasn’t my favorite gauge of market breadth – the New York Stock Exchange A/D Line – demonstrated that the stock bull is back?
Not really. Not yet, anyway. At the moment, the A/D Line is bumping up against the same resistance as it did in the October-November period. The February-March bounce has more of the markings of a bear market rally than a true blue bull. Moreover, the downward slope of the A/D Line’s long-term trendline is more indicative of future volatility and bearish implications.
The same technical analysis uncertainty exists in popular ETFs like the S&P 500 SPDR Trust (SPY). The downward slope of the 200-day moving average is bearish. What’s more, the October-November bounce logged “lower highs.” The same appears quite probable for the current rally.
Additionally, there are plenty of technical signs that are rather disadvantageous for risk assets. For instance, one is only going to find 40% of individual stocks above respective 200-day moving averages. Similarly, in the immediate-term, Bespoke Research reports that two-thirds of S&P 500 stocks are overbought.
In sum, earnings are awful and fundamental overvaluation remains irksome. Also, corporate buybacks are slowing at a time when corporations are the primary support for low volume price appreciation. Most historical comparisons to similar circumstances are unfavorable. And the technical forecast is “cloudy with a chance of afternoon thunderstorms.”
If only the headwinds stopped there. Political uncertainty is also hampering risk-taking in equities. Does anyone truly believe that Trump and Sanders would be influential in the present primaries if the U.S. economy were “hunky-dory?” Voters do not vote to bring down the establishment unless they are disturbed by threats to their financial well-being.
Consider these realities: (1) Since the Great Recession ended, the percentage of Americans who own homes has FALLEN from 67.3% to 63.8%, (2) Since the Great Recession ended, real median household income has FALLEN from $54,925 to $53,657, and (3) Since the Great Recession ended, millions of 25-54 year old Americans are no longer working, as the percentage of people in the 25-54 demographic working has FALLEN from 83.5% to 81%.
In what prior economic recovery have wages decreased, the rate of home ownership decreased, and the percentage of working-aged individuals in the labor force decreased? None. In other words, economic weakness breeds political unrest; both are significant headwinds to stock price gains.
Perhaps the most disconcerting misrepresentation in the media is the headline unemployment rate of 4.9%. In reality, job creation in low-wage industries has not been able to keep up with the growth of the working-aged population. The Federal Reserve’s own Labor Market Conditions Index (LMCI) reflects the reality that the misleading employment data fails to capture the weakness in actual employment trends. It should be noted, in fact, that the LMCI is currently contracting.
It follows that if the Fed pays attention to its own LMCI, as opposed to the Bureau of Labor Statistics (BLS) headline U-3 data point of 4.9%, they may back off the rate hike train. My guess? They’re going to maintain their guidance of gradual stimulus removal. So they may not hike overnight lending rates in March. Yet they may do it in May or June. And that would likely come at a time when corporate profits will be set to decline for a fifth consecutive quarter.
Put on your safety goggles!
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