by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
- Correlations have plunged, leading to wider sector dispersions and a “cancelling out” effect on volatility
- Earnings are moving from a four-quarter recession to strong double-digit growth in 2017
- Forward valuation looks reasonable when looking through an inflation-filtered lens
Much ink spilled these days—including by yours truly—tends to be of the macro variety. This is for good reason as studies have shown that macro forces have been greater determinants of asset class performance than traditional underlying fundamentals. This was corroborated by high correlations among and within asset classes. But this has recently changed; and we’ve been arguing that traditional fundamentals like earnings, valuation and (as always) sentiment will be more dominant market drivers.
Volatility low, but for an interesting reason
Correlations have come down markedly, especially among sectors. In fact, one of the reasons why volatility has been so low is due to the “offsetting” effect. The spread between sectors’ performance has widened, which means for sectors displaying strength, there are offsetting sectors displaying weakness. Year-to-date we’ve seen strength in Technology and Consumer Discretionary in particular; which has been offset by nearly-equivalent weakness in Energy and Telecom Services. In essence, sectors have been washing each other out, resulting in suppressed volatility.
One way to think of it is that the market has gone from a “risk on, risk off” environment (with high correlations) to a “Trump on, Trump off” environment (with low correlations). And it’s not just the performance of sectors which has diverged—the spread between the winners and losers in terms of earnings growth has widened out.
Earnings: from recession to recovery
The chart below looks at the trajectory for S&P 500 earnings growth back to 2012 and including estimates for the next four quarters. From the earnings recession—which spanned four consecutive quarters and ended in the third quarter of 2016—earnings are expected to rebound back into double-digit territory in 2017.
S&P Earning Growth
Source: Thomas Reuters, Yardeni Research, Inc., as of February 9, 2017. 4Q16-4Q17 based on estimated earnings growth.
The chart below looks at quarter-by-quarter estimated earnings growth for the five quarters beginning in last year’s fourth quarter (its reporting season is still underway). As is abundantly clear, the turn in the energy sector from deep negative territory in 2016 to massive year-over-year growth in this year’s first half has been the largest contributor to the S&P 500’s earnings rebound.
S&P Sector Earnings
Source: Thomson Reuters, as of February 9, 2017. *Prior year’s earnings are negative.
Beat rates underwhelming
As noted, fourth quarter earnings (bottom line results) are still being reported, although we are through about 75% of the season. To-date, 68% of S&P 500 companies have beaten expectations, 11% have matched, and 20% have disappointed according to Bloomberg. That “beat rate” is in line with historical averages. The revenue (top line results) story is a bit uglier. Only 48% of companies have beaten expectations, while 52% have disappointed; decidedly worse than the historical average.
The three top sectors in terms of the beat rate have been Technology (87%), Health Care (80%) and Financials (76%). This is a perfect dovetail with our sector recommendations which have those three sectors as overweights. Bringing up the rear in terms of beat rate have been Telecom Services (25%), Utilities (33%) and Real Estate (47%)—which happen to be our three underweight recommendations.
Valuation reasonable on forward earnings
We’ve covered the E in the P/E equation. Let’s look at valuation in a bit more detail. There are myriad methods for valuing companies and/or the market overall and they tell very different stories at times—like today. Measures which take a long-term look back at earnings, like Shiller’s Cyclically-Adjusted P/E (CAPE), show the market as quite overvalued. However, measures which incorporate inflation and/or interest rates, like the Fed Model or equity risk premiums, show the market as fairly inexpensive.
Particularly at or near earnings inflection points—as we are now—I tend to focus on a traditional forward P/E, which is based on the next four quarters of earnings expectations. You can see a chart of this measure below. Yes, the current P/E is marginally above the 20-year median; but bull markets don’t tend to peter out near median valuations. The pendulum tends to swing wider at market troughs and peaks.
S&P 500 Operating Forward PE
Source: FactSet, as of February 10, 2017. P/Es are based on forward 12-month earnings.
An inflation “filter” is also appropriate to apply any time valuations are being analyzed. Clearly, a dollar of earnings you or I make is worth more when inflation is low as less of it gets eaten up by the cost of living. When inflation is high, our earnings are worth less. The same analysis can be applied to valuing corporate earnings. The table below shows that we are presently in the inflation sweet spot for valuations.
S&P Forward Inflation Valuation
Source: Bureau of Labor Statistics, FactSet, as of December 31, 2016. Inflation is y/y % change based on core CPI. P/Es based on forward 12-month earnings.
Corporate tax cut implications
I have one final note on a subject about which I’ve been getting a lot of questions. Although we believe enthusiasm should be curbed for a corporate tax cut in the near-term, the implications for earnings are potentially significant. Ned Davis Research (NDR) looked at what the tax benefit could be for the S&P 500 assuming a 15% effective tax rate—both with and without allowing interest expense to be tax deductible.
The biggest winners would be those sectors with the highest effective tax rates. Utilities, Materials, Consumer Staples and Financials all currently have effective tax rates above 28.5% and stand to benefit most. Those which would benefit the least are sectors which currently have the lowest effective tax rates: Health Care, Technology, Energy and Real Estate all have effective tax rates of 22% or less.
The sectors that would be impacted least by making interest expense non-deductible are Technology, Consumer Staples, Financials and Health Care. Those which would be impacted the most would be Utilities, Materials and Telecom Services as they are the sectors with the highest leverage.
Icing on cake of fiscal stimulus
In sum, the market’s march to all-time highs brought valuations up with it; but courtesy of better earnings growth ahead, valuations are not stretched to the extreme. My preference would be for the market to continue to take breathers—either in price or in time—in order to allow earnings to catch up to valuations. Positive caveat: the expected earnings trajectory highlighted above is exclusive of fiscal stimulus via some combination of tax cuts, regulatory reform and infrastructure spending. Anything on those fronts which get implemented this year would likely lead analysts to ratchet up their earnings expectations for 2017.
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