There is no expiration date on a market cycle, but this bull is starting to show its age. The S&P 500 Index is up a scant 0.2% through May 18, an impressive recovery from the 10% slump at the beginning of the year, but still short of the all-time high of 2,130.82 set on May 21 of last year. 2016 looks like a replay of 2015, a year in which the S&P 500 traded in a 12% price range before settling at a loss of 0.7%, or a slight gain of 1.4% when dividends are taken into account. Indeed, the market has traded within a range of 1,800 to 2,130 since the second half of 2014, failing on multiple occasions to break out of this territory. To paraphrase the immortal Bard of Avon, market action has been full of sound and fury, ultimately signifying nothing.
Whence this malaise? Put simply, the two drivers of market action – earnings growth and valuation – are providing little direction at present.
Corporate earnings are in retreat. With the first quarter reporting season now behind us, the aggregate operating profits of the S&P 500 dropped 6.5% from the prior year, the sixth consecutive quarter of year-over-year declines. Margins have contracted, from a cyclical peak of 10.1% in the third quarter of 2014 to a current level of 8.0%. Revenues are similarly in decline as companies find it difficult to increase unit volume sales or prices of their goods and services. The good news is that consensus expectations call for earnings to rebound in the second quarter of 2016, accelerating to a year-over-year growth rate of 38% by the fourth quarter. The bad news is that these forecasts likely tell us more about the innate optimism of Wall Street analysts than about the realistic path of earnings going forward. Hope springs eternal.
It is tempting, but inaccurate, to blame this recession in earnings solely on the energy sector. Clearly the collapse in energy prices has weighed heavily on that particular part of the market, but the pain is broader. Energy earnings slipped into a loss for full-year 2015, but materials and utilities also posted earnings declines. For the first quarter of 2016, seven out of 10 economic sectors in the S&P 500 reported earnings declines; only consumer discretionary and healthcare companies posted aggregate improvements.
If earnings fuel the market, we’re running on fumes.
To make matters worse, valuations provide little support. The math is simple: earnings have shifted into reverse while prices have held steady. That implies that valuations – at least as measured by the price-to-earnings ratio – have ratcheted higher. As of May 17, the S&P 500 trades at 20.9x trailing operating earnings. Whereas it is true that the market price should be based on discounted future earnings, we prefer to gauge broad market valuations on trailing earnings to avoid the bias of optimism captured in the consensus earnings expectations to which we’ve already referred. A price-to-earnings ratio of 20.9x is by no means in bubble territory, but as the nearby graph illustrates, that measure is above the post-war average by more than a full standard deviation.
This combination of declining earnings and lofty valuations does not necessarily spell the end of a market cycle, but it does imply that the market is hypersensitive to external developments and that the reaction to those developments – whether positive or negative – is likely to be magnified. This precisely defines a market with heightened price volatility but no real direction, and that is the world in which we live and invest.
The bad news is that we are likely in a prolonged period of market volatility, driven by little support from earnings growth or compelling valuations, and catalyzed by economic, global and political developments. The good news is that price volatility need not be the enemy of the disciplined and patient investor. In fact, it is precisely the volatility of prices that creates the opportunity for value investors to exploit the difference between valuation and price and therefore acquire fractional shares in companies with a margin of safety.1 It’s easier said than done, but this environment is likely to continue offering up opportunities to invest.
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1 Margin of safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of its intrinsic value.