Where are the earnings driving this market higher? This is the question we
pose for investors as we look out into the rest of 2016 and early 2017. So
far in 2016, we have seen the market show some gains just after the BREXIT
vote. The markets were scared to death of the unraveling of the European
Union, now it seems as if it really does not matter. Trade will continue,
companies will forge new ventures, etc.
The bears may have sharpened their claws, but they have still yet to use
them. Even in the face of political uncertainty in the U.S., so many
commentators on the idiot box have declared ruin to the stock markets. In
spite of this and BREXIT, the market as of this writing has moved to new
highs. Some of this can be traced to the seasonality of the stock market.
In fact the chart below shows the month of July has increased 70% of the
time over the last 10 years on average of 1.9%. However, August is
followed up by an average drop of -1.1% and drops nearly half the time.
This year may be no different. We will examine some additional charts
later in this Update to show the valuations of the markets are fairly
valued by all accounts but one or two. We will discuss those in more
detail a bit later.
If you have sat on the sidelines like Carl Icahn and George Soros who have
both shorted the market and bet against stocks, you may be licking your
wounds here a bit. However, a 5% move in the market higher does not create
a trend up. In fact, there is still plenty to be worried about, and only
earnings will ultimately drive the market higher. In light of these
anticipated earnings it is worth noting the market breadth of stocks
advancing vs. declining suggests markets have plenty of momentum to move
higher. However, we believe only earnings will accelerate the next leg of
the bull market. Look at the next chart and you can see earnings have
severely stalled and are indicating a slowdown in the market. Many will
say this is just Energy related, however, the S&P 500 through the second
quarter earnings releases have shown an overall -.8% decline in sales.
With the Year over Year earnings looking dismal, how can the market
possibly move higher? Great question. If you look at the chart below we
can see the market is overvalued by most accounts. Even Utilities which
have been on a tear and ran up wildly are now trading at a trailing P/E of
22.3x vs a Median of 14.7 back to 1990. I highly doubt Utilities are
growing at a 15-20% clip to keep these valuations for the near term. So
why are utilities trading at a P/E high? Simple, interest rates are low,
Why would one metric be so high and yet another so low? EV (Enterprise
Value) equals the level of debt a company holds + the Market
Capitalization of a Company. EV has averaged roughly 50% higher than
Market Cap over time. Today, stock prices have increased tremendously
while the price of corporate debt has not risen nearly as fast. Further,
this can be explained by the level of debt companies have taken on to
their balance sheets (or the market value of that debt). Companies are
cash rich and therefore have paid down debt, in turn making the company
look much more enticing. In addition, as investors have been driven to
purchase equities, especially those with some kind of dividend, the market
values have grown of those companies and clearly the debt levels have not
grown or kept up proportionately with the market capitalization of stocks.
Small Cap stocks look very similar, but the EV/Market Cap for small stocks
is at an 83% rank which suggests they are overpriced historically. This is
because Small Caps typically borrow more to keep up with their growth,
however, they look a bit overpriced as well.
So as the very first chart showed as well as the following chart,
earnings, which have stagnated, will be the next leg of this market if it
is to move substantially higher. We need to see corporate profits grow.
The main reason we have been so timid in our projections over the last
couple of years is we have seen a vast slowing of profits and sales.
Companies can only cut costs so much and then they need to drive an
increase in sales to get more money to the bottom line. From this
standpoint, we see the market finishing the year a few percent higher than
it is currently somewhere in the 2200 area.
With the second quarter behind us and having declines in earnings and
sales year-over-year in the S&P 500, many analysts have driven down
expectations to very low levels. Oftentimes the market reacts based on
expectations. With expectations so low it may just be easy to beat these
lower levels and thus drive the market higher. Any increase from here in
earnings should translate to a proportional increase in the market if we
lived in a "perfect market world." Since we do not, we should expect the
market to rise another 3% from this level into year-end. However, we
anticipate some turbulence along the way.
There is another way for the market to rise higher and by this standard,
much higher. If central banks continue to "print money", it could cause
inflation and in this market, a little inflation is not a bad thing. This
could potentially move the market much higher than it is today as
companies revenues and profits would accelerate. Not from the sale of
additional goods and services, but merely due to higher prices. We will
discuss this further next quarter if we see this coming to fruition.
The Archer Team
Troy C. Patton, CPA/ABV
Steven C. Demas
John W. Rosebrough, CFA
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