The Waiting Game

I read an interesting bit of trivia in a Barron’s article over the weekend. The article said that this Thursday “marks the day when the bull market that began in March 2009 will become the second-longest in history, at 2,607 days, topped only by the technology bull of October 1990 to March 2000.” Wow. That is pretty astonishing if you ask me. Everyone knew things were great in the 90’s, but this time it hasn’t felt so great. There are many, many individual and professional investors who are just not buying into this rally. Of course, it could be just shell-shock from all the volatility we’ve endured over the past 15-20 years. But I think there is another factor as well. Many investors simply are not seeing the fundamental support needed to drive stock prices sustainably higher. Instead, investors have been conditioned that the most important factor driving stock prices, one way or another, is the Fed’s posture with regard to monetary policy and interest rates.

The market action in the 1Q16 represented just the latest in a long series of developments that have demonstrated the Fed’s dominion over the capital markets. To say the least, we endured some serious volatility during the quarter. During the first six weeks of the quarter, stocks plunged over 10% as investors digested both the initial Fed rate hike (in December) as well as the central bank’s intent to raise rates an additional four times in 2016. During the course of that “correction”, estimates for 2016 S&P 500 earnings growth were still very respectable at +7.5%. Nonetheless, the selling became rampant and indiscriminate at times. Quite predictably, though, stocks experienced a V-shaped recovery as Fed members began to back off their prior projections for rate hikes. By the end of the quarter, stocks had made a complete recovery. What should be troubling to investors is that during that market recovery, expectations for S&P 500 earnings growth fell from +7.5% at the end of 2015 to just +1.1% as of April 22.

85d79ed6-912a-45a9-a911-ccb692fd4797Source: FactSet

Wall Street’s constant lowering of 2016 earnings estimates since December 31st warrants caution. A lot of pundits will blame the energy sector as the reason S&P 500 earnings in 2016 are now only expected to grow 1.1%, down from 7.5% at the start of the year. However, while energy is the main contributor, earning expectations have been revised down in nine of the ten sectors that make up the S&P 500, with the only outlier being Utilities, as the graph above shows. How can anyone suggest that this market is driven by fundamentals when stocks are rallying as earnings estimate drop?

Over the long run, earnings growth has been the most powerful predictor of stock prices as the price of a stock represents the present value of all future earnings potential. While we acknowledge that there is a dearth of investment alternatives to high-quality US stocks right now, an investment philosophy based on “TINA” (“There Is No Alternative”) is not likely a sound one. We see it as indisputable that the Fed, through artificially low interest rates, has created a stock market that cares less about fundamental drivers of stock prices. As I write, stocks yet again seem poised to reach record highs against the backdrop of falling corporate margins and earnings estimates. For the past few years, we have been waiting patiently for evidence of normalcy in the markets. By “normal” we mean that stocks prices react to earnings prospects rather than the level of Fed monetary largesse. We’ve suggested that a cautious, defensive posture is warranted until that time comes. The 1Q should serve as evidence that that day has not yet arrived. Our investment discipline is based on fundamentals and designed to endure markets declines. We never know what the future holds, but we are well satisfied with the quality and defensiveness of the companies in our portfolios.