UP, UP, BUT NOT AWAY

Factset’s weekly summary:

In terms of estimate revisions for companies in the S&P 500, analysts have made higher cuts than average to earnings estimates for Q1 2016 to date. On a per-share basis, estimated earnings for the S&P 500 for the first quarter have fallen by 9.0% since December 31. This percentage decline is already larger than the trailing 5-year average (-4.0%) and trailing 10-year average (-5.3%) for an entire quarter.

In addition, a higher percentage of S&P 500 companies have lowered the bar for earnings for Q1 2016 relative to recent averages. Of the 118 companies that have issued EPS guidance for the first quarter, 92 have issued negative EPS guidance and 26 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 78%, which is above the 5-year average of 73%.

As a result of the downward revisions to earnings estimates, the estimated year-over-year earnings decline for Q1 2016 is -8.4% today, which is below the expected earnings growth rate of 0.3% at the start of the quarter (December 31). Seven sectors are projected to report a year-over-year decline in earnings, led by the Energy, Materials, and Industrials sectors. Three sectors are predicted to report year-over-year earnings growth, led by the Telecom Services and Consumer Discretionary sectors.

If the Energy sector is excluded, the estimated earnings decline for the S&P 500 would improve to -3.7% from -8.4%.

Ex-Energy estimates were -3.6% YoY last week and -3.3% two weeks ago.

As a result of downward revisions to sales estimates, the estimated sales decline for Q1 2016 is -0.8% today, which is below the estimated year-over-year sales growth rate of 2.6% at the start of the quarter. Five sectors are projected to report year-over-year growth in revenues, led by the Telecom Services and Health Care sectors. Five sectors are predicted to report a year-over-year decline in revenues, led by the Energy and Materials sectors.

If the Energy sector is excluded, the estimated revenue growth rate for the S&P 500 would jump to 1.9% from -0.8%.

Thomson Reuters’ tally also shows a -9.0% revision to Q1 estimates although TR sees Q1’16 EPS down 6.7%, slightly better than Factset’s -8.4%. Energy EPS are expected materially worse but several other sectors also look considerably weaker than 11 weeks ago.

Trailing EPS are set to drop $1.50-2.00 during the first half per TR numbers. However, analysts keep the faith and see EPS rising 5.5% YoY in Q3 and 10.2% in Q4 bringing full year EPS up 2.3% to $120.50. FYI, note that Factet also sees full year EPS up 2.5% (to $120.91) but that S&P has them jump 18.0% to $118.57. S&P was the most conservative in 2015 dealing with so-called non-operating charges (see PICK YOUR FACTS)..

Corporate pre-announcements were a little more positive last week as 4 companies raised guidance against 3 reducing it. Overall, guidance is not materially weak or weakening.

The S&P 500 Index has gained 13.3% from its recent low even though earnings expectations have worsened and core inflation rose to 2.3%, up considerably from 1.8% last September and 2.0% in December. As a result, fair value per the Rule of 20 has declined from 2169 last September to 2110 in December and to 2084 currently, only 1.7% above current levels.

Note also that “fair value” (yellow line) is likely to decline further in coming quarters along with trailing EPS.

The Rule of 20 P/E stands at 19.2 up from 18.0 when I upgraded equities on Feb. 16. I then argued that a better risk/reward relationship had emerged adding that the collapse in Energy earnings was depressing Energy P/Es to 40, taking 2 full P/E points off the overall P/E after normalizing for these depressed earnings. Energy stocks have significantly outperformed the overall market in recent weeks, as have Materials as investors suddenly decided cyclicals were in.

There is much confusion on valuation at this point and I would be cautious using P/E ratios which can be shown all over the map based on which aggregator one uses and whether or not Energy EPS should be normalized.

We know a few facts however:

• Higher inflation is not positive for P/E ratios. The Fed wants higher inflation and there is increasing evidence that we are having higher inflation.
• Equity investors are generally turned off by declining earnings and this is what seems to be in store for another 6 months.
• Wage pressures are rising in less cyclical industries.
• While overall inflation is rising, Core Goods inflation remains negligible (+0.1% YoY in February). Meanwhile, Core Services inflation is +3.1% YoY.
• This combination of slow top line inflation, rising wages and services costs is pressuring profit margins, another potential P/E depressant.

Moody’s illustrates the declining rate of revenue growth with and without energy. In fact, the declining rate of revenue growth coupled with the rising rate of costs inflation means that the pressure on margins will certainly intensify in coming quarters.

Factset calculates that ex-Energy margins will decline to 10.0% in Q1 from a peak of 10.9% in Q2’15. That assumes that current estimates are met, rather than exceeded as usually happens so the 10.0% forecast is likely to prove low. Nevertheless, unless the economy revives rapidly, profit margins will likely decline for another 6 months.

Paban Raj Pandey, who writes Hedgopia (thanks Drew), argues that declining margins increase the risk of bear markets

In the chart, grey bars represent bear market in U.S. stocks.  Evidently, a sustained drop in the red line has not been good to stocks.

Hmmm…not that evident to me. I added the black arrows to show periods when declining margins did not lead to a bear market. I also see many bear markets with rising margins. In all, there is enough evidence on this chart to reject the idea that declining margins cause, lead or coincide with bear markets.

This is a highly volatile market. It has demonstrated solid resistance to decline below 1800, presumably because of valuations when equities reach that level. It has also had trouble around the 2100 level, for similar reasons.

Last week, equities easily traversed the 200-d. m.a. but the trend remains down, short and longer term.

• It must have to do with valuations since trailing EPS peaked in May 2015 and inflation troughed in September.
• It also must have to do with rising uncertainties:
  • Oil?
  • Inflation?
  • U.S. consumer?
  • U.S. dollar?
  • U.S. manufacturing?
  • Fed?
  • China?
  • Europe?
  • U.S. politics?
  • Brexit?

I honestly would not dare putting high positive probabilities to any of the above, except perhaps Brexit and the consumer. But even there, recent data leave me perplex.

Financial Sense follows a wide handful of US leading economic indicators (LEIs) and compile them into an index showing the percentage that are expanding or contracting to get a read on future economic growth.

As of February 2016, only 33% of the LEIs in our composite index are expanding with the majority (66%) showing contraction. The last time it dipped this far into negative territory was in the first quarter of 2008 at the beginning of the last recession.

Many of the LEIs are subject to revisions and may change in subsequent months; however, the current reading certainly suggests that the US economy is on a weak footing and close to a tipping point (note: ISM manufacturing PMI shown in red as a comparative benchmark).

The JPMorgan Global Services and Manufacturing PMIs are also resting right at the key threshold of 50 separating contraction from expansion. If both of these measures don’t pick up in the months ahead (and deteriorate further), expect market weakness to continue.

Hopefully, the economy will start to provide positive surprises, something it has not done for 2 years.

In reality, uncertainty prevails on most fronts. The Fed is a prime example as it just can’t make its mind up on the economy. No doubt its transparent ignorance is having an effect on consumers and investors alike.

As a result, like it or not, this is a trading market, at least until we get clearer trends on the economy, profits and inflation. I am not a big user of technical analysis but Lowry’s Research stands out by the quality of its data and the intelligence of its analysis. Its recent conclusion is a good way to conclude this analysis:

This is not a time for bold actions in the stock market. It is a time for observing the forces of Supply and Demand and making progressive changes to portfolios as the evidence emerges. Thus, any purchases based on the registration of Buying Control No. 1(A) should be focused primarily in highly liquid large-cap stocks.

I am keeping my 3-star rating but staying very choosy and income-minded. Any sustained rally from here would worsen the risk/reward equation when profit trends are shaky and inflation seems to be rising.