With the dollar and oil acting more favorably and manufacturing data improving, could we see an earnings rebound in 2016?
While the US economy has avoided an economic recession in the past few years, it has not been able to avoid an earnings contraction. As a result, 12-month forward earnings-per-share estimates for the S&P 500 have not grown for almost two years, stuck between $120 and $125 per share.
Much of this stagnation is the direct result of two variables—a stronger US dollar and lower oil prices. Now, both the dollar and oil appear to have stabilized and are moving in the opposite direction of their previous trends. These reversals should remove a headwind and even create a tailwind to earnings for the rest of 2016.
For investors, this means that we can finally have some confidence that this earnings season will mark the trough quarter in terms of year-over-year growth. Earnings are the ultimate driver of stock prices, and their recovery may allow stock prices to break out of the range in which they have been stuck for two years. The chart below illustrates how this trough has been perpetually pushed out over the last year starting as far back as the second quarter of 2015.
In making this call, I feel a bit like the boy who cried wolf. But with the dollar and oil acting much more favorably and the manufacturing data improving, I must say that my confidence is quite a bit higher than in the prior two or three quarters when we had a similar set-up.
Besides earnings, the other variable to consider is valuation and here, too, I am feeling a bit better about the potential upside for equities than just a few months ago. While longer-term growth concerns are still weighing on valuation metrics, looser financial conditions—and tighter credit spreads, in particular—are helping.
Since the Feb. 11 market lows, central bankers around the world have stepped in aggressively to calm the waters—and it’s working. Financial conditions have returned to their most supportive levels in more than a year while credit spreads have retraced more than half of their widening. The net effect is that corporate bond yields on Baa-rated industrials have fallen more than 65 basis points since their highs in mid-February. As the key discount rate for equity prices, this has had a material effect on “fair value” for stock prices. The chart below illustrates.
Granted, the fair value calculation is a function of both corporate borrowing costs and earnings. Therefore, the fall in rates will be for naught if we are wrong about corporate earnings troughing this quarter. However, if we are right, and earnings start to rise, the fair value will rise even further and support the higher prices we foresee later this year. This is why the next few weeks will be so critical to whether stocks can break out of this range or if we need to wait another quarter.
Either way, stocks are not wildly overvalued as some commentators have suggested, at least not under the current financial conditions. Given the Fed’s new self-imposed triple mandate of employment, inflation and now, stable financial conditions, that is worth considering for equity prices.