Company valuations have dropped roughly 15% on average globally in just two months. Has the world really changed that much?
Emotion can be a powerful influencer. It’s also contagious.
When the investment circle becomes vicious or virtuous, emotion reigns. Emotion is not only hard to control, it can also affect how we interpret real information about the economy or companies’ prospects.
Today, that emotion is fear. Fear is telling investors not to trust anything. Sell first and ask questions later. “Better to take a loss today and live for tomorrow” is the mantra du jour.
This is not to say there aren’t things to worry about. There are, and we at the Global Investment Committee (GIC) believe that the risk of bad outcomes has undeniably increased since December. However, we’re not as hysterical about actual developments as perhaps some others. What concerns us more is that markets have become a bit hysterical, and that’s had a very real impact on client portfolios.
To date, 2016 is absolutely the worst year on record for many, if not most, equity markets. The strange thing, however, is that no one seems to be able to pinpoint exactly why.
Go back to the beginning of year when we experienced a sharp sell-off on the first day of trading. The rationale back then was that China was devaluing its currency again, stoking fears of a hard landing for China’s economy and worldwide deflation.
Next, it was the Saudi/Iran conflict and the presumed death of OPEC, which led to a quick 25% fall in oil prices and further fears of bankruptcies in the oil patch and credit contagion to the banks. Then came concern about a US recession, as the manufacturing/industrial/energy profit slump was certain to spill over to the consumer. Finally, talk shifted to another banking crisis emanating from Europe, or maybe China, or even Japan.
In the melee, investors even sold stocks in leading companies with strong earnings reports. The bottom line is that we do in fact have a recession—it’s just on Wall Street, and it’s driven by fear.
As far as the fundamental data go, things have actually held up fairly well this year when talking about the economy and earnings.
Let’s start with the economy. The fourth quarter of 2015 was undoubtedly weak and came in at 0.7% growth. However, much of the quarter’s weakness was caused by an inventory drawdown; personal consumption remained okay. Meanwhile, the real-time first-quarter data look pretty decent, starting with the 151,000 jobs created in January. The US unemployment rate is now firmly below 5%, the official “full employment” level.
Second, the consumer remains confident and unfazed by the market turmoil. Sure, at the high end we’ve seen some softness and New York City real estate is starting to feel the effects—not to mention Sotheby’s and Tiffany’s—which Wall Street notices for sure. But the heart of America is doing better and holding up. So is spending, with January’s national retail sales beating lowered estimates and showing a nice acceleration to 3.4% on a year-over-year basis. Gas prices trump stock prices for most Americans and perhaps this dividend is finally starting to translate into better spending, rather than saving.
Finally, if you look at the Atlanta Fed’s GDPNow forecast model below, GDP has risen substantially in the past few weeks and currently predicts 2.7% GDP growth for the first quarter. This real-time forecasting tool has a pretty good track record of getting the number right, just like it did for the weak fourth quarter.
Right now it shows we are not in recession and the probability that we will be remains low, a view the Global Investment Committee shares.
Equity markets may react to economic data releases but what they really care about is corporate profits. Here, the score remains much like it has been. Just under half of corporate America is experiencing a profits recession and fourth-quarter earnings supported that view. However, more than half continue to show profit growth with stable margins.
What the fourth-quarter earnings season also confirmed is that things aren’t deteriorating to recession levels. Forecasts for 2016 earnings remain relatively stable for the S&P 500, falling approximately 2% since the beginning of the year—far less than the 10% decline in the index. For Japan, the disconnect is even more dramatic; 2016 earnings estimates for the Topix are down less than 1%, while the index was down more than 20% at its worst point last week.
So, how have average company valuations declined by approximately 15% globally in just two months? Has the world really changed that much?
We think it has changed at the margin somewhat, and uncertainty around China, oil prices, credit and central-bank potency has increased. But we’re not sure a wholesale 15% valuation reduction is justified, given the assumption that the economy and earnings look fairly stable and may actually begin to accelerate later this year, based on key leading indicators.
Finally, keep in mind that a weaker-to-stable US dollar could add significant upside to current S&P 500 estimates. The GIC believes that last year’s dollar strength subtracted close to $9 per share from S&P earnings, about 7%. Nevertheless, equity markets are unlikely to revalue significantly higher until there is more clarity around some of the uncertainties mentioned above, or the vicious cycle of fear subsides.