Earnings Season Review
So far earnings this season have been surpassing estimates, which is nice to see but needs to be viewed in the context of estimates that were quite subdued given the actual 2.9% contraction in the economy in Q1. The tough thing is that now the market is priced for perfection, which is a bit reminiscent of prom night expectations. According to data from Bloomberg, the S&P500 is trading around 17.4 current P/E and over a 16.2 forward P/E multiple, (translation – share prices for stocks in the S&P500 are about 17.4 times the current earnings) which is very much on the high side since 2007. This means the market is priced towards perfection. We’ve got some serious headwinds to these hopes with the geopolitical tensions, plus the ramifications of changes in Federal Reserve policy as now five Fed Presidents are pressing for not only the end of QE but also for a rate hike this year. July 30th we learned that not only did the economy grow much more in Q2 than expected, 4% versus 3% consensus expectations, but inflation hit 2.3% versus 1.4% in Q1. That inflation rate is above the Fed’s target, so concerns are increasing that the Fed will end up being behind the curve with respect to managing the impact of all this liquidity. In the QE world such good news for the economy can become bad news for the markets because, not only has the probability of getting cut off from more of that lovely QE addiction increased, but we are also more likely to get put on an exercise regiment with rising Fed fund rates as well! Although the Fed’s QE exit plan is likely to result in some increased volatility across asset classes, we welcome monetary policy inching ever closer toward normalization.
Then there is the political side. Throughout history, occasionally a seemingly contained, regional conflict can have unanticipated ripple effects that increase global tensions to such a point as to have significant economic and political impact. Thus it should come as no surprise that a Potomac Research Group poll of institutional investors found that “Global unrest from Ukraine to the Middle East has changed the mindset and investing outlook of leading investment professionals.” The poll of hedge fund, pension fund and money market managers found that nearly half believe foreign events will have a greater impact on the equity markets than domestic versus last year when 65.7% believe domestic events were more important. This is particularly troubling given that 88.6% of those surveyed believe that President Obama has been ineffective in dealing with foreign issues and incidents while only 5.7% said that the President’s foreign policies were effective. So far only 32% claim that recent geopolitical events have driven them into less aggressive investments, which means that more shifting could occur if perception of the risks worsens sufficiently. For full details of the poll go to http://bit.ly/WDQwgO
Bottom Line: Markets are priced for a goldilocks economy which while possible, is not likely. Most of what you can buy for your portfolio is priced pretty richly, but this seemingly ceaseless upward climb could continue for longer than anyone might imagine, putting traders in a challenging position. Do they choose safety, which may cost them participation in this powerful rally, or do they jump into the expensive end of the pool and risk losing in a pullback that will eventually come… the question is when. As we mentioned above, the early signs in stock and bond liquidity preferences are indicating that a pullback may come sooner than later.
