The Impact of Oil and the Dollar on 2Q Financials

Summary: 2Q financials have been poor, with negative growth in both sales and EPS. Sales growth has been affected by a 50% fall in oil prices and 15% fall in the value of trading partner currencies. Both of those are likely to make upcoming 3Q financials look bad as well.

Of note is that profit margins are still expanding for most sectors.

Looking ahead, perhaps the biggest wildcard is the dollar, which historically weakens after interest rates start rising. This would be a boon to the roughly 40% of S&P sales and profits that are derived from overseas.

Especially for their rate of growth, S&P valuations are high. Even if sales and EPS growth start to pick up, valuations are likely to remain a considerable headwind to equity appreciation.

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About 87% of US corporates have reported their financial results for the 2nd quarter of 2015. What have we learned?

Using figures from FactSet, EPS growth in 2Q is tracking minus 1.0% (year over year) versus an expected growth rate of minus 1.9% on March 31st when the quarter began; sales growth is tracking minus 3.3%, exactly as expected when the quarter began.

Although EPS turned out to be better than expected while sales met expectations, neither result is impressive as both are down from last year.

By now it should be no surprise that the energy sector has been hard hit by falling oil prices. The average price of oil was over $100 in the 2Q of 2014; it fell 50% to an average of roughly $55 in 2Q of 2015.

Companies Are Doing Much Better Than 1Q Financials Show

Summary: Companies are doing much better than 1Q financial figures show. Energy sector EPS has fallen 60% in the past year; for the remaining 90% of the S&P, EPS is growing 7.5%. Only energy has seen a meaningful drop in margins; among the other large weighted sectors, margins are either close to flat or higher than a year ago. If oil prices can rise to $70 by the end of the 2015, the year over year impact of falling energy profit margins on total S&P EPS will become negligible.

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About 70% of US corporates have reported their financial results for the 1st quarter of 2015. What have we learned?

Using figures from FactSet, EPS growth in 1Q is tracking minus 0.4% (year over year) versus an expected growth rate of 4.2% on December 31st when the quarter began; sales growth is tracking minus 2.6% versus an expected rate of 1.6%.

These are horrible results, right? Actually, companies are doing much better than these figures show.

It should be no surprise that the energy sector has been hard hit by falling oil prices. The average price of oil was roughly $100 in the 1Q of 2014; it fell 50% to an average of roughly $50 in 1Q of 2015.  As a result, EPS for the energy sector fell by 60% and sales by 33% (data from FactSet).

The Legend of Buybacks Outperforming The Market Has Outlived The Reality

There are two myths associated with stock repurchase programs (buybacks). The first is that companies with large buybacks consistently outperform the market; they don't. The second is that buybacks are responsible for most of the market's earnings growth; it's not even close to being the case.

It is true that buybacks are an important source of demand and that it has pushed the market indices higher. So it's noteworthy that the amount of money being spent on buybacks has been declining since the start of 2014.  That US equities have struggled to move higher over the past 5 months might well reflect, in part, the diminishing inflows from stock buybacks.

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One of the things that everyone knows is that the stock market has been driven by stock buybacks. So it's noteworthy that the companies doing buybacks have not been outperforming the S&P in the past 18 months.

For most of 2014, the S&P index (blue line) outperformed the buyback index (red line). So far in 2015, their performance has been exactly equal. Both have vastly underperformed the Nasdaq 100 (green line).

On Its Own, Declining Profits Are Not A Risk To Equities

The US indices have been struggling to produce gains for the past four months. In fact, the S&P is lower today than it was before Thanksgiving.

There are any number of reasons for this pattern but the one that is currently most often referred to is falling sales and earnings growth.

S&P 500 sales are expected to decline yoy in 2015 and EPS is expected to register only a very small gain (data in the next two charts from FactSet).

Why "Missed Expectations" Are Not What They Seem

Question: What do the following have in common: falling inflation, soaring bond prices, disastrous corporate earnings, plunging retail sales and "the worst US macro relative to expectations since 2009"?

Answer: The price of oil.

Crude oil prices have dropped 60% since June. This single event has wrecked havoc across a number economic and financial barometers. As a result, many are saying the US is headed into a recession.

Identifying The Correct Risk Associated With Weak Earnings

Even casual observers of the equity markets know that there is always a multitude of risks which threaten the advance of stock prices. It takes little effort to identify these. Focusing on the correct risk is trickier part.

Let's take corporate earnings as an example.

The French bank Societe Generale (SocGen) is warning clients that weak earnings is a leading indicator that the US economy is headed into an imminent recession. Here's their chart (EPS growth in red and GDP growth in blue).

2015 EPS Growth May Be Half What Analysts Are Expecting

US corporates have started reporting their financial results for the 4th quarter of 2014. So far, it looks horrible.

Bearing in mind that just 18% of the S&P has reported, this is how the quarter is tracking: EPS growth of 0.3% versus an expected growth rate of 8.5% on September 30 when the quarter began; sales growth of 0.6% versus an expected rate of 3.7%.

The question is whether these results indicate that the trend in earnings and sales growth is changing. The answer is no for sales but yes for earnings.

It should be no surprise that the energy sector has been hard hit by falling oil prices. The average price of oil was roughly $95 in 3Q; it fell 30% to an average of roughly $65 in 4Q.  The year-over-year fall is about the same. As a result, EPS for the energy sector fell by 24% and sales by 17% (data from FactSet).

Separating Facts From Popular (But False) Narratives

Investors are confronted on a daily basis with an array of confusing and seemingly contradictory information. Is the economy expanding or shockingly weak? Are corporate profits improving or just the result of tricky financial engineering? Are investors buying equities or is it all just driven by the Fed and other central banks?

The picture is much less confusing if you take a step back to look at the bigger picture. Below is some suggested reading to help separate the facts from the popular but often false narratives.

The economy is expanding at a slow but fairly steady rate. Demand is growing and so is employment. The biggest weakness lies in price: inflation has been falling. More here.

There's More To Share Outperformance Than Stock Buybacks

Stock buybacks have been grabbing a lot of headlines. Goldman estimates that buybacks in the S&P will amount to $600b in 2014, a 26% rise over 2013. And this comes on top of a 20% rise the year before.

S&P 500 Company Sales Are Accelerating And Margins Are Expanding

S&P 500 company results for 3Q were really very good.  Let's review and discuss what this means heading into 2015.

Sales grew 3.9% on a trailing 12-month (TTM) basis. That is as good as analysts had expected. What is impressive is that sales growth is accelerating: a year ago, growth was 120 bp lower (2.7%; data in the next three charts is from FactSet).

When 'Buy and Hold' Works, And When It Doesn't

Imagine if you had invested in the S&P 500 in 1984 and held through the tech bubble and crash and then through the financial crisis and its recovery. How would you have done over those 30 years? As it turns out, very well. On a real basis (meaning, inflation-adjusted), your holdings would have appreciated by over 400%.  A $100,000 investment in 1984 would now be worth more than $500,000.

Now, imagine that you had made that same investment only 30 years earlier, in 1954. You probably imagine that you did even better. The economy was booming in the post-war/baby-booming 1950s and 1960s and was well into a new bull market by 1984. As it turns out, you barely broke even. Your $100,000 investment was worth about $120,000 a full 30 years later.

The chart below looks at the appreciation in the S&P over a rolling 30 year basis since 1900. The line at 1984 shows the appreciation of an investment made 30 years earlier, in 1954. The end of the line to the far right, at 2014, shows the appreciation if you had bought 30 years earlier, in 1984.

Are Low Rates Responsible For High Valuations

Interest rates are low, so stock valuations should be high.  After all, a lower discount rate means that company cash flows are worth more; hence, a higher stock price. And the higher yield offered by equities makes them more attractive than low yielding treasuries, another reason to pay up for stocks.

This is a very common view.  And its bolstered by the fact than interest rates have been falling for 30 years while stock valuations have mostly gone higher. These two seem to be inversely correlated. There must be a cause and effect reason behind it.

So, is this view correct? The short answer is no.

The chart below looks at valuations versus 10 year yields. Current yields (2.3%) have been associated with valuations over 20x and under 10x. Interest rates were higher in the 1990s and so were valuations (orange dots). Valuations have been under 10x when interest rates have been over 10% and under 3%.  There is no discernible correlation between rates and valuations at all (chart by Doug Short).

Weekly Market Summary

The 2Q earnings season is over. Per Fact Set, earnings grew at 7.7% yoy and sales grew 4.5%. These are the strongest results in several years and, remarkably, they are coming when the bull market is already more than 5 years old.

The sales growth rate was particularly strong. Analysts had expected 3.7% in 2Q. The consensus forecast for 3Q and for the full-year are still for 3.7%; so, some moderation is expected.

The recent macro data supports growth of 3.5% to 4.5% in sales. But it shows a curious lack of accelerating growth after the winter slump.

Real personal consumption (PCE), which comprises about 70% of GDP, grew at annual rate of just 2% in July. There had been a post-winter pop to 2.5% in March, but the rate of growth has declined every month since then.

These figures are inflation-adjusted. Adding a 1.6-2% deflator yields a roughly 4% annual growth rate in nominal terms, equivalent to the sales growth rate expected for SPX in 2014.

Historically, A Decline In Earnings Caused P/Es to Spike Higher Than They Are Today

In a recent post, we looked at factors, including valuation, that will drive SPX returns over the next 12 months (post).

Since the late 1800s, SPX trailing 12 month (TTM) P/Es have been a median of 14.5x. In comparison, current "as reported" P/Es are 19x through 1Q14 (source).

19x is quite high. Between April 2005 and September 2007 - the heart of the prior bull market - P/Es never exceeded that level.

Yet, it's generally assumed that P/Es go higher than 19x (into the 20s) during bull markets. A look at the chart below seems to confirm this.

June 2014: What Will Drive SPX Higher in the Next 12 Months?

Last September we asked what fundamental factors could drive SPX higher in the year ahead (post). We considered three variables: sales growth, margins and valuation. Our conclusions were the following:

• Sales growth had been about 2% since 2011 but with better overseas growth could rise to 4% in 2014. 
• Margins were 9.5%, at 70 year highs, and were unlikely to expand further. Labor and interest costs were likely to become headwinds. 
• Valuations were average at 15.6x and an unlikely source of substantial upside potential.

Since then, SPX has risen about 15%. What has been the source of this growth?  The short answer is valuation.

• 70% of the gain is due to multiple expansion, which increased to 17.2x. Without this expansion, SPX would be near 1730 instead of 1910
• Sales accounted for only 2% growth (or 10% of the gain). 
• Margins expanded slightly, from 9.5% to 9.7%, enough to add 3% to growth (or 20% of the gain).

The question now facing investors is what will drive the market higher from here. The short answer is sales:

• Sales are likely pace index appreciation. The consensus of 3-5% sales growth is reasonable based on recent data.
• Margins have already flattened. Further margin expansion seems unlikely. 
• Valuation is now well above average. Even on generous assumptions, the market is above 'fair value' of 1900 for year end 2014 already. 

Let's take each variable in turn.


Sales growth
Sales growth continues to be the bright spot for fundamentals. Unfortunately, as we discussed in September, it has the lowest leverage on future returns of the three variables. Margins and valuations both have much higher leverage.

Trailing 12-month sales growth was 2.3% in 3Q13; that has moved up to 2.8% in 1Q14. The consensus is expecting 3.4% for FY14 and 4.3% for FY14. 3-5% growth is reasonable and also fits with recent macro data (post). Current growth is, it should be stressed, much lower than during the prior bull market and the forecast is for an acceleration during the 6th year of an expansion, which is unusual.

Popular Memes That Are Partially or Completely BS

As the US markets head higher, contrary evidence is being explained away in one fashion or another. This is part of a larger issue: popular memes persist despite evidence that correlations don't (or do) exist.

Not all stories are neat; the current bull market is no exception. Evidence that support different conclusions are always present. Better to acknowledge those differences in order to better understand how solid the foundation for the current market really is.

Below are just a few memes that have recently been popular that are partially or completely BS.


The late-1990s are a useful benchmark. 

Placing the Current Bull Market In Perspective

The current cyclical bull market is now second largest and third longest of the last 80 years. The current gain is twice the average for a cyclical bull market, and its length is almost 2 1/2 times the average.

The bull market of the 1990s (first on the list) is clearly in a completely different league; this is a theme throughout this post (data from Ned Davis).

As the data above shows, the rate of gain in the current bull market is among the highest ever. Since the end of 2012, the slope of ascent has become even steeper. This is similar to mid-2006 to mid-2007 (arrows).

September 2013: What Will Drive Equities Higher In The Next 12-Months?

This rally, which started in 2009, has now run 1640 days, which is well over double the average 'cyclical bull market' of the last 80 years (article). It is, in fact, the third longest cyclical bull market of the post-depression period. The percentage gain (140%) is also nearly twice the average and the third highest.

It is, in other words, the right time to ask what, if anything, will drive the indices higher before they instead head lower.

(Note: 'Cyclical' bull markets are distinct from 'secular' bull markets. A secular bull market (1982-2000) is generational and comprised of several cyclical bull and bear markets, each lasting two years on average (as above). Read further here or here. This post is only focused on the cyclical trend).

There have been two distinct stages to this bull market.

Stage One ran from 2009 to late 2011 and was driven primarily by fundamentals: strong sales growth and strong earnings growth (EPS doubled; sold blue line below). In Stage One, fundamentals outpaced the appreciation in the indices.

The second stage has run from late 2011 to the present. Fundamentals have slightly improved but Stage Two was overwhelming about the indices becoming revalued upwards. Since the end of 2011, less than 20% of the gains in the SPX can be accounted for by EPS growth; the remaining 80% has been multiple expansion. The chart below shows the rise in the trailing 12-month (TTM) PE; it has increased by one-third in Stage Two.

If fundamentals drove Stage One and valuation drove Stage Two, what will drive the next leg higher?

How Are Investors Positioned and What Does It Imply Now and in 2014?

If you are fully-invested long and in a profitable position, you would feel even more confident if you knew a majority of investors were in cash wanting to get into the market. This is an assertion heard frequently, but is this the case at present? A look at the data and the implications below.

Individual investors ('retail') are now more long equity (65%) than they have been since September 2007 (blue line, below). Their cash balance (18%) is 6 percentage points below average. Their holding of bonds (17%) is at a 4 year low. In short, retail investors are already in the market. Can they get even more long? Of course, but the point is we are not at the beginning of the cycle. Readers of this blog know that professionally managed funds are likewise positioned long equity, short bonds (here).

Moreover, investors are continuing to pile into equities. In July, fund flows into mutual funds and ETFs reached an all-time high, surpassing the highs from the tech bubble peak in February 2000 (data from Trim Tabs).

FY13 EPS: Growth Expected Where There Has Been None

With 97% of 4Q12 earnings in the book, S&P has FY12 EPS at $97, a 0.5% increase over FY11. For FY13, consensus bottom-up is $112 and top-down is $108. That works out to 11-15% annual growth. Their data is here.

To make matters more interesting, FY13 is not getting off to a good start: Factset reports that 77% of the companies issuing 1Q13 guidance, issued negative guidance, the highest rate of negative guidance since they started tracking in 2006. More to the point, 1Q13 EPS is expected to come in 0.4% lower.

In the first chart below, the 11-15% growth in FY13 EPS all comes after 1Q. What is impressive is EPS will have not grown at all in the prior 7 quarters.

Relatedly, year over year GDP growth this week was reported to be just 0.1% higher in the US; in Europe, it was 0.9% lower and the continent is officially in recession. Recall that half the earnings for $SPX is from overseas.

Despite this, SPX companies expect more than 3% growth in revenues. Which means that the growth in earnings is primarily margin expansion. But, as GS explains, margins have actually contracted four quarters in a row (second chart). Consensus nonetheless expects margins to expand to their highest ever.

Charts below.