Tuesday, November 10, 2015

3Q Financials Were Poor; 4Q Won't Be Better. What To Expect in 2016

Summary: 3Q financials have been predictably poor, with negative growth in both sales and EPS. Sales growth has been affected by a 50% fall in oil prices and 15% rise in the trade-weighted dollar. Both of those are likely to make upcoming 4Q financials look bad as well.

Of note is that overall profit margins expanded slightly, even with negative margins for energy stocks.

Looking ahead to 2016, at $45-50, oil prices will no longer negatively affect sales and EPS growth. Year over year changes in the dollar may also become negligible starting in 2016.

In fact, 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.

A return to 4% growth is not an unreasonable expectation for 2016.

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 in 2016.

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About 88% of US corporates have reported their financial results for the 3rd quarter of 2015. What have we learned?

Earnings: Large impact from oil price drop

Using figures from FactSet, EPS growth in 3Q is tracking minus 2.2% (year over year); sales growth is tracking minus 3.5%.  Both EPS and sales growth are poor.

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 nearly $100 in the 3Q of 2014; it fell 50% to an average of roughly $50 in 3Q of 2015.

As a result, EPS for the energy sector fell by 56% and sales fell by 36%, almost the exact same declines seen in both 1Q and 2Q.

There are 10 sectors in the S&P 500; 7 of the 10 saw a rise in EPS over last year. The energy sector is clearly an outlier, driven by the rapid fall in the price of a single commodity. The only other sector where profits were significantly lower was materials (data from FactSet).

It's useful to consider what happens to the S&P's sales and EPS growth once the year over year decline in oil prices becomes negligible. After all, the price of oil today is essentially the same as when the year started. Excluding the energy sector, 3Q15 EPS growth for the remaining 90% of the S&P rises to a respectable 4.5%. 

The point of excluding energy is not to imply that actual S&P results are better than they are. It's possible that energy will no longer be a drag on growth starting in 1Q 2016. By excluding energy companies' financial results, we can see what the underlying trend for the rest of the S&P is.

Earnings growth of 4.5%, excluding energy, is below trend: throughout 2014, the trailing 12-month average was about 8%.

Sales: Large impact from rising dollar

Sales growth in 3Q of 1.4%, excluding energy, is a significant drop from the trend: throughout 2014, the trailing 12-month average sales growth was about 4%.

In fact, although energy was the largest drag on 3Q sales growth, other sectors (utilities, technology, industrials and materials) also declined.

So, the drop in corporate growth was not just about lower oil prices. The largest factor affecting the rest of the S&P is the rise in the dollar; the lower value of trading partner currencies lowered revenues earned overseas. The value of the trade-weighted dollar rose about 15% yoy in 3Q (blue line; inverted scale).  That has had a predictably negative affect on revenues (red line; data from Yardeni).

Margins: Slight expansion

When EPS growth exceeds sales growth, it means that profit margins are continuing to expand. In fact, that is the case: average profit margins were 10.4% in the most recent quarter, a small rise from 10.2% a year ago.

Those margins would have risen more if not for energy. Energy margins have collapsed from 9% a year ago to less than zero. Margins for the other large weighted sectors were relatively unchanged, with the exception of technology, which rose 120 bp (data from S&P).

What to expect in 4Q and in 2016

The margins for the energy sector will remain low or negative in 4Q 2015: the average price of oil a year earlier was about $70 versus $45 today. Reflecting this, FactSet expects average margins, including energy, to fall to 10.1% in 4Q from 10.4% in 3Q.

If oil prices remain at current levels of $45-50, the impact of falling energy profits on total S&P EPS will become negligible in 1Q 2016. Profit margins might even expand, other things being equal.

Sales growth will continue to be weak in 4Q. The year over year changes in the dollar are still unfavorable for the roughly 40% of the S&P that derives sales from overseas (blue boxes). But that will also change for the better in 1Q 2016, as the dollar is now where it was a year ago (green box).

The relationship between currencies and relative interest rates and relative growth are complex. But it's noteworthy that the Fed is considering raising rates in December and that, historically, the first rate increase has been met with a fall in the dollar. Whether that happens this time, or even whether the Fed raises rates, is unclear. But an end to the appreciation of the dollar would likely return sales growth to trend (data from Credit Suisse).

Impact of valuations on SPX appreciation

Today, the consensus expects total S&P EPS growth for the full year 2015 to be flat. A year ago, the consensus had expected more than 10% growth in EPS this year, so expectations have fallen hard.

For 2016, consensus currently expects EPS and sales growth of 8.3% and 4.6%, respectively. This is probably too optimistic. Assuming flat margins, a more conservative estimate would be for EPS and sales to both grow at 4%. 4% is the nominal growth of personal consumption expenditures; it was also the trend in 2014, before the fall in oil and appreciation of the dollar.

In the meantime, reflecting low and uncertain growth, the S&P index is marking time. Year to date, the index has gained just 2%. The trailing 12-month P/E ratio is 18x, which is high relative to the past 10 years (the pop in P/E in 2009 was due to EPS falling). Even if sales and EPS growth returns to 4%, valuations are likely to remain a considerable headwind to equity appreciation.

How much of a headwind? For arguments sake, assume that valuations stay at current (high) levels. Also assume that margins remain relatively unchanged: better energy margins may be countered by the higher cost of labor and interest. The S&P may only appreciate by the rate of growth of sales, 4%, to around 2175 (green box). A drop in margins to 10% would mean that the S&P would gain only 1%. As you can see, a small 10 bp change in margins has high leverage, changing equity appreciation by 100 bp.

A 1x change in valuation has even higher leverage on appreciation. Using the same margin and growth assumptions, but assuming a drop in valuation to 17x from 18x, would knock growth down by 600 bp: 4% appreciation becomes a fall of 2%, to 2050.

Making a meaningful forecast is a challenge, since we don't know growth, margins or valuations. But we do know that current valuations are relatively high and that valuation has the largest impact on future returns, more than growth or margins. What drives valuations? In large part, its a function of sentiment, meaning a ramp up in bullishness could push the stock indices higher than might now seem reasonable (the reverse is also true; data from Yardeni).

In summary, 3Q financials have been predictably poor, and 4Q won't be much better. All else equal, 2016 should see a return to growth as the impact from lower oil and a higher dollar may become negligible.

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 in 2016.

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