In the first two trading days of 2015, the market fell 1.9%. I believe the pullback was caused by the market's somewhat-belated realization that 2015 earnings estimates have been reduced massively in the past six weeks.
As I've written before, I always believed the consensus estimates for 2015 S&P earnings were too high and the market is finally catching up. There is more downside, as energy EPS estimates will have to keep coming down with oil under $50 a barrel and natural gas under $3 per million BTUs.
But it's not just the drillers. Watch out for earnings weakness among other sectors as well. Banks will suffer from the continuing flatness of the yield curve as the 10-year Treasury note closed with a yield of 2.04% Monday. Net interest margins are compressed when long rates go down and if the Federal Reserve really does hike short-term interest rates in the first half of 2015, as the consensus is indicating, (I believe the first rate hike will come later in the year), that will lead to further net interest margin compression.
Also, the raging strength of the dollar is not good for U.S.-based multinationals, as foreign profits must be translated into a stronger dollar. The dollar's strength indicates the market's belief that the rest of the developed world is in an economic funk (I can't disagree with that) and is a negative for emerging markets, as the relative weakness of their own currencies makes it harder to justify local currency/local market investments.
So, I believe 2015 estimates are too high, as I thought about 2014.
As of this writing (the last FactSet earnings update was on Dec. 19 and I am eagerly anticipating the next issue) 2015 EPS for the S&P 500 are estimated to grow 7.9%. This is a significant reduction from the 11.8% growth envisioned as of Oct. 3, but, again, because of the headwinds I mentioned above, I believe the consensus estimate for S&P 500 earnings for 2015 is still too high.
I made the same call at the beginning of this year, and I was right. On Jan. 3, 2014, the consensus held that S&P 500 EPS would measure $119.83 for 2014. As of the last update, as shown in the graphic below, the estimate had fallen to $118.27. So, the estimate didn't rise during the year, but the market certainly did. The S&P 500 posted an 11.39% total return in 2014.
And that leads me to my key point: the move in the S&P 500 in 2014 was ENTIRELY driven by multiple expansion. The P/E on Jan. 3, 2014 stood at 15.3x and by mid-December it risen to 17.5x. The market is paying more for each unit of earnings growth and I do not believe that behavior is sustainable as we move through 2015. A 17.5x multiple is well above recent and historical average valuations.
At some price level, any asset gets too expensive to generate a fair return and I believe we have already passed that point on the S&P 500. The index is simply going to have to be re-priced for lower earnings estimates and a more normal multiple by historic levels.
So, there seems to be a rule of thumb among market pundits that 15x is still cheap and 16x is starting to get expensive. I'm going to haircut the earnings estimate further (it will happen) to $124.50 (which would imply 5.3% annual growth vs. 2014) and split the difference vs. the rule-of-thumbers. So, 15.5x times $125 yields my Portfolio Guru fair value estimate for the S&P 500 for 2015 of 1,930. We're still 5% above that, so I'm not buying the market.