Last week, the markets were bobbing and weaving like Muhammad Ali's butterfly, with the S&P 500 and the Dow Jones Industrial Average managing to close above their 50-day moving averages for the first time in 2016. In contrast, China's markets plummeted, with the Shanghai down 4.2%, which brought its year-to-date decline to nearly 22%. By comparison, domestic indices have rebounded, but still remain in the red on a year-to-date basis.
For the Growth Seeker portfolio, it was a bang-up week with all of our positions handily beating the market over the last few days. To give you an idea of how well the positions performed, the weaker ones included Amazon (AMZN), up 3.8% last week, and Under Armour (UA), up 3.9%. We've been keeping our powder dry for the most part in 2016, but this week we scaled further into B/E Aerospace (BEAV) shares following solid results at Airbus that boosted its aircraft production levels and backlog that easily spans several years.
With earnings season nearing a close, we can see that profit margins are being squeezed, down to 16.9% from 19.6% during the mid-2013 peak, for non-financial companies. More importantly, we are in a full earnings recession, with the blended earnings decline for 4Q 2015 (according to FactSet) at 3.3% for the third consecutive quarter of year-over-year declines in earnings, the first such sequential decline since the Great Recession. U.S. GDP may not be in a recession, having been revised up to 1% vs. the prior 0.7% estimate and 0.4% revision expectations, but investors pay for earnings, not GDP. Looking forward, for the first quarter of 2016, 88 companies have issued negative EPS guidance while only 22 have issued positive guidance.
We've been holding onto a lot of cash because we believe there is a reasonable probability we will have a chance to buy at lower prices than today based on our analysis of earnings going forward vs. typical valuation cycle moves. The average price-to-earnings multiple at the trough of a corrective phase is 12.4x on trailing earnings and 14.7x on forward earnings. Consensus estimates around earnings for the S&P 500 in 2016 are $120 and, in 2017, $135. This gives a potential lower range of around 1480 to 1980. Given the slowing global outlook and increasing headwinds, we think consensus EPS for the S&P 500 is probably a bit overstated, so the lower end of that range is more likely.
Despite the recent rally, which in part can be attributed to short covering, many of the fundamentals that have been pushing equities down still remain:
-- Friday morning S&P 500 futures peaked right around when oil prices peaked, giving evidence that the tight correlation between equities and oil still remains. With Saudi Arabia's comments last week that no output cut is in the works for them, stability in oil prices is still unlikely until we see material levels of production capacity taken offline with the associated defaults and bankruptcies.
-- Waiting on the other oil shoe to drop. Despite the rebound in oil prices, let's remember we have yet to feel the full impact of the oil price drop. Comments from the CEO of Devon Energy (DVN) imply most U.S. shale producers need $55-$60 oil to work and we're beginning to hear about more oil-related layoffs as Halliburton (HAL) cut another 5,000 jobs, following up on cuts of 4,000 jobs in the December quarter. Meanwhile, Wells Fargo (WFC) has set aside $1.2 billion for potential oil and gas sector loan losses as different forecasts suggest up to 35% of public oil companies could face bankruptcy. JPMorgan (JPM) revealed last week it is taking out a $500 million reserve provision against energy credit losses. A report from Deloitte found 175 such companies are facing "a combination of high leverage and low debt service coverage ratios." Odds are more financial institutions than just Wells Fargo will be hit should Deloitte be correct.
-- While we've heard much lip service concerning the irrelevance or at least immateriality of the contraction in the manufacturing sector, this week that argument was dealt a serious blow with the news that the Markit Services Sector Flash PMI for the U.S. dipped into contraction territory, falling to 49.8 in February from 53.2 in January; anything below 50 is considered in contraction.
-- Markit's flash composite U.S. output index for February also declined to the lowest level since October 2013 at 50.1, putting overall economic growth at stall speed.
-- While the GDP estimate was revised up, consumption and fixed investment were both revised downward, with the improvement being driven primarily by less negative contribution from inventories. To us, this revision moved up for all the wrong reasons.
-- Outside the U.S. is looking rather grim as well, with the value of goods that crossed international borders in 2015 falling 13.8% year over year in U.S. dollar terms. This is the first contraction since the depth of the financial crisis in 2009 and highlights fears of slowing global growth. U.S. companies that derive a significant portion of their revenues from exports are facing material headwinds.
-- The economy in China is expected to have contracted even further in February, which would mark the seventh consecutive monthly decline in China's manufacturing sector. A poll conducted by Reuters based on 23 economists says China's official manufacturing Purchasing Managers' Index (PMI) is expected to dip to 49.3 in February from 49.4 a month earlier.
-- Bond yields are not confirming the bullish moves in equities, remaining stubbornly low, and are below their levels just one month ago in much of the developed world. Keep in mind that the European bank situation is far from resolved and these eye-poppingly low and even negative yields in some cases are not helping that much-battered sector.
-- Sector leadership is also not confirming the bullish moves, with the defensive sectors of utilities and consumer staples reaching new highs as measured by Utilities Select Sector SPDR (XLU) and Consumer Staples Select Sector SPDR (XLP). Investors have been running to safety to such an extent that XLP, which was up more than 2% year to date as of Thursday's close, has moved to more than two standard deviations above its 50-day moving average, which is the most overbought in the past year.
Stepping back and looking at the NYSE McClellan Oscillator (an indicator or market breadth based on the number of advancing and declining issues on the NYSE), it has rebounded sharply over the last few days, past levels from which we've seen pullbacks in the market. This is another reason to be cautious as global growth expectations are poised to be adjusted further in the coming days.
As earnings season comes to a close, the usual rash of economic data will be joined by investment banking conferences and annual shareholder meetings. There will be some corporate earnings stragglers we'll be dialing into, such as Costco Wholesale (COST), Taser International (TASR), Big 5 Sporting Goods (BGFV) and Dick's Sporting Goods (DKS), to name a few. (Wells Fargo and Costco are part of TheStreet's Action Alerts PLUS portfolio.)
On the economic calendar we have the usual start-of-the-month data including ISM Manufacturing and Services indices, the complete February PMI reports from Markit, and several employment indicators for February culminating in Friday's February employment report. With inflation picking up of late per the January CPI report and Friday's January PCE Price Index (up 1.3% year over year in January vs. up 0.7% in December), a hotter-than-expected February job creation figure could reignite speculation the Fed might boost rates in March. Looking at the larger economic picture we described above that points to slower growth, we see a high probability the Fed will take a pass next month.