We have highlighted in recent investment newsletters that for the last several months we could be in a market rally or a market that is going sideways and marking time for the E (earnings) to catch up with the P (S&P price). So, which is it? While there are no definitive answers until after the fact, we will try to shed some light on this subject. Before we do this, we need to dissect what is going on in the stock market. In other words, where are earnings going and is the price ahead of, equal to or less than earnings?
To do this, we need to break down earnings, and what they look like going forward, and then break down the multiple expansion of the P/E ratio. Before we get started, we need to remember that since mid-2009 the market rose due to two things: earnings were severely depressed so they basically had nowhere to go but up, and then the multiple expansion (P/E) needed to move higher as well. Let’s take a look at each component as things have now changed, in our opinion.
Price and Earnings
If you will recall it was in the late summer of 2008 when Lehman went under, Bear Stearns got bought for $2/share (later revised to $10/share), Fannie and Freddie almost went under and by the time we got to the 4th quarter the S&P 500 operating earnings had not only disappeared, they were actually slightly negative.
It didn’t take long for earnings to start a slow recovery. Since then they have recovered to a little over $118/share for 2014, up from $39.61 as of September 30, 2009. Heading into 2015, analysts were predicting earnings to be around $138/share. That number was recently reduced several times to $110/share as a much stronger dollar and the crash in the energy sector have had a major negative impact on most of the sectors in the S&P 500.
If we look at the S&P 500’s price from December 31, 2011 to December 31, 2014, it has shot up 64% (a P/E of 13) yet the earnings over the same time period have increased only 17%! Today, the P/E ratio, over the last 12 months, is almost 19 times earnings. That tells us that, for whatever reason, the P has far outpaced the E over that 3-year time period and we may be in a sideways market for a while until the E somewhat catches up with the P.
This was exactly what was happening from the end of February until the middle of August of this year until we had the market swoon from August 17th to August 24th, where the market lost 11%. Since then the market has recovered almost all of the loss and is very close to being back where the S&P 500 was on August 13th. This type of market behavior, while not completely typical, is not totally unusual for the stock market because the P and the E almost never increase or decrease at the same rate. However, one recent exception would be from September 30, 2007 to March 31, 2009, where the P was off 48% and the E was off 51%. Nonetheless, the P usually gets ahead of the E most of the time.
Having said all of this, where does your Investment Committee stand with respect to the next 6 months
(+/-) on the stock market? We just concluded our quarterly Investment Policy Committee (IPC) meeting and while we are constructive on the market longer term, we feel that there may be some volatility in the shorter term. As a result, the IPC has instructed the Investment Department to go from a slight equity underweight to a full 5% equity underweight for now. Of course, if market dynamics change significantly, we will adjust the portfolios again.
As far as interest rates (i.e., bonds) go, we are still of the opinion that the chance of the Fed raising the federal funds rate at their December meeting is still less than 50% and probably closer to 30%. If the Fed fails to act in December, the next logical time for them to modestly increase the federal funds rate would be towards the end of March 2016. There were several members on the IPC who expressed doubt that it would even happen that soon. We will be updating our thinking in future newsletters.
For now, we are making one marginal allocation in the bond market by trimming (not eliminating) one of our shorter-term bond positions and moving some of those proceeds into one of our intermediate term existing positions. What doesn’t get moved to the intermediate bond position will go to our money market fund for now. This is not a permanent move to our money market fund, only a temporary re-allocation.
Please give us a call at (800) 321-9123 if you have any questions.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.