The market in 2015 has performed much as we expected: it has been volatile. After a difficult month in January where the S&P 500 dropped 3%, February saw new market highs. The big question in everyone’s mind: can the market continue to advance?
We think the market can certainly continue to move upward, but it will be bumpy along the way.
Why was January so glum? In the early part of earnings season, banks and energy companies dominated the announcements. Neither sector reported much in the way of positive earnings news. Banks are suffering from narrowing spreads as interest rates continue to fall. The fourth quarter was the first time energy companies had to report results that reflected rapidly declining oil prices. Investors looked at these results and extrapolated them to the rest of the market, sending shares down.
February has brought much better news. For starters, fourth quarter GDP grew a respectable 2.6%. This is down from roughly twice the pace of last summer, but that was influenced by military purchases that were not likely to repeat. The consumer did better, contributing 2.9%. This was below what many economists had expected given the boost in spending power from lower oil prices, but an upward trend nonetheless.
The consumer appears set to contribute more to economic growth in future quarters. TD Securities estimates that the decline in gasoline prices during the fourth quarter translated into $130 billion in savings to consumers. There is evidence that consumers are being cautious with the windfall, as December’s personal savings rate increased to 4.9% of income, up from 4.3% in November. Spending should pick up over time as confidence increases.
Employment growth should also give a boost to consumer spending. In January the economy created 257,000 jobs. After an upward revision of an additional 147,000 jobs in November and December, the economy created over 1.0 million jobs in the past three months, the strongest three month pace since 1997. More importantly, the labor force expanded by 700,000 in January as workers on the sidelines perceived a stronger labor market. The unemployment rate ticked up by 0.1%, to 5.7%, reflecting this larger labor pool.
As for the rest of the economy, trade appears set to introduce some headwinds. Trade subtracted 1% from fourth quarter GDP as the benefit from lower oil prices was more than offset by slowing exports due to the strong U.S. dollar and economic weakness overseas.
Worldwide economic growth is certainly a concern. In Europe, the combined 18 countries that share the euro saw fourth quarter GDP grow only 1.4%. This weak growth, coupled with falling commodity prices, led to a drop of 0.6% for consumer prices in January. When excluding food and energy, consumer prices still grew only 0.6%, well below the European Central Bank’s (ECB) target of 2.0%. In response to these weak conditions the ECB launched a bond buying program of €60 billion per month starting in March and continuing through September 2016, or €1.14 trillion in total.
In Japan, fourth quarter GDP grew only 2.2%, but much of this came from exports, which added 2.7% to GDP. Consumer spending grew a meager 0.3% as consumers struggle with an April sales-tax increase and slow wage growth.
This environment presents an interesting challenge for the Federal Reserve. On the one hand, the domestic economy is on sound footing and growing fast enough to induce employment growth, a recipe for higher rates. On the other hand, several factors argue for leaving rates alone. Wage increases are scant, rising only 2.2% over the past year. The strong U.S. dollar and relatively higher U.S. interest rates are attracting overseas investors, keeping the 10 Year Treasury yield around 2%. Inflation is low as the Fed’s preferred measure, the GDP price deflator, increased only 0.7% in the fourth quarter, well below the Fed’s 2% target. The Fed has previously signaled it would like to begin increasing interest rates in June but will let data determine the timing.
Given this background we don’t see a major correction in the stock market. While volatility is likely, the main reasons for a correction—a falling economy and higher interest rates—don’t seem likely just now.
However, stock selection is critical. According to Birinyi Associates, companies in the S&P 500 traded at 20.4 times net profits for the past 12 months, about 30% above the historical average of 15.5. Further, aggregate earnings growth is tepid, as analysts expect full year 2015 profit gains of only 2.4% for all companies in the S&P 500. Profit growth looks better when excluding energy companies, at 9.2%.
We have long advocated not trying to time the market, but rather building a portfolio of solid, growing companies purchased at reasonable prices. With volatility expected to continue, this advice makes more sense than ever.