After strong market advances in 2013 and 2014, we have been bracing ourselves for a modest 2015. So far we have been spot on.
The S&P 500 through April has advanced 1.9% for the year, currently down slightly from a fresh record on April 24th. We also expected more volatility this year and that has come to pass as well, with January down 3%, February up 5.8%, March down 1.6% and April up 1%.
Why is the market so flattish and choppy? Elevated valuations coupled with uncertainty. According to FactSet, the S&P 500 now trades at 17.5 times the past 12 months of earnings compared to the 10 year average of 15.8. While this is only 11% above the average, the market is always looking into the future to establish today’s valuation and a combination of mixed economic data, a strong dollar, and flat corporate earnings is holding back a stronger advance.
After GDP grew 5% in last year’s third quarter and 2.2% in the fourth, the belief among investors was that the economy was finally returning to post-recession growth of 3% or better. Not so fast. First quarter growth was a tepid 0.2%, held back by slowing consumer spending, a plunge in exports, and weak investment. The fall in oil prices didn’t lead consumers to increase their spending, but instead to save as the personal savings rate rose to 5.5%, the highest quarterly reading since 2012. Exports were hurt by the strong dollar and fell 7.2%. Business investment fell by 23.1%, largely due to the halting of energy projects in reaction to falling oil prices. Further, the trade deficit expanded by 43.1% in March from February, aided by the movement of additional imported goods as a labor strike at West Coast ports was resolved. Since the GDP reading was taken before the March trade deficit surprise, we are almost assured a negative first quarter.
However, the weak first quarter GDP reading doesn’t seem consistent with other economic data. Since 2010, first quarter GDP growth has averaged 0.6%, but for all other quarters it’s averaged 2.9%. While it’s true that the past couple of winters have been quite harsh, it does seem that the seasonal factors used to remove calendar effects might be underestimating first quarter results.
Looking at corporate earnings, the first quarter is turning out better than expected. At the start of earnings season, analysts expected S&P companies to report a decline in profits of 4.6% due to lower oil prices and the stronger U.S. dollar. With 455 companies reporting, the S&P 500 is on track for a 0.4% increase. While this tepid earnings growth isn’t a reason to throw a big party, it is better than expected and the recent softening of the U.S. dollar sets up the remaining quarters of 2015 for better growth.
Given the weak first quarter, investors now expect the Federal Reserve to hold off on interest rate increases. When examining federal-fund futures market expectations, investors see a 7% chance the Fed will increase rates in June, 22% in September, 38% in October, and 55% in December. We think the Fed might act sooner rather than later, particularly after Fed Chair Janet Yellen delivered a speech in early May that suggested stock prices were too high as investors take “excessive risks.” We likened the speech to former Fed Chair Alan Greenspan’s December 1996 comments that the stock market was showing signs of “irrational exuberance.” After that speech, the bull market continued until March 2000. In any event, rising interest rates are a negative for the market and tend to reinforce volatility.
With the market at all-time highs, we are finding it more difficult to find reasonably priced growth stocks. It is therefore more important than ever to do research and select great companies that can grow in any environment.