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Stock Market Outlook

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Stock prices continue to climb as earnings estimates for US companies come down, resulting in price earnings ratios that are beginning to look stretched. For example, many large cap growth stocks such as Starbucks are trading at 30 plus multiples.  Going forward there are only two ways that valuations will look reasonable; either stock prices decline or earnings move higher.  What is surprising is that the market has not followed the earnings estimates downward.  We mentioned in earlier notes that only two things ultimately drive stock prices – earnings and interest rates.

The reason the market is ignoring the decline in earnings estimates is low interest rates.  Investors drove stocks higher again in 2014 in the hunt for higher returns. Contrary to what pundits expected, the interest rate on the 10 year US Treasury note fell from 3% at the end of 2013 to 2% by yearend 2014. Significant amounts of money went into US stocks as investors took more risk in hopes of greater return.

The Federal Reserve announced the plan to terminate the stimulus program and raise interest rates once the economy improves to the point where an increase is warranted.  The expectation has been that rates will begin to rise by mid-2015 although some expect this to get pushed out until 2016.  In either case, interest rates will go up.  This is the point at which investors will pay attention and if rates go high enough, they will look for yield elsewhere and run from risk.  A five year rally in itself is not enough to cause a market decline.  Stretched valuations and rising interest rates though could cause the market to pause or reverse course.

In early December, analysts expected 2015 S&P 500 earnings growth of 10%.  A month later, in early January, this growth expectation dropped to 6.5%. The dramatic and sharp drop in estimates from the oil patch has played a major role in the earnings decline.  US oil prices have been hit hard.   Rig counts are down about 20% and the price of oil has dropped from $100 per barrel to under $60 per barrel.   This isn’t the only reason for the decline in earnings estimates. US multinational companies are faced with foreign currency losses because of the high US dollar and sales in many countries have not kept pace with expectations, especially in emerging markets and Europe.

The good news is that expectations have come down.  Stock prices move when earnings are not what analysts expected.  If Wall Street lowers earnings expectations enough companies will be able to surprise on the upside. Stock prices will hold up if oil prices stabilize, the dollar declines and energy companies continue cutting expenses and production to meet demand.  Corporate America is in good shape overall.  Any strength in the European economies or emerging markets would support stock prices while earnings growth catches up.

The quality of earnings is something to watch.  There are companies that engineer their earnings to report a good number.  Their revenues are flat to declining and earnings higher because of stock buy-backs or cost cuts.  Ultimately, they run out of things to do to prop up their profits. Many of the stocks that doubled in 2014 were those that were given up for dead – about to sell out or close their doors.  It wasn’t actual earnings that drove their prices higher last year.  It was the hope of better earnings and in some cases a catalyst, such as a rumored takeover or reorganization, buoyed stock prices.  Companies like Tesla that reported little or no earnings or recently public tech stocks did well in 2014, regardless of their earnings strength.    At the end of a bull market investors throw caution to the wind and bid up stocks, hoping for returns regardless of risk.  We saw some of that in 2014 but not across the entire market.

Dividends matter.  Studies have shown that companies with above average dividends perform better over the long-run.  It isn’t the absolute level of dividends.  It’s the ability to pay and increase dividends that matters.  Payout ratios – the percentage of earnings paid in dividends- are low today which means dividends can move higher without compromising company fundamentals.  Companies that raise dividends will be rewarded.  Shareholder returns will continue to be in focus.  This takes free cash flow which will be a factor in determining future stock prices.

The easy money has been made.    A company that can raise prices and invest in their business for future growth will be rewarded long-term.  There isn’t one sector of the market that will produce quality earnings across the board.  There will be companies in every sector that do well and those that don’t will disappoint.  The key will be to not lose money.  The appetite for risk will be diminished and investors will hunt for stability, dividends and growth rather than risk and return.  This will be especially evident if interest rates begin to rise.

2014 was also unusual in that the world markets did not rise in unison.  The US stock markets, and especially the S&P 500, did exceptionally well while the international markets declined.  This was due in part to the US economic recovery which was clearly in place while concerns for slower growth or even recession were rampant elsewhere.  As the chart below shows, the S&P 500 was up double digits last year while the MSCI EAFE and emerging markets were down.

2014 Index ReturnsThe green bar is the S&P 500 which performed better over 3 years and 5 years as well as last year.  Over time, the gap closes as the world indexes move toward similar performance.  Investors are looking for ways to invest for future returns and beginning to appreciate how undervalued the foreign markets are relative to the US.  Diversification did not help last year but should in 2015.