My bet is that all the chaos we are now seeing around the world that suddenly seems to be depressing stock investors won’t end as badly as circumstances in 2008 but rather will sort itself out, allowing the secular bull market to resume.
Let’s review why:
(1) Rerating valuation.
Our Blue Angels analysis of the S&P 500/400/600 shows that last week’s plunges of 6.0%, 6.4%, and 7.2% in the three market-cap indexes reflected big declines in their forward P/Es, while their forward earnings remained stalled at record highs during the second half of 2015, mostly weighed down by falling earnings in their Energy sectors. The forward P/Es of the three have plunged from last year’s highs to Friday’s lows: the S&P 500 from 17.2 to 15.1, S&P 400 from 18.7 to 15.5, and S&P 600 from 19.6 to 16.1.
We aren’t expecting a recession in 2016, so we are expecting that forward earnings will resume their climbs to new record highs this year. Energy should weigh much less on overall earnings this year even if oil prices continue to fall, since the Energy sector now has much smaller shares of total earnings in each of the S&P 500 (3.7% now, down from 21.3% at 2008 peak), S&P 400 (0.5%, 13.7% in 2006), and S&P 600 (-1.5%, 14.4% in 2008).
After their recent declines, Joe and I can see upside in the valuation multiples over the rest of this year since we doubt that the Fed will be hiking the federal funds rate four times this year, as predicted in the Fed’s “dot plot.” Another year of one-and-done seems much more likely to us. The soaring dollar is continuing to soar, which is bound to limit the Fed’s rate-hiking enthusiasm. By the way, since 1995 a strong (weak) dollar has tended to be associated with a rising (falling) P/E.
(2) Downside & upside of commodities.
The stock market has been spooked by the ongoing weakness in commodity prices, particularly oil prices. Falling commodity prices directly weigh on the Energy and Materials sectors, but they also raise concerns that the global economy is falling into a recession. With the benefit of hindsight, it’s obvious that the commodity super-cycle was a bubble. Debbie and I came to that conclusion back in late 2013. That bubble has burst and is depressing exports, revenues, earnings, capital spending, and the employment of commodity producers. It is also causing a credit crunch in that sector.
While the CRB raw industrials spot price index is showing some tentative signs of bottoming, the price of oil still seems to be falling in a bottomless pit. Unlike previous bubbles, this one has been financed in the credit markets much more so than in the banking system. So we don’t expect that it will have the same contagion effects that the previous financial crisis did.
We also see lots of geopolitical benefits of cheap oil. It may cause more chaos initially in the Middle East, but it also greatly reduces the revenues available to our natural-born enemies in the region along with those in Russia. There may be more chaos for them, but less mischief inflicted on us. Of course, the biggest upside of cheap oil and other commodities is that they provide a big windfall for commodity users. On balance, we think the net effect should boost, rather than depress, global economic activity.
(3) China stir-fried.
Of course, last week’s plunge in the stock market was very reminiscent of the drop in August that also was triggered by turmoil in China’s stock market and weakness in the yuan. Once again, the situation has raised concerns about weaker Chinese economic activity, though December’s official and unofficial M-PMIs and NM-PMIs were somewhat contradictory. However, deflationary pressures continued for the 46th consecutive month in manufacturing, with the PPI down 5.9% y/y through December.
In addition to last week’s plunge in the Shanghai Shenzhen 300 by 9.9% and the inept official response to stop the rout, investors were unsettled by the 1.4% depreciation of the yuan, which now is down 8.3% from its January 14, 2014 peak. We also learned last week on Thursday that China’s non-gold international reserves dropped a record $108 billion during December and $665 billion since peaking at a record high of $4.01 trillion during June 2014. Keep in mind that some of that reflects the devaluation of some of the other key currencies held by the Chinese, such as the euro and the yen. However, China clearly has a problem with capital outflows as Chinese investors seek to protect some of their wealth by buying real estate and other assets overseas.
The weakness in China’s currency is bad news for other emerging economies. So is the weakness in commodity prices. No wonder that the MSCI Emerging Markets stock price index (in dollars) fell 6.8% last week to the lowest since July 2009 (Fig. 16). For the US, it isn’t bad news. Imports from China and other EMs will be cheaper, which will keep a lid on inflation and provide more purchasing power for American consumers. It is bad news for those Fed officials who are trigger-happy to raise rates again, albeit at a “gradual” pace.
(4) Europe with and without borders.
While we are on the subject of chaos, Europe’s refugee crisis certainly seems to be out of control. There have already been a few criminal activities associated with the refugees. They certainly increase the risk of terrorist activities. Odds are that European authorities will have no choice but to regulate their borders more strictly.
In any event, as Debbie reports below, economic sentiment indexes rose to new cyclical highs in the Eurozone and the broader EU at the end of last year. German factory orders rose for the second month in a row during November. On the other hand, the volume of retail sales (excluding motor vehicles) fell during November for the third month in a row.
(5) US oasis.
With the exception of the US presidential campaign, the US seems like an oasis of tranquility compared to the rest of the world. We soon will see how the first round of Republican primaries unfolds, but there certainly is a chance that the final race will be between Hillary Clinton (with Bill as her VP) and Donald Trump (with Gary Busey as his VP). If I had to pick between the two pairs, I might go for the least corrupt.
Meanwhile, despite fears of a manufacturing recession and stalling GDP growth, employment remains strong while wage gains remain moderate. Our Earned Income Proxy rose 0.2% m/m during December to yet another record high. That’s an auspicious sign for wages and salaries in current dollars. In real dollars, they are also getting a lift from falling gasoline prices. Average hourly earnings rose 2.5% y/y during December for all workers and 1.9% in real terms through November.
On balance, we think that the increased purchasing power of US consumers will fuel more consumer spending and boost economic activity, more than offsetting the slowdowns in merchandise exports and energy-related capital goods. While labor costs may be rising, they don’t seem to be doing so fast enough to weaken profit margins. In other words, profits should continue to grow this year.
Dr. Ed Yardeni
is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.
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