Traditionally, equity people are supposed to be more optimistic than bond people, but I am prepared to buck the stereotype just a little as we enter day four of the Q1 earnings season.
Brad Tank, our fixed income CIO, followed Erik Knutzen in expressing cautious optimism that U.S. corporate earnings would recover enough in the second half of 2016 to justify much of the market rally that we’ve enjoyed since mid-February. They both wanted the economy to “show them the money” before dialing-up risk, as they put it, but they saw changes in the recent trends in the U.S. dollar and oil as the foundation for this recovery.
Truthfully, we are talking small degrees here. Brad and Erik both emphasized caution—as Erik put it, things were never as dark as they seemed on February 12, and they are probably not as bright as they seem today. Nor am I about to argue that we’ve inflated a bubble and stand on the brink of savage correction. Nonetheless, I think it’s fair to say that I am a little more circumspect.
The market pendulum tends to swing too far in both directions. Does the simple recognition that the world is not about to end explain why the S&P 500 Index went up more than 15% in 10 weeks? At 17.0-17.5 times forward earnings, U.S. large caps will not look particularly cheap should run-rate earnings for Q1 2016 come in at around $100-$105 per share, as seems likely. That’s a long way from the $120-$125 per share that we feel is required to support today’s multiples.
Amid the headline-grabbing extremes of pessimism, the more sober talk in January and February was of an earnings recession, and I don’t see anything that has fundamentally changed that narrative.
For sure, dollar strength has eased—but wasn’t that already underway by the second half of 2015? And yes, energy may be less of a drag this year—but does it follow that we are about to see break-out numbers from the financial, industrial, or consumer sectors?
Financials are especially important as it’s difficult to sustain a rally of this strength while banks are struggling to generate positive earnings. Q1 earnings from JPMorgan Chase, Bank of America Merrill Lynch, Wells Fargo and Citigroup have been released. We are used to the game in which analysts set expectations so low they’re almost impossible to miss: JPMorgan’s earnings per share beat the 13% slide that had been estimated. But the real takeaway was simple: the largest bank by assets in the U.S. saw its earnings fall by 7%. Citigroup’s, Bank of America’s and Wells Fargo’s reports told a similar story, with capital markets weakness hurting the first two and energy exposure the latter.
Elsewhere, some good news emerged out of Italy last week as a better-than-expected support program was thrashed out for its struggling lenders, but on the whole, European banks have performed poorly despite the expansionist policies announced by the ECB in March. Dealogic estimates that revenues in global investment banking are down 36% year-on-year, which would represent the toughest Q1 since 2009.
This background explains the elements of caution that underlie this rally in U.S. stocks. Small caps are still down year-to-date. The big value sectors that bore the brunt of the New Year sell-off, energy, materials and industrials, are up 6-8%, but the other big performers are defensive consumer staples and utilities.
I believe this is a “relief rally” that lacks a degree of conviction and is really a response to the excessive pessimism of the New Year. Again, to be clear, we are not talking about extremes in valuations. But the pendulum has swung far enough that I don’t feel compelled to chase this market, and I would need to see much firmer evidence of an earnings revival over the coming seasons to change my mind.