Signs Point Everywhere

6/20/2016


Legendary investor Benjamin Graham once called the stock market a voting machine in the short term and a weighing machine over the long haul. In this presidential election year, investors have elected to bid up the S&P 1500 Index by 2% in advance of a potentially tight and volatile race.

Entering 2016, investors faced middling valuations and slowing operating growth for stocks of all sizes, as shown in the table below. In the opening weeks of 2016, stocks got a jolt as falling commodity prices sparked fears of slowing demand, particularly in China, potentially sparking a global recession.

HIGH PRICE, LOW GROWTH
--------------- Average Stock In The . . . ---------------
S&P
SmallCap
600 Index
S&P
MidCap
400 Index
S&P 500
Index
(Large-Cap)
S&P 1500
Index
Trailing P/E
End of 2015
23
21
20
22
Current
24
22
22
23
10-year average
22
21
19
21
20-year average
22
21
21
21
% of months lower, past 10 years 
80
68
93
80
% of months lower, past 20 years 
83
60
65
73
Forward P/E
End of 2015
22
20
19
21
Current
20
21
19
20
10-year average
20
19
18
19
20-year average
NA
NA
NA
NA
% of months lower, past 10 years 
43
80
80
68
% of months lower, past 20 years 
NA
NA
NA
NA
12-month EPS change
End of 2015 (%)
4.1
4.1
4.2
4.2
Current (%)
2.0
1.0
2.9
2.1
10-year average (%)
4.6
6.4
7.2
6.0
20-year average (%)
6.1
7.5
7.7
7.0
% of months lower, past 10 years 
17
16
17
17
% of months lower, past 20 years 
15
13
15
15
12-month sales change
End of 2015 (%)
4.8
3.7
3.0
3.9
Current (%)
2.8
1.4
1.3
1.9
10-year average (%)
6.6
6.9
7.1
6.9
20-year average (%)
7.7
8.2
7.4
7.7
% of months lower, past 10 years 
14
14
14
13
% of months lower, past 20 years 
13
12
13
13
NA Not available.

However, U.S. stocks have since rebounded. Encouragingly, smaller stocks, which tend to be more sensitive to the U.S. economy, led the way. The S&P MidCap 400 Index is up 6% and the S&P SmallCap 600 up 5% in 2016, well above 2% gain of the S&P 500 Index. Midsize and small stocks trailed large stocks in 2014 and 2015.

Operating growth has continued to slow marketwide while P/E ratios marched higher. S&P 500 stocks' average trailing P/E ratio stands at 21.8, 14% above the 10-year average and higher than 93% of month-ends in the last decade. Midcap and small-cap stocks trade at respective premiums of 6% and 8% to 10-year norms. Per-share-profit and sales growth are unusually low but remain positive.

Amid sluggish sales, corporate profits face constraints from wage growth and declining labor productivity. Profit estimates for the S&P 500 Index have retreated sharply, with the current consensus expecting less than 1% growth this year, versus 8% growth projected at the end of December.

The Federal Reserve has been reluctant to raise interest rates since its December hike. In May, Fed Chairwoman Janet Yellen said a rate increase was likely "in the coming months." But job growth came in weak last month, leading the Fed to postpone a rate hike again in June. The Fed also trimmed its long-term expectations for interest rates.

Until recently, the strong U.S. dollar and low energy prices have kept inflation in check, complicating the Fed's plan to raise rates. While an energy-price rebound has boosted headline inflation this year, core CPI (excluding food and energy) has remained steady at 2.1% to 2.3% from December through April. An upbeat June employment report (news breaks in early July) and U.K. decision to remain with the European Union (June 23 vote) could lead to a July rate hike. About half of economists polled by The Wall Street Journal expect the Fed to raise rates in July, though fed funds futures prices imply less than a 21% chance of a rate hike then.

Decelerating operating momentum, elevated valuations, and rising short-term interest rates aren't a great recipe for strong stock returns. But we continue to like our chances of using Quadrix to uncover stocks with strong growth potential at a discount — and believe the great weighing machine that is the market will come to agree with our assessment on these stocks.


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