Markets

The Scariest Chart Stock Investors Will See In 2016

On Monday, with the release of Alcoa (AA)’s third quarter results, earnings season will begin. The term “earnings season” sounds a little mystical in some way, but it is simply the period during the last three weeks of April, July, October and January when the majority of S&P 500 companies report their results for the preceding quarter. It falls when it does because most companies align their fiscal quarters with the calendar quarters, and then it takes them a week or two to collect and analyze data and produce a report. In theory, earnings season should set the tone for the stock market during the time that earnings are actually reported and for several weeks thereafter. Corporate profits are, after all, the most basic driver of stock prices and seemingly have a huge influence on the market. Yet, as obvious as that may seem, it hasn’t really held true for just over a year now.

At the start of the recovery from the recession of 2008-9, we heard a lot about how, while many consumers were still struggling, corporations were, to quote the President “…doing fine.” Corporate profits did indeed recover quickly and, as you would expect, the market followed them. Over the last five quarters, however, that relationship has completely broken down. If you watch financial networks or read about markets, you will have heard or read some people, including me over the last few months, say things like “Valuations are a bit stretched”. Many people, in fact, will have heard it so often that it begins to have little meaning.

Often when that is the case, it takes a visual representation of what is going on to truly bring it home, and the chart below serves that purpose. It is from macrotrends.net and shows the Earnings Per Share (EPS) for S&P 500 companies as an orange line, plotted along with the index itself, shown in blue, over the last five years. As you can see the market has held steady and even climbed somewhat since the end of 2014, as profits have fallen dramatically.

There are two main reasons for that, one benign and one quite worrying. The first, and less problematic reason, is that what has happened is simply a process of earnings multiples normalizing. It took a while for the market to adjust to the recovery and trailing Price to Earnings Ratios (P/Es) lagged historical averages as the corporate recovery gathered pace from 2011 to 2014. Once we got to that average level and then subsequently passed it, however, stock prices continued on up even as actual profits began to drop.

That is explained by the second reason…Fed policy. I am not a big critic of the Fed as I genuinely believe that their actions at the time of and following the recession probably averted complete disaster. The problem, though, is that those necessary measures, an ultra low or even zero interest rate policy and QE, have proved difficult to get out of, and that has had consequences. With short term rates at virtually zero every fund, and indeed every investor, has been forced into reaching for some kind of return and therefore into the stock market.

Once the Fed indicated their intention to raise rates, and then began to delay that action, that problem became even worse. Not only were fund managers looking at low yields on bonds, they were also facing the prospect of declining capital value if interest rates went up. There was really little choice but to buy stocks, regardless of valuations, and that has left us here, where stock prices have disconnected from the trend in their fundamental value.

It should be said, of course, that even the scary chart above doesn’t mean that a complete crash is imminent. While the current trailing P/E is above average that means that it has been higher for quite long periods, and that has not always led to disaster. Usually in those cases, though, it is because the market has got ahead of itself as earnings are increasing which is not the case here. If anything, most analysts are actually forecasting another drop in corporate profits this quarter. If that is the case and the Fed continues to force money into the market by talking about a hike but not acting then we are building towards at the least a severe correction, and in that context, this could well be the scariest chart of the year for equity investors.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

Read Martin's Bio