I wrote yesterday about the economy and how I believe that, while we are seeing some weak data, we are likely experiencing a temporary “snowdown” (much as we saw the past two winters) rather than a true slowdown. Still, we have to ask ourselves, Is the market pullback similarly temporary, or is it the first stage of a deeper correction?
Initially, I was very concerned about the possibility of a deeper market correction, and I posted here about how much further it could fall. Since then, however, the market has largely rallied, and while a deeper correction certainly remains possible, it now seems more likely that we could see the market move higher toward the end of the year. How is that possible?
Corporate earnings: The bad and the less bad
Let’s start by looking at earnings. Although the economy is important for the market, what investors are really buying is a share of corporate earnings. Markets are valued on the basis of earnings—the price/earnings ratio, that is. And earnings are what matter as the foundation for any purchase decision.
The news for earnings, unfortunately, has decayed. For the third quarter, with announcements starting today, the expected earnings decline is down to a drop of 4.5 percent from an expected drop of 1.0 percent at the start of the quarter, per FactSet. There is increasing talk of an “earnings recession,” which is defined as two consecutive quarters of declines in earnings. Things look bad.
Just as we did with the economy, however, let’s look at what history can tell us. For the first two quarters of 2015, earnings expectations were similarly poor, but, per FactSet, actual growth came in three to four points better than expected. In fact, this is quite typical for the market. Companies provide guidance to analysts, who revise their estimates downward; then companies come back and “surprise” analysts with better-than-expected results, which contributed to a positive atmosphere and hopefully higher stock prices. In aggregate, we have seen this same dance this year and can reasonably expect to see it again. Perhaps things are not as bad as they look.
The impact of the energy sector
Also worth a look is why earnings are dropping—and the answer continues to be energy. Excluding the energy sector, both profits and sales are actually growing, not shrinking. Now, arguably, it makes no sense to take out the worst performer; that’s simply cherry-picking the data.
I would argue, however, that drops in other sectors have been demand driven, and thus bad for the market, while the drop in energy has been supply driven, with lower oil and gas prices coming from advances in drilling and technology. As such, the damage to the energy sector, from better technology and lower oil prices, is actually a positive for the rest of the economy—unlike problems in other sectors.
You can see exactly this effect in the real data in two ways:
- Looking at nonfarm nonfinancial corporate businesses profits before tax (a statistic with an intimidating name), profit growth is accelerating on a year-on-year basis, from a 2.1-percent gain at the end of 2014 to an 11.3-percent gain in the second quarter of this year.
- Looking at the consumer discretionary sector—which relies on the consumer, who comprises two-thirds of the economy—profits are up 11 percent year-on-year for the third quarter.
Rather than exhibiting weakening demand, the rest of the economy is actually accelerating, which is exactly what you would expect if lower energy prices—and the damage in that sector of the market—are good for the rest of the economy.
Once again, when you look at the big picture, the foundations of the market are healthier than the headlines would suggest, just as they are with the economy. Although a deeper downturn remains possible, the weight of evidence suggests to me that, for the moment, a recovery and upturn seems more likely.