Seeking Alpha
What is your profession? ×
Research analyst, CFA, Director of Research, long/short equity
Profile| Send Message|
( followers)

Summary

  • Non-farm payrolls rose 288K and the market stood still; well above consensus percentage growth in 1Q EPS also failed to move the market.
  • An unchanged first third of the year, dead money in June-September, and an autumn rally disrupted by mid-term elections could produce a flat 2014 year for stocks.
  • A stagnant stock market amid still rising earnings and GDP could restore valuations and extend the life of an aging bull market.

The stock market has not gotten much of a lift from a clearly above-consensus earnings season. So it was only appropriate that a blow-out jobs number also failed to move the market - in fact, stocks sold off. Despite the less than spectacular reception, both earnings growth and jobs growth signal underlying health in the economy, in our view.

A do-nothing first third of the year now gives way to the June-September period, historically dead money in the market. And the typical fall rally could be compromised by mid-term elections. Given this backdrop, we may get a flat year for stocks. If so, an unchanged stock market combined with rising business and economic activity could restore valuations to more attractive levels seen earlier in this bull market - and extend the bull's life by a few years.

Gala Jobs Number, No Parade

Total non-farm payrolls rose by 288,000 in April 2013, blowing out consensus expectations in the 225,000 area. The previous two months were revised upward by a net 27,000. As a result of strong April and positive February-March revisions, the three-month average for February through April was a monthly gain of 238,000 - the strongest three-month stretch since the first quarter of 2012.

Argus Chief Investment Strategist Peter Canelo points out that government jobs rose in each of the past three months for the first time since 2010. The net decline in local, state and federal payrolls during the post-recession years has helped offset the rise in entitlement spending and - along with tax hikes and elements of sequestration - has brought the federal budget closer to balance. But the decline in government as a percentage of GDP has also been a headwind for GDP growth. The newly positive trend in government employment suggests that government operations are now sufficiently lean to allow some hiring; more significantly, government could now be contributive to rather than subtractive from GDP growth.

Caveats and quibbles abound regarding the employment situation in the United States. There are genuine concerns about the sustainability and quality of jobs in a service economy, as opposed to the higher-paying careers generated within a manufacturing economy. A second set of concerns - that unemployment was declining merely because workers were too discouraged to seek employment - is equally real, but is now being whittled away.

According to the household survey released concurrent with the non-farm payrolls report, the official U3 unemployment rate for April was 6.3%, down from 6.7% in March - and down from 10.0% in October 2009. Other measures of unemployment that include marginal, part-time, and discouraged workers have also come down dramatically. U5 unemployment, which includes discouraged workers, has fallen to 7.6%, down 380 bps from its 2009 high. And U6 unemployment, which also counts involuntary part-time workers, has declined 490 bps to 12.3% from its 2009 high.

A jobs surge of 288K would have triggered a 300-point rally in the DJIA during 2013. This time, the market response was a half-hearted morning rally that could not survive jobs-Friday afternoon. Stocks have since sold off more forcefully - not on payrolls, but on the familiar "what's wrong with China?" theme and Twitter (NYSE:TWTR) jitters, as if another former high-flyer missing expectations counted as news.

Super Earnings, Also No Parade

The consensus of analysts headed into 1Q14 EPS season with low expectations, having shaved aggregate EPS growth forecasts to the 1% range. The reduction in expectations came in response to the harsh winter weather and signs that the spending slowdown in housing was more than weather-induced. Analysts got fooled again by low-balling CFOs, however.

As of 5/7/14, 414 companies in the S&P 500 - representing 83% of constituent companies - had reported results for calendar 1Q14. On a market-cap weighted basis, calendar 1Q14 earnings grew 7.6% year over year; on a non-weighted basis, 1Q14 earnings were up 9.6% from the first quarter of 2013.

Among the 83% of companies reporting for the calendar quarter, 69% reported higher earnings (up an average 22.7%, unweighted), while 27% reported lower earnings (down an average 18.6%, unweighted). Positive "surprises" (against consensus expectations) were also recorded by 71% of reporting companies, while negative "surprises" were recorded by 20% of reporting companies.

In theory, the market is "efficient": it prices in existing information precisely, and adjusts to new information by re-pricing itself. How much re-pricing occurred in response to this unforeseen information? Not much. Between 1980 and 2103, the S&P 500 averaged 1.9% capital appreciation in the first-quarter earnings period, which we measure as running between April 15 and May 15. As of 5/6/14, the S&P 500 had advanced 1.3% in this span.

Granted, there is a week left in 1Q14 season; but most of the big names have reported. And the dichotomy with the market mood one year earlier is stark. This year, earnings bested expectations by over 800 bps (unweighted change), and stocks have been rewarded with a puny 1.3% advance. In 1Q13, EPS also outperformed very low expectations, but ultimately grew just 3.7% (Argus data). The S&P 500 responded with a 5.2% jump between 4/15/13 and 5/15/13.

The Silver Lining…

Late in February, Chief Investment Strategist Canelo noted that the S&P 500 was about 4% below fair value, based on the "Fisher" inflation-based model of the earnings-price yield. Strategist Canelo acknowledged that stocks frequently overshoot fair value on the upside, as they often overshoot on the downside. Still, this was the first call to caution from Argus on valuations in nearly five years.

Since then, the stock market has largely stood still on the surface, while undergoing sector and style realignment below the surface. Little-changed market averages mask a sharp correction in high-growth and small-capitalization stocks.

May, as we have noted, is actually not a bad market month, averaging 0.83% capital appreciation on the S&P 500 since 1980. But then investors sell and go away, and June through September is a four-month stretch of dead money. The market could come into autumn in the same shape - up 1%-2% YTD - that it has sustained through spring. The strong fall months are next - but so, too, are the mid-term elections, which have a poor reputation among stock pundits. Unlike Presidential election years, when everyone votes, only the disgruntled and the die-hards vote in mid-term years. Comfortable incumbent parties lose House seats in mid-term years; and when Washington is front-page of the financial press, the market always loses.

Under this scenario (and granted it's only May), the stock market could end 2014 within a few percentage points of where it started. So where's the silver lining? In valuation.

We expect U.S. GDP to rise in the 2.5%-3.0% range for 2014. BRIC and emerging nations are decelerating; but long-moribund mature economies in Europe are growing again, led by UK and Germany. Global GDP should advance 3%-4%in 2014. Earnings should grow at their typical rate of two-to-three-times global GDP. The official Argus forecast is for S&P 500 earnings to grow 9.9% in 2014.

Assuming the S&P 500 ends 2014 roughly unchanged, the index will trade at 15.4-times trailing EPS and at 14.8-times forward EPS - in line with its 5-year average trailing P/E of 14.7-times. In 2012 and 2013, the S&P 500 averaged 21.5% capital appreciation; yet earnings grew 4.5% and 5.3%, respectively (based on Argus data). A flat market year in 2014 amid accelerating earnings growth and global economic growth would be an opportunity to rewind the valuation spring and restore stocks to more attractive levels.

Structuring Portfolios for This Opportunity

Argus CEO and Economist John Eade recommends maintaining a diversified approach to investing in order to capture opportunities without introducing excessive risk. Our Tactical Asset Allocation Model for Moderate Accounts calls for a 65% weighting in stocks, 25% in bonds, 5% in commodities and 5% in cash. Within equities, the Russell 2000's YTD decline of 3.0% trails the 1.8% gain in the S&P 500. This pattern is an early reversal of the trend in recent years, as Small-Caps have outperformed Large-Caps over the trailing 1, 2 and 5-year periods.

On valuation, Large-Caps appear to be the better value, based on our review of trends in P/E ratios, price/sales ratios and dividend yields. And with the Federal Reserve rolling back quantitative easing this year, less-risky assets could be poised for outperformance. Our recommended exposure to small- and mid-caps is 15% of equity allocation for Moderate Accounts, in line with the benchmark weighting.

Globally, non-U.S. economies account for approximately 75% of global GDP. But given risks inherent in global investing (currency, regulatory, political, security), we recommend that Moderate investors target a 25% exposure of the equity portion of their portfolios to Global stocks. Our top regions and countries include the hard-currency countries (Australia, Sweden, and Switzerland) and key US trading partners including the UK, Taiwan and Mexico. We also favor the Pacific Rim (ex-Japan) region.

Market-leading sectors year-to-date include Utilities, Energy, Healthcare, Materials and Technology. Looking ahead, we currently favor sectors that are poised to benefit from a stable dollar and global economic growth. These sectors include Technology, Energy and Materials. We recently lowered our sector weighting on Healthcare to Market-Weight, based on valuation. Within each sector, we favor growth companies with growing dividends, as opposed to mature companies with high dividends. Our Under-Weight sectors include Consumer Staples, Utilities and Telecom.

Conclusion

We continue to model high-single-digit to low-double-digit stock market appreciation for 2014 based on strong underlying fundamentals in the economy and in earnings. But we are cognizant that slow starts to the year often translate into below-average stock price appreciation for the full year. If the stock year misses our expectations, but earnings and economic activity continue to accelerate, valuations could be restored to attractive levels seen in the early years of recovery from the great recession. That could add a few years of life to a bull that until recently appeared to be getting long in the tooth.

Jim Kelleher, CFA, Argus Director of Research

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.