Potential To Derail

Includes: DIA, IVV, IWM, QQQ, SPY, UWM
by: Financial Sense

By Thomas J. Smith, CFA

The market advance continues with investors still having to contend with a number of conflicting signals. Last week I addressed some of the issues that those in the bearish camp felt could derail the market. While I certainly am not here to dismiss the bearish side of the argument, last week I attempted to look at both sides of some key issues. If there is a bearish argument but the market continues to move higher, there must be a more compelling bullish force or argument we should recognize in the bull camp.

This week I'm going to review some of the catalysts that have driven the market higher. Also, I'll examine the probability of these catalysts having a continued positive impact and, as well, some of the factors that can lead to a less positive investing environment.

The expansion of P/E multiples has been a major catalyst for the market's move higher for the past two years. That length of time has more meaning when you place it in context. Those in the bearish camp feel that multiple expansion has gone on for too long. When faced with that type of argument, it is vital that we don't get too swayed by the delivery of the person making the argument.

Let's look back over the past 50-plus years to see if we can find any trends when it comes to multiple expansion or contraction. In the 1950s, P/E multiples expanded for seven years. With the post-war expansion going on it makes sense that investors would be willing to pay more for a dollar's worth of earnings. It doesn't take long to analyze what happened to multiples in the 1960s. P/E multiples essentially went sideways for the entire decade.

During the 1970s multiples imploded. Inflation, stagflation, gas lines, impeachment trials and several other factors led to a nine year contraction in multiples. When the Fed beat back inflation, multiples began to expand in the 1980s. This was the golden age of multiple expansion. This expansion was a major driver in the great bull market that ended in 2000. Sustained GDP growth, declining interest rates, tax reform, the spectacular advance of the technology sector and an increased appetite for risk drove multiples and stock prices to unseen heights. Multiples expanded for 20 years.

The reaction to this huge run in the markets was a sustained period of multiple contraction. It was not surprising that the long expansion was followed by an extremely difficult time for the market. We have discussed several times that the explosive growth in China in the 2000s hurt profit margins and led to multiple contraction. Growth in the Chinese economy created a sustained period of increases in commodity prices. This imported inflation hurt profit margins across the board and made investors less positive on stocks. As profit margins came under pressure investors found stocks less attractive and multiples contracted.

So, history tells us those trends in P/E multiples can last for several years. Multiple expansion fuels higher stock prices. Stock investors have a very difficult time making money in a period of contracting multiples. We are just two years into a period of multiple expansion. Many investors anchor to what has happened over the past five years. That becomes their reality - the prism through which they view the world. That can be a very destructive course of action when trends change.

Since the evidence tells us we need to see continued P/E expansion to drive the market higher, what factors could derail the P/E story? For the past several years now I have focused on energy prices. Spikes in energy prices act as a pay cut for us all. In 2010, 2011 and 2012 aggressive moves higher in energy prices led to a sell-off in the market. There was a small contraction in P/Es earlier in the year as natural gas prices spiked. The extreme winter created some awfully large heating bills for many earlier in the year. We saw a decidedly negative day in the market last week when oil moved more than two dollars higher in one day. A sustained move higher in energy prices will set a negative backdrop for the equity averages. Higher energy prices have a negative impact on earnings and put a damper on multiple expansion.

After looking at energy prices we need to see how things are developing in China. The sharp rise in interest rates in China since mid-2013 has led to a cyclical slowdown in their economy. This slowdown has helped keep imported commodity price inflation low. Recently, the PBOC has introduced some stimulus measures. I will keep a close eye on trends in China since sustained growth there will have a negative impact on our markets through higher inflation numbers.

If we do some simple arithmetic it will tell us where we should focus our efforts in assessing the prospects for future multiple expansion. A price target for a stock or the overall market is the product of earnings expectations times a P/E multiple. Good news on both of these fronts has fueled the strong market we have seen over the past several months. We need to see companies continue to beat earnings expectations and increase forward earnings estimates while inflation remains subdued. Easy, right? It is never easy, but that is the formula we need to see.

There has been a tremendous amount of fear heading into earnings season for the past several quarters. The bears have said that earnings growth is simply not sufficient to drive prices higher. The actual performance of companies during reporting season has been consistently better than expected. For the past several quarters more than half of the companies in the S&P 500 have reported revenues above expectations. More than 70% of companies have exceeded analyst earnings expectations. Second quarter earnings season is a month away. The Leading Economic Indicators (LEIs) drive earnings expectations. We saw an uptick in the LEIs this time last year. The data, for the most part, from the LEI front remains positive. In the recent advance from the lows of last month, economically sensitive sectors of the market have been leaders. A decrease in the prices paid component of several economic releases points to continued strength in the LEIs.

The LEIs tell us that earnings growth for the second half of the year should be strong. Analysts have responded to the favorable trends in the LEIs by increasing the number of positive earnings revisions. If the cycle of better than expected earnings followed by higher guidance can continue, then multiples can continue to expand. Higher energy prices and increased growth in China are two potential issues that could derail the growth story.

Let's switch gears to look at the technical condition of the market. There remains more right than wrong with the long-term technical trends. 66% of stocks on offer in the S&P 500 are in advancing chart patterns. While small-cap stocks have improved since mid-May, fewer than 50% of stocks in the small-cap universe are in sound shape technically. Advance-decline lines are in good shape and many hit new all-time highs last week. The intermediate-term trend also is positive. Our sector work shows that there are more favorably-rated than unfavorably-rated groups. Applying our weight of the evidence approach, there is more right than wrong with the technical condition of the market.

On a near-term basis the market is overbought. For the averages that I follow, the S&P 500/Dow/Nasdaq/Russell 2000, support levels are: 1900/16,548/4200/1142.