Who Will Win On Stock Market Performance: The Fed Or Earnings?

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Includes: IYF, VFH
by: John M. Mason

Summary

The stock market dropped after the Fed's December increase in its policy rate, but rose beginning in February as the Fed's "forward guidance" indicated fewer increases for the year.

Corporate earnings performance has been down for the last three quarters and is expected to be down again here in the first quarter of 2016.

Will investors continue to "follow the Fed" or will the market begin to absorb the bad news coming out of the corporate world?

Well, it's earnings season again. Steven Russolillo in the Wall Street Journal thinks investors are rather bearish on how earnings are going to be reported for the first quarter of 2015. According to FactSet's calculations, "first quarter earnings are forecast to log a contraction of 8.5 percent." "Furthermore," Mr. Russolillo continues, "if earnings fall again, it will mark the fourth consecutive quarterly decline."

This obviously is not very good news. Yet, the recent performance of the stock market has not seemed that depressed. "The S&P 500 has surged about 12 percent since bottoming in February and is roughly flat for the year." It seems that the performance of the stock market was impacted, among other things going on, by what was going on in the Federal Reserve System.

Coming into the new year, investors faced a Federal Reserve that had just increased its policy rate of interest and its officials had provided their "forward guidance" that it was likely that this policy rate would be raised four times in 2016, by a quarter of a percentage point each time. This was not very good news and the stock market reacted accordingly.

But, in early February, the Fed started to back off. And, then in March, the Fed backed off again. And, the backing off continued through the end of March. Now, there is wonder whether the Fed will move at all this year. And, if the Fed doesn't move on interest rates, this is good for the stock market…right?

So, if the Fed continues to maintain interest rates at their current level for most of the rest of the year and if the earnings performance of the economy is falling, what is the likely performance of the stock market?

One could argue that the stock market is already quite high. If one looks at Bob Shiller's measure of stock market performance, the Cyclically Adjusted Price Earnings ratio, one gets the impression that the stock market is overpriced.

The estimated value for the CAPE measure in April is 26.24, which is below the near-term peak of 27.00 reached in February 2015, but is substantially below its long-term mean value. Historically, CAPE always reverts back toward its long-term mean, although it provides no information as to when this reversion will take place.

CAPE started falling in 2015 as investors believed that the Federal Reserve was going to start raising its policy rate in the spring of the year. This initial raise kept being pushed off until December, but the investment community operated throughout the year under the shadow of such an increase in interest rates.

The overlying rule of the market seemed to be, "Don't fight the Fed." Since the middle of February, Federal Reserve officials seem to be united in their "forward guidance" that rates will probably not be moved much in 2016, investors seem to be optimistic about stock prices. But what happens if corporate earnings season is dismal?

Investors may be overly pessimistic, as Mr. Russolillo suggests in his WSJ article, but it seems highly likely that the earnings season is going to start out on the negative side. Bank earnings are expected to be very disappointing this year. Ben McLannahan writes in the Financial Times that "US Lenders to Take Hit on Energy Loans."

But this only adds to their woes as almost every analyst expects the trading revenue of the banks, especially of the larger banks, will be down and the net interest margin of the banks continue to be compressed.

Bank net interest margins are not going to be helped at all if the Fed keeps interest rates at current levels. What hope is there for bank earnings with the two-year US Treasury note yielding about 70 basis points and the 10-year US Treasury note yielding only around 1.70 percent?

The story can be told in terms of stock market performance: at the start of the year, bank stocks gained from the December move by the Fed to raise its policy rate. However, as the word got out that it was unlikely that the Fed would follow up on this increase in 2016, bank stocks took a tumble.

As reported in the Wall Street Journal:

"Financial companies are the worst performers in the S&P 500, down 7.6 percent in 2016 as the broader index has risen 0.2 percent. The KBW Nasdaq Bank Index of large U. S. commercial lenders has fallen 15 percent this year."

It does not seem that earnings season will get off to a good start this week. On top of this, we hear that corporate defaults this year have reached a total of 40 worldwide, with 85 percent of this number coming in the united States. 14 of these defaults have been in the oil and gas area.

The question becomes, how can the market continue to "follow the Fed" when the actual performance of the economy seems to be having troubles. Central bank policies may be able to go only so far.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.