By Margarita Fernandez
After a punishing January and a mediocre February, the first quarter of 2016 ended on a positive note. With the exception of some international markets, March was a very nice rebound month across the board. The rising tide of optimism (or maybe just less pessimism) impacted domestic equity and fixed income markets and by quarter-end the Standard & Poor's 500 had risen 1.35% and the S&P U.S. Aggregate Bond index increased by 2.51%. March's strong positive return of +6.78% for the S&P 500 Index was broad with all ten economic sectors participating, led by Energy stocks (+9.31%) as oil prices rose and investors anticipated a positive outcome - for oil producers - at this Sunday's OPEC meeting.
Market volatility continues into April, up 1% one day and down 1% the next, although, as of today, we are ahead for the month and the year. We have seen recent improvement in some of the economic data; the Institute for Supply Management's Services index (54.5) and Manufacturing index (51.8) both returned to expansion last month. ISM Manufacturing finally showed signs of life, increasing for the first time in six months. New orders, production and backlog orders rose as manufacturers' and customers' inventories contracted.
Employment also showed progress with more people joining the workforce and wage growth finally rising. The Bureau of Labor Statistics' U6 unemployment measure, declined from a seasonally adjusted 10.9% March 2015 to 9.8% for March 2016. U-6 is a broader measure than the official (U3) rate of 5%, as it includes short-term discouraged workers. During particularly onerous unemployment periods, the spread between the official unemployment rate and U6 widens. In 2010, following the Great recession, this spread rose to 7.4 (U3 was 10.6% and U6 was at 18%). The spread has recently contracted to 4.8 versus March of last year when it stood at a 5.4 differential. Janet Yellen's dovish stance has also impacted stock prices and bond prices as tightening expectations waned.
Although the progress on the economic front is comforting, we also continue to see the antithesis. Global growth forecasts have been pared down again and, adding to these concerns, China and Hong Kong have had their ratings cut by Standard and Poor's. The rating agency pointed to "increasing economic and financial risks to the mainland government's creditworthiness." In the US, consumer spending is lackluster and the latest consumer sentiment figure from the University of Michigan showed a slight decline. Reflecting the slow growth in corporate profits, a WSJ analysis of CEO compensation in 2015 determined that the median pay for the heads of approximately 300 large companies actually declined by 3.8% - the worst showing since 2008.
Economists have cut first quarter 2016 GDP to approximately 1%, following an uninspiring 1.4% in the previous quarter. Energy prices are higher, possibly stifling the much heralded yet deferred increase in consumer spending from lower pump prices. Alternately the increase could provide some relief to the sickly energy sector and related manufacturing and financial companies. April is an important month for the energy companies since it is one of the semi-annual months that banks determine the oil price base used to value reserves. A lower oil price base will influence the willingness of banks to extend capital.
First quarter earnings season has officially begun with the large banks reporting last week to generally favorable reviews. Keep in mind that the bar has been lowered for the banks (and all the economic sectors for that matter) and beating estimates is not the same as expansion. JPMorgan (NYSE:JPM), for instance, beat analysts' estimates handily even as their bottom line continued to deteriorate. It is a harsh environment for the banks with low interest rates, a hostile and ever-changing regulatory environment and growing credit concerns, largely in the energy sector. Valuations in the financial industry are low but it is hard to find a catalyst in the short run for revenue growth and cost cutting can only take you so far.
Looking ahead to the rest of earnings season, we expect to see a lot of reports like last week with companies beating lowered estimates but overall earnings continuing to contract. Barring unforeseen developments outside of announcements, those companies that can "beat" on earnings should have favorable price movement, but beware of guidance. Outlooks from CEOs and CFOs will be in the spotlight as earnings growth is widely expected to resume in the second half of the year.
The year-over-year expected 8% decline in first quarter earnings is large, although actual earnings will likely be a bit better than that. It will still probably not be enough to reverse Corporate America's profit slump. We will be looking for improvements in corporate rhetoric, those green shoots that we need to start seeing - and perhaps, higher oil and a slightly weaker dollar can assist.
We'll be looking for companies with positive revenue growth, increasing backlog orders and innovative products; companies with cash who are investing for growth. Assuming continued slow growth, companies exhibiting those characteristics should be worth a premium.
Core portfolio positions in stable companies that generate positive cash flows and return a good portion of these to shareholders in the form of dividends and buybacks should be monitored closely for balance sheet deterioration. It is easy to get too comfortable with long-held positions. Much of corporate America has been slowly but surely adding leverage even as growth wanes and the business cycle ages. Earnings season is a good time to conduct in-depth reviews and make sure you really know what you own.