Ignoring, for the moment, the last three days of trading action, the stock market appears to be in the early stages of a correction. Last week, the S&P 500 broke below 1820, its October 2014 low, setting the next downside marker in the pattern of lower highs and lower lows that is characteristic of a downtrend.
The weekly chart of the S&P 500 shows that the market has been rolling over since it peaked in May of 2015. Over the past nine months, the S&P has suffered two sharp breaks – first in August and then in January. It is still in the process of trying to recover from the sharp January sell-off.
After the first break in August, the market rallied, but topped out in early November, sixteen S&P points below the May peak – a lower high. In this latest sell-off, the S&P has broken below the August low of 1867.01 – a lower low – briefly touching 1810.10 during last week’s plunge before snapping back. Thus, the pattern of lower highs and lower lows has been established.
In my mind, the benefit of the doubt now belongs to the bears. The odds should favor those who think that the market is headed lower. Bullish bets should have a better than average payout because the chances of succeeding are lower.
The question now becomes: how low will the market go? Estimates for the bottom vary quite a bit. Some say that the S&P could trade down to 1570, a decline of 18.5% from Tuesday’s (2/17) close. A retracement of the entire stock market rally since March 2009 low could conceivably take the S&P 500 down to 1400, a potential drop of 27%.
Yet, the market may already be at or near a bottom. To make that assessment, I look for supporting evidence and clues.
Here are a few:
- In my last post, I provided a look at key economic indicators to support the view that the U.S. economy is experiencing a slowdown in growth that could prove to be temporary. I argue that it is not necessarily on a quick path to a recession;
- As for valuation, the 9.7% decline in the S&P 500 since the May 2015 peak has been driven mostly by cuts in forward earnings estimates. Valuation multiples are little changed. Back in May, operating earnings estimates for the S&P were $117 for 2015 and $134 for 2016. Today, operating earnings for 2015 are coming in at $104, a decline of 11.2% from May’s estimate, and projections for 2016 are now $120, a decline of 10.5%. The 2015 operating earnings multiple has therefore risen slightly from 18.2 to 18.5 and the 2016 multiple has also increased slightly from 15.9 to 16.1.It is also possible that the cuts in earnings estimates have been overdone – which is plausible, if not probable, in sectors like energy and materials. If so, forward multiples may be overstated and the market could be cheaper than it appears.Although multiples are little changed in the major sectors, there are some subsectors that are showing more significant changes. For example, I have noted that forward multiples on homebuilding stocks have declined significantly. There, the market seems to be anticipating a more significant decline in 2016 production, sales and earnings, which is at odds with trends in orders and backlogs.
For now, the stock market appears to be waiting for an improvement in the earnings outlook and not forecasting a recession. It apparently sees the recent cut in earnings estimates as a blip.
The changes in valuation multiples by sector tell a more nuanced story. All sectors have experienced cuts in 2016 earnings estimates. Only three sectors, however, show gains in price since the May peak: consumer staples, utilities and telecom. Valuation multiples are up in energy (because 2016 earnings estimates have plunged 70%), and are up only slightly in consumer staples, utilities, consumer discretionary and materials (i.e. share prices have not fallen as much as earnings estimates). Multiples are slightly lower in healthcare, industrials and financials. They are essentially flat in technology and telecom.
On balance, therefore, the market has been responding to changes in earnings estimates. If it were anticipating a more significant drop in earnings (which might be associated with a recession), I would expect to see a decline in P/E multiples. The market seems to be reacting rationally and methodically to changes in the earnings outlook for specific sectors – energy and materials have been hit hardest – , even though market volatility conveys more emotion in these sell-offs.
- Transportation stocks have been outperforming the broader market since mid-January. Under Dow Theory, movements in the transports should be followed (or confirmed) by similar moves in the industrials. Since goods are shipped before they are sold, an improving outlook for transportation stocks often precedes a similar move in industrials, consumer goods and retailers;
- Integrated oil companies have outperformed the broader market so far this year. The large integrated oil companies have stronger balance sheets, giving them a greater ability to ride through this period of low commodity prices. So far this year, the Dow Jones U.S. Integrated Oil & Gas Index is up 2.9%, better than the losses of 4.8% in the Dow Jones U.S. Energy Index and 6.4% in the Dow Jones U.S. Total Market Index. Thus, it appears that investors have begun to bottom fish in the oil patch, presumably sensing that a bottom is at hand;
- With today’s (2/17) gains, the market has experienced its first three-day advance this year. The gains over this period have essentially erased all of last week’s losses and should provide at least a modest psychological boost to the market.
By definition, the market will remain in a downtrend, if it keeps making lower lows and lower highs. Alternatively, it will remain range-bound if it continues to trade between the recent low of 1810.10 and the May 2015 peak of 2134.72 on the S&P 500. An uptrend will not be reestablished until the S&P 500 breaks above that May 2015 peak.
February 17, 2016
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036