Ouch! Stock Market Earnings Fell 15%. Should You Sell? Market Valuation Update: June 2015
The stock market is driven by valuation, and valuation is driven by earnings. This is how the wealthiest investors think, and they use that thinking to help them manage their investment risk. The term is “margin of safety” and it’s an important concept. Successful investors are searching for that margin of safety, whether they are small investors with a million or two, or a mutual fund with hundreds of billions under management. Big or small, investment success demands the same discipline.
Generally speaking, the higher the valuation versus the historical average valuation, the lower your margin of safety.
There is another side to this coin –“expected return“–it’s the potential reward you may receive for buying at a certain valuation level. The lower the valuation versus earnings, the larger the margin of safety and the larger the expected return.
Add expected return to the dividend payout and you get “total expected return” which is exactly what it sounds like. We’ll have a look at that below.
So what return might you expect if you buy the S&P 500 or Energy Sector right now?
The first quarter of earnings has finished reporting and both the S&P 500 and the Energy Sector had a tough go of it. You might recall the S&P 500 earnings chart I published in the last valuation update. This one looks different.
You can see the S&P equal weighted earnings have fallen about 15% from last quarter, beneath the earnings trend line that was established in 2011. For the Energy Sector, it was even worse. Earnings plummeted to levels not seen since 2009.
How does the reduced earnings impact expected returns?
In case you were wondering, these returns would be classified as poor. Lame. Sub-par. Some might say downright crappy, even. However, it gets better (a little) when we add in those much needed dividends.
The S&P’s proxy, SPY, pays about a 1.9% dividend at $210 a share.
3 year expected total return for SPY at $210 per share if earnings don’t improve next quarter: about 3.4% compounded annuall.
How about energy? XLE, the Energy Sector proxy, pays about 2.5% dividend at $75 per share.
3 year total expected return for XLK if earnings don’t get better, and quickly: about 1.7% compounded annually.
If you are happy to expect 1.68% a year for buying a basket of stocks, step away from the checkbook and get some help. Now. Yesterday would have been better, but with that thinking tomorrow may be too late.
More seriously, if you are putting money into either the S&P 500 or the Energy Sector at these prices, give it a second think. Buying here is betting that earnings are going to improve strongly in the next couple quarters. Be aware of that. Maybe you should take a look around at some of the other sectors out there. There are 10% + opportunities out there, you just have to look, and know how to look.
So, should you sell? If you just bought at these prices, you might consider putting that money to work elsewhere. If you bought significantly lower, you might be just fine where you are.
Hope this helps. Thanks for stopping in and and please share. Almost every investor can learn something useful here.
And send me your questions. Use the contact page or email me directly: dhartsock at aciwealth dot com. If I didn’t really enjoy helping people understand investments and how the markets work, I wouldn’t spend my time on this blog.
To Smarter Investing — Dak
The rest of this post is for those of you that are interested in my personal take on what’s happened to earnings in the S&P and Energy. If all you wanted to figure out is what you may get for investing money in the S&P 500 or the Energy Sector right now, you might as well stop reading here. Nothing for you below.
Still with me?
Okay, here is my opinion. Understand the market couldn’t care less about my view.
We had a big slowdown in the earnings of these two sectors in the first quarter for reasons I won’t go into detail about, but at this point I don’t see the reasons persisting through the next couple quarters. I think we’ll see a re-acceleration in the S&P by 3rd quarter if not the 2nd, and same goes with Energy. The plunge in energy hit the S&P as well as the Energy Sector as the index has a number of substantial energy or energy related companies in it. Several other sectors my firm and I track are doing okay on the earnings front and a couple are doing better than okay.
Right now the Energy Sector is re-allocating capital to make themselves competitive in a prolonged period of $60 – $80 oil. The cratering earnings from the last quarter reflects those adjustments. There will be consolidation in the industry with some of the majors buying some of the smaller companies to increase their growth rate and their field leasing footprint. When the sector emerges from the restructuring, earnings will increase — not at the pace we saw last year, but enough to push expected returns back north of 5% at least.
Those changes will track into the S&P 500 as well.
A quick look at the RPI (Recession Probability Indicator) also tells me that while we’ve seen some risks rising, we are still well within the tolerance of the market to sustain an uptrend, or at least avoid a bear market.
The Fed could bring that to a screeching halt with a couple missteps, but unlike the other 92% of managers CNBC surveyed the other day, I don’t expect the Fed to raise in September. I think December is the earliest. I have a lot of reasons for that, and I may be wrong, but as long as the Fed doesn’t shock the market by raising too early or too aggressively, I think the market motors on. It might chop a bit, but it should grind higher. Sometimes it’s hard to see it, but things are improving. Much more slowly than they should thanks to excessive regulation and the Gov bailouts from previous years, but the track is still upwards.
Questions or thoughts? You know where to find me —>>> Contact Dak