Who could have seen this correction coming? Everyone.
Over a trillion (yes, the big T) has been erased from accounts and the market.
Somehow, whenever a correction or downward slump happens, there is a downright disturbing level of confusion or outright ignorance as people are blindsided.
No better word could capture what has happened this time around. Investors aren’t being blindsided because they couldn’t have known.
They are being blindsided because they weren’t paying attention to a reality that was staring them in the face.
The standard MSM response is out in full force now. Every day for the past week-and-a-half we’ve seen headlines and talking heads calling a bottom. Every day the blindly bullish cheerleaders have been wrong.
So what is so obvious? The simple fact that companies need to keep making more money to justify higher stock prices.
Yes, it really is that simple, and the lack of understanding doesn’t bode well for the market going forward.
This is a Domestic Issue
Before we look at the domestic side, the one that truly matters, a quick word about China is probably in order.
Yes, China can be seen as an indicator for global economic activity, but it is not a very good one, especially for most S&P 500 companies.
While the domestic stock market will rightfully react to Chinese economic news, it doesn’t explain why people are selling off so much, driving down the S&P 500 by 8.6% from the high on December 29th.
The U.S. market is surprisingly walled off from the rest of the world. Based on information available in 10-K filings from companies in the index, a mere 2% of revenue is generated in China, while 67% is generated in the U.S.A.
Europe and the rest of the Western hemisphere account for far more revenue — 7% from Europe, 5% from Canada plus Central/ South American countries.
Yet the U.S. market has displayed a resilience to bad news from Europe and the major economies to our south.
That suggests that U.S. equity investors attach an irrational weight to China alone, or that negative news from China serves as a trigger or catalyst for sorting out irrational exuberance in our domestic stock markets.
With mixed results over the past several years of the bull run, in which trends in China that we’re seeing today were already well established, I’m leaning towards the latter being responsible for the bulk of the selling to date.
It is a reminder to all that, when left to our own devices, we’ll gladly step back into our echo chamber of complacency and buy buy buy.
U.S. stocks never would have slipped this far if it weren’t for underlying weaknesses that were in play for most of last year, and will remain for most of 2016 as well.
All About Revenue
To get to the bottom of why there is so much downside in the market right now, all you need is the weekly Factset Earnings Insight report.
Here are the key takeaways from the one released on Friday:
- Q4 2015 blended earnings are set to decline 5.7%.
- If and when earnings for Q4 come in negative, it’ll be the first time S&P 500 has seen three consecutive quarters of year-over-year declines since Q1 through Q3 2009.
- So far for Q4 2015, 84 companies have issued negative EPS guidance and 29 companies have issued positive EPS guidance.
That -5.7% figure should be taken with a grain of salt. Estimates and reality often diverge quite a bit.
However, the trend of shrinking shows an undeniable trend, summed up quite well in this chart:
All of this is due to a steady slide in underlying revenue, projected at around -3.3% for the fourth quarter.
The share buyback spree cannot hide that, though anyone taking the steady stream of earnings misses and beats that is coming up will miss the critical information.
It should come as no surprise that the Materials and Energy sectors are responsible for a lot of this, yet the market is out of step with reality.
As Factset noted last week:
At the sector level, nine of the ten sectors recorded a decline in the bottom-up EPS estimate during the fourth quarter, led by the Materials (-21.7%) and Energy (-14.8%) sectors. However, the price of these two sectors moved in opposite directions during the quarter. The Materials sector recorded the largest price increase (+9.1%) of all ten sectors during the quarter, while the Energy sector recorded the largest price decrease (-0.3%) of all ten sectors during the quarter.
The status quo appears to still be a steady stream of buying, in spite of no positive news, dreadful estimates, and no recovery in sight for either sector.
Abnormally high P/E multiples, even after the last couple weeks of share price declines, show how inflated the S&P 500 remains:
Getting Paid
The short version of all of this is, “The beatings will continue until the bottom lines improve.”
As a result, the broad index investment, as crucial as it is as a long-term portfolio allocation, isn’t going to do much to build wealth for the foreseeable future.
A better option for long-term, stable returns that dodge short-term capital gains taxes is to disproportionately allocate new retirement funds to sources of income that are not dependent on the “greater fool” strategy.
Instead of counting on someone to pay more for what you own today, get paid by the investment itself.
In spite of earnings and revenue declines, there are plenty of great companies out there that will provide consistent dividend payments.
Many of these companies haven’t seen a reduction in shareholder income for decades, and an elite group have seen dividends go up every year for a quarter century.
When the earnings and revenue recession passes, probably in the second half of 2016, you can always shift new funds towards broader, growth-oriented passive investments to return to your ideal long-term allocation.
However, until then, don’t count on market gains to drive retirement fund gains. Use sources of income that are functionally independent from these market swings to your advantage.
Utilize programs that drive down fees and costs by cutting out the Wall St. middlemen to effectively boost these virtually guaranteed returns even further.
There is good reason why the Wall Street Journal called this strategy, “The best-kept secret on Wall Street,” and now is the ideal time to utilize it.
