The S&P500 and the Fed
About the author:
- Author name:
- By Michael Knox
- Job title:
- Chief Economist and Director of Strategy
- Date posted:
- 26 August 2016, 4:00 PM
The S&P500 is surprised to find that it is in another up-leg in a long term bull market. This up-leg in the bull market is a result of the improved outlook for US earnings.
In the previous cycle, 12 month rolling operating earnings per share for companies listed in the S&P500 peaked at $US114.34 per share in the third quarter of 2014. Earnings then saw a steady slump for the next seven quarters. This decline in earnings has now reached its low in the second quarter of 2016 at a level for 12 month rolling operating earnings of $US98.31 per share. This decline in earnings was caused by the decline in the earnings of energy companies together with a slump in investment in non-residential construction in the energy sector.
Just as the decline in the $US oil price has come to an end, so has the decline in the earnings of energy companies and the slump in non-residential construction. This does not mean that the market expects a significant increase in earnings from energy companies. It is however the case that the market does expect that the losses from energy companies are now behind us. The result is that operating earnings per share of companies in the S&P500 outside the energy sector should be able to contribute a dramatic increase in earnings over the next year and a half.
In Figure 1 above, we see the recovery in operating earnings per share from Q2 2016. The primary areas of growth are consumer discretionary, information technology and health care. The US economy has reached full employment with unemployment at less than 5% and US wages are beginning to rise at an increasing pace. Skilled middle income jobs are returning. Consumer incomes are rising. This return of prosperity is generating a new life in consumer discretionary.
Quarterly operating earnings per share are expected to rise from $US98.31 in Q2 2016 to $US132.83 by Q4 2017. This is a rise of 35% in operating earnings per share over the next six quarters. The S&P500 has anticipated the increase in operating earnings per share as far as the first quarter of 2017.
Our model of the S&P500 tells us that fair value for the S&P500 for Q1 2017 is 2161. The S&P500 was already trading at that level in August 2016. Still, further rises in US earnings are anticipated. Our model of the S&P500 tells us that the level of earnings for the S&P500 expected in Q4 2017 increases the value of the S&P500 to 2333 points. Our model of the S&P500 showing the effect of the improvement in earnings up to Q4 2017 is shown in Figure 2 below:
The Federal Reserve and the Real Economy
Against this background of improving fundamentals, the Federal Reserve faces the problem of maintaining growth in the US economy at a steady level. Its objective is to keep US inflation based on the core personal consumption deflator at its target or around 2%. The core personal consumption deflator is usually around 0.5% lower than the core CPI. This means that the Federal Reserve target on the personal consumption deflator of 2% is almost identical to the Australian RBA target of 2.5% on the core CPI.
As unemployment falls, and as wages growth increases, this puts upward pressure on core inflation. The Federal Reserve must gradually increase the Fed Funds rate to slow the growth rate of unemployment. Right now US monthly employment is increasing at an average rate of 190,000 new jobs per month. In order to stabilise inflation at the target level, the Fed needs to reduce that growth rate in employment to around 80,000 new jobs per month.
In order to stabilise employment growth and the level of inflation, this means that the Federal Reserve must begin to increase the Fed Funds rate in the very near future. The market believes that the Fed will not increase the Fed Funds rate until March next year. The market is wrong.
The Fed could begin to increase the Fed Funds rate as early as September this year. These increases in the Fed Funds rate will present shocks to the US equities market. These shocks will be presented in the environment of improving fundamentals. The result will be a series of bull market corrections in the S&P500.
Conclusion
These bull market corrections in the S&P500 will reveal the Federal Reserve at work, making sure that the US economy continues to grow at a healthy but steady pace.
More information
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