The Market - what's going on?

About the author:

Michael Knox
Author name:
By Michael Knox
Job title:
Chief Economist and Director of Strategy
Date posted:
29 February 2016, 10:35 AM

Over recent weeks, the market has been beset by major swings both up and down. Almost daily major shocks kick the market around. The causes suggested by commentators sometimes run to oil prices and the Saudis. Sometimes they run to the Chinese exchange rate. Sometimes they run to the problem of Britain exiting the European Union.

This poses the question that I have been asked more than once - "What's going on?". My view is that the basic causes of the big swings in the market are much simpler. The swings relate to disappointments in US earnings. 

In the chart below we see the path of operating earnings per share for the S&P500 since the beginning of 2014. The blue line on the chart shows the actual level of earnings per quarter, up until the final quarter of 2015. For 2016, we show the consensus earnings forecast as the red line:

S&P500 operating earnings per share chart

When we look at the blue line we see that the actual earnings peaked in the third quarter of 2014. The peak level they achieved was $US29.60 per share. Then they fell. The fall in earnings can be attributed (you guessed it) to the fall in the oil price. In the first quarter (the final quarter of 2014), operating earnings per share fell by almost $US2.85 to $US26.75. Operating earnings again declined in the final quarter of 2015 to $US25.81.

The earnings for the first quarter of 2015 were published (as normal) in the second quarter of 2015. It was this slump in the data series which set up the models which drove so much stock market activity for a sell-off in the third quarter of 2015. The combination of those lower earnings and the decline in momentum set off the aggressive computer driven collapse of the market on 24 August 2015.

The market then rebounded from that sell-off. The reason that the market rebounded was that consensus forecasts of operating earnings per share were offering a brighter future. By the end of August 2015, the consensus analyst forecast was that operating earnings per share would recover to $US28.93 in the third quarter of 2015. These numbers, when they actually came to pass, would be reported in the fourth quarter of 2015. The problem was that the earnings did not live up to the forecast. The actual level of earnings for the third quarter of 2015 was only $US25.44 per share. The reason for the failure of earnings to recover was again energy companies but also the materials sector.

What we see is the beginning of a pattern of earnings disappointments. By November, analysts were again providing a consensus estimate of a dramatic recovery of operating earnings in the fourth quarter of 2015. By November 2015 they were suggesting that operating earnings per share for the fourth quarter would recover to $US29.32. These earnings would be reported in the first quarter of 2016.

Once more, the earnings did not live up to the forecast. As this became apparent at the beginning of 2016, the market again sold off. At the present time, the level of operating earnings per share for the final quarter of 2015 is estimated to be $US25.35 per share. This is one more whopping disappointment.

What we have seen over recent quarters is the market quite rationally adjusting to firstly a decline in operating earnings per share and then in repeated failures of that operating earnings per share to recover. These repeated disappointments have generated repeated surges and selloffs in markets as markets have attempted to adjust to the most recent information.

The variation of the market has not actually been driven by China or by Brexit or even that much by the Saudis. The market has actually been driven by good old fashioned fundamentals. The market has been driven by variation in earnings. 

Where to from here?

Let's go back and look at the current consensus forecast of earnings that we see in the chart above. These are shown as the red line. Now these charts don't assume any recovery in the oil price. All they assume is that the oil price won't fall much further from here. This means they assume that we can look forward to a future when we can stop thinking about the oil price and just look at what is happening in the US economy.

We have said elsewhere that there are significant areas of investment happening in the US this year. There is a recovery in residential construction. There is a recovery in non-residential construction. There is the building of new office space and new hospitals. There is also considerable investment in refurbishing US factories. This will provide considerable growth to the US economy over the balance of 2016. No one, including us, really thinks that the US economy is falling into recession.

This means that earnings will recover over the balance of the year. Right now we are coming off a quarter where operating earnings per share were $US25.35 for the final quarter of 2015. The consensus estimate is that this will rise in the first quarter of 2016 (a quarter we are now in) to $US26.76. The big increases begin in the second quarter of 2016. In the second quarter of 2016, operating earnings per share are expected to reach $US29.52. Should this be achieved it will take operating earnings per share back to the peak level of 2014.

In the third quarter of 2016, operating earnings per share are expected to rise to $US31.42 per share. This would be a new record high for this market cycle. The new record high would be broken again in the fourth quarter of 2016. In that quarter, operating earnings per share are expected to reach $US32.46. Should these operating earnings per share actually be achieved, then it would be reasonable to expect that the market would be trading at or near new record highs.

It all depends on what earnings are actually delivered. We are all going to have an interesting ride as the market discovers the level of earnings that the economy is going to deliver.

Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents ("Morgans") do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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