Yellen Consigning Stocks Fate to Earnings That Keep Falling

  • Falling profit greets Fed tightening for first time since 1967
  • P/E tops levels at eight of the past 10 bull market peaks

U.S. Interest Rates: the Fed's Plan for 2016

It’s hard to know which would be worse for U.S. equity investors right now: a contraction in valuations, or if stocks were left to rely on earnings growth to push them higher.

Both are likely outcomes of this week’s Federal Reserve meeting, where policy makers are poised to raise interest rates for the first time in 9 1/2 years. Past hikes have almost always put a ceiling on Standard & Poor’s 500 Index price-earnings ratios, and one now would come at a time when profits are already in decline. Such a combination hasn’t occurred in five decades.

The one-two punch is part of Goldman Sachs Group Inc.’s forecast that equities will go nowhere in 2016. The New York-based bank pins most of its pessimism on valuations, which would be a concern regardless of whether the Fed were meeting. At 21 times annual income, the S&P 500 is trading higher than it was at the end of eight of the past 10 bull markets.

“Raising interest rates is the equivalent of putting a brake to a car,” said Rich Weiss, the Mountain View, California-based senior portfolio manager at American Century Investment, which oversees $146 billion and favors European stocks over U.S. equities. “No question it’s dangerous with slow or no earnings growth, relatively high multiples and arguably an economy that’s stagnating.”

Fed Support

Should the Fed tighten, it would be retreating from support that has contributed to one of the biggest bull markets, an advance that could become the second-longest on record in 2016. Seven years of near-zero borrowing costs have helped corporate profits double since 2009 and fuel a boom in takeovers and buybacks.

Following the biggest weekly plunge since August, the S&P 500 added 0.5 percent at 4 p.m. in New York.

While Fed Chair Janet Yellen has pledged to raise rates at a gradual pace, history shows the negative effect on equity valuations is almost inevitable. Over the past 70 years, the S&P 500’s price-earnings ratios shrank during the first year in 10 out of the 12 Fed tightening cycles, falling an average 15 percent, according to data compiled by Bloomberg, Ned Davis Research and S&P Dow Jones Indices.

When P/E multiples are under threat, it helps if earnings are rising -- but that’s not the case now. Profits from S&P 500 companies are mired in the worst decline since the global financial crisis as a strengthening dollar and plunging oil wreak havoc on sales for companies from Exxon Mobil Corp. to Procter & Gamble Co.

Analysts predict a 0.6 percent decrease this year, marking the first time since 1967 that the start of a Fed tightening coincides with a drop in corporate profits. Such a thing has happened only three times since the World War II. In two, stocks held on to modest gains as earnings growth accelerated following the initial rate hikes in September 1958 and November 1967. During the cycle that began in April 1946, equities fell into a bear market despite a profit rebound.

“We view it as a pretty high-risk environment, very hard to justify many share prices for which they trade,” said Mark Travis, chief investment officer of Jacksonville Beach, Florida-based Intrepid Capital Management Inc., which manages $900 million and now holds more cash than normal. “Once we get through periods of volatility, it’s going to be interesting to see where we go.” Travis said he estimates stocks are on average 20 percent to 30 percent overvalued.

While Wall Street firms anticipate S&P 500 profit will rebound next year, their forecasts have shown a tendency toward excessive optimism. After predicting second- and third-quarter earnings would rise by as much as 7 percent and 9 percent, respectively, analysts were forced to reduce estimates only to see growth turn negative.

Should their 7.1 percent growth forecast for 2016 come true, the pace is still way below the average rate of 24 percent in the first year of past tightening cycles.

‘Steeper Path’

David Kostin, chief equity strategist for Goldman, is more bullish about earnings, expecting S&P 500 profits to expand 10 percent next year. Yet after taking into account a potential Fed-induced drop in valuations, his year-end target for the index is 2,100, a level that’s been crossed 38 times this year.

“Following the December lift-off, we expect a steeper path of tightening than implied by the market,” Kostin, based in New York, wrote in a Nov. 23 note. “When fund managers eventually realize the tightening process will be more sustained than originally anticipated, the P/E multiple will contract and offset the otherwise positive impact of 10 percent earnings growth.”

The August-September rout in equities shows that Yellen has no easy way to soothe markets. Not raising rates can be as dangerous as raising them when investors are holding concentrated bets in securities like financial shares, according to Stacey Nutt at ClariVest Asset Management LLC. Equities suffered their worst decline since 2011 in the third quarter as the Fed kept interest rates on hold and sounded caution over slowing growth in China.

The selloff “was a wake-up call for us as to just how systematic in nature this trade has become,” said Nutt, chief investment officer at ClariVest in San Diego, California. “When the market believed during that time that China would fall apart, and U.S. rates would maybe not go up, there was an extreme systematic reaction across commodities and stocks.”

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