As I begin writing this post the S&P 500 is retesting its low of mid-January (1813) and the NASDAQ composite is trading down nearly 20% from its peak last July. Since the beginning of the year US equities have been trading in an above average volatility environment which reflects a continued period of uncertainty within equity markets. Over the last five years, periods of high volatility have typically lasted less than one month. The last time we saw a period of sustained volatility was 2011 when volatility was high for more than 6 months and we are currently experiencing another period of sustained volatility. Why is there so much uncertainty?
Low oil prices and a strong US dollar are supposed to be good for the economy. Cheap oil and a stronger dollar provide more buying power for the US consumer and cheaper input costs for other industries outside of energy. In 2015, the US consumer spent $100B less in energy goods and services relative to 2014, however, consumers also saved $77B more in 2015 than they did in 2014 (Source: BEA). Consumers may be pocketing their oil savings because it is not a stable benefit like a wage increase. The lack of meaningful wage growth may be reducing the consumer’s appetite to spend.
Companies don’t seem to be fairing as well either as 4Q earnings may mark the first time since 2009 that there has been three consecutive quarters of year-over-year earnings declines. That statistic is a bit deceiving because the decline in earnings, with 334 out of 500 companies having reported, is really concentrated in the energy sector (negative 72%) and materials sector (negative 20%). Excluding those sectors the average earnings growth per company is around a positive 13% (positive 3% excluding Telecom). An interesting fact is that there have been 15 calendar years since 1960 when the market experienced negative EPS growth, but in only 4 of those years did the market have a negative return.
Our biggest concern is that the fallout from the energy sector will spill over to other sectors. Dividends were the first casualty in the energy sector and the market is now looking for its first bankruptcy. The concern about the energy sector hinges on oil prices, which is why we are seeing the high correlation between the equity markets and oil. With the elevated correlation also comes higher volatility because oil is so widely traded. In the short term the market will continue to trade with oil prices until oil finds a sustainable equilibrium. The other catalyst for equity markets moving higher will be wage growth and consumer spending. There are a number of positive signs in the economy as well (low unemployment, positive leading indicators, etc. ) so we maintain our conviction that equity markets can move higher, but we are keeping a close eye on what could go wrong in the markets.