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Halfway-point blues notwithstanding, strong earnings and other catalysts that could push the S&P 500 into the black by Christmas
August 20, 2015 — 3:53 PM UTC by Guest Columist Burt White
Brooke’s Note: An editor of mine back on the 1990s explained to me the perils of publishing an article about the market. If you suggest the markets will head in one direction, it is all but certain that they will immediately head in the other, À toute vitesse. But it is August and time to presume every raccoon is a grizzly bear and so Burt White was particularly brave writing with a hint of optimism in his voice. The market has obliged his half-full spirit by heading south but only until we get around to writing about bear riots as the likely trend.
This year has brought a whole lotta flat.
The S&P 500 dipped into negative territory for the year last week (on Aug. 12) and is only up about 1% year to date. The bond market has been flat — the Barclays Aggregate Bond Index has returned just 0.51% so far in 2015. Even the U.S. economy was relatively flat during the first half of 2015, with just 1.5% growth in gross domestic product on an annualized basis, well below potential.
Flat, flat, and more flat.
With the S&P 500 still fairly close to flat on the year (+1.6% on a price basis as of Aug. 14), we look at how likely stocks are to produce a solid year of gains. A look back at history over recent decades is encouraging.
The S&P 500 is about 1% higher than where it started the year, but it crossed under the flat line briefly last week (Aug. 12) and into negative territory intraday on a price basis. The first question we tackle is how likely the S&P 500 is to produce a positive year when it moves less than 2% as of the start of August.
We looked at data back to 1950 and found that if the S&P 500 is within 2% of where it started the year as of Aug. 1, it is more than 70% likely that the index ends the year higher (see figure 1), similar to the odds in any year. And in those years when it does end higher, the average gain is a solid 7.4% (excluding dividends).
A fairly encouraging picture.
Rally in the wings?
A different way of looking at the data reveals an even more encouraging picture. There have been 30 years since 1950 in which the S&P 500 was flat or down as of Aug. 1. In 14 of those 30 years the S&P 500 ended the year higher. An impressive feat, considering some of those years saw significant annual declines when August began.
But the same analysis during a more recent period — going back to 1980, which some refer to as the modern stock market era — reveals an even more compelling story. During those 17 years in which the S&P 500 was flat or down as of Aug.1, in only six of them did the S&P 500 end lower (eight were higher and three were flat). The average gain during those up years was 9.6%.
It is also interesting to look at how late in the year the S&P 500 showed a year-to-date loss before producing these solid gains (see figure 2).
The figure shows years when the S&P 500 was flat or down at the start of August and ended the year higher. Many of these solid years (1971, 1982, 1998, and 2004) were in the red for the year as late as October or even November and still produced solid high-single-digit or even double-digit gains. This is the classic fourth- quarter rally that we may see again this year. See: It’s a rent-and-hold market for stocks.
Some observations after reviewing this data:
1998: Quite a year for the stock market. The S&P 500 was down on the year as of October 8, 1998, and rallied to end the year up 27%. Granted, it was near the peak of the internet bubble and the Federal Reserve was cutting interest rates, but still quite a comeback. See: The cost of waiting for interest rates to rise.
2007: Stocks rallied from being down in early November to end the year 4% higher. Although that scenario could potentially occur this year (hopefully we are doing better than breakeven in early November), we believe that is where the similarities between 2007 and 2015 end.
1986: This year is not included in the list of flat or down years as of Aug 1. The S&P 500 was up 12% that year as of August 1 and never looked back, producing a 15% gain that year. We highlight this year because of the U.S. energy boom and subsequent collapse in oil prices seen then and now.
Though not listed here, the years when stocks are down in August, and stay down, have clear catalysts: energy crisis (1973 and 1977), high inflation (1981), and bubbles bursting or recessions (1990, 2000 — 2002, 2008). The U.S. stock market is clearly facing some challenges today, but the current environment looks very different from these years. See: Why the only thing bigger than the bond bubble is the bubble of bond doom-sayers.
Bottom line, history suggests stocks are capable of posting total returns this year in the range that we forecast in our Midyear Outlook 2015 (5% to 9% including dividends), despite touching negative territory on the year in August.
So what might fuel another late year rally?
We continue to expect earnings to be a catalyst to push stocks higher over the balance of the year. Although on the surface the 1% to 2% year-over-year earnings growth figure for the S&P 500 in the second quarter is hardly impressive, earnings growth excluding the energy sector is very impressive (estimated at 9%).
Also consider that figure includes several percentage points of drag from the strong U.S. dollar, which reduces overseas profits generated by U.S. multinationals. Better economic growth in the U.S., less drag from the energy sector and a strong dollar, and effective cost controls could potentially all contribute to improving earnings growth in the second half, while moving further beyond the one-year anniversary of the start of oil’s decline (June 20, 2014) should help contribute to a more positive earnings trajectory as 2016 begins. See: Saudi Arabia-fueled RIA adds an academic to its oil-rich mix.
The possibility that the Federal Reserve surprises the market somehow is a risk, but as we discussed at length in our Midyear Outlook 2015 publication, the stock market has a history of effectively negotiating the start of Fed rate hike cycles. Slowing growth and the currency devaluation in China do not change our expectation that the Fed will hike rates before the end of 2015. See: Can we handle the truth? The 30-year golden era for the S&P 500 may have been a period of decent growth juiced by leverage.
A more pronounced slowdown in China, however, is a risk (though not our base case). We expect slower growth in China to be offset by potentially stronger growth from other overseas economies, including most of Europe and Japan, and to lead to slightly stronger global growth in 2015 than 2014 (see our Weekly Economic Commentaries, “Global GDP Tracker: Summer 2015 Edition” and “China Currency Conundrum”). Meanwhile, previously enacted stimulus measures from the Chinese government are still working their way through the system and more actions are likely on the way. See: Why the U.S. should follow China in issuing 50-year bonds.
This year has brought a whole lot of flat. But the S&P 500’s dip into negative territory last week should not be interpreted as a sign that a weak year for stocks is a guarantee. A look back at history reveals that stocks are more likely to end this year higher than lower, and that high-single-digit returns may be in the offing even if the S&P 500 is flat or down slightly well into the fall. We see several potential catalysts for a late-year rally — most notably earnings — and continue to expect stocks may deliver high-single-digit returns in 2015.
Burt White is chief investment officer of LPL Financial. He provides strategic guidance for the LPL Financial Research team, ensuring alignment with the firm’s goals for maintaining the highest levels of integrity in pursuit of conflict-free, objective investment advice.
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