Tickets Please!!

Welcome to the Roller Coaster! After four years of enjoying a gondola ride up the mountain, the market has finally decided it is time for more normal action and the ticket you have in your hand is for the Fury 325 Roller Coaster! While this correction has certainly been fast and furious, this is a normal part of market activity.

Historical Corrections

For the past 100 years, the market typically averages a 10% correction every 18 months. Every 5 to 6 years one of these corrections drops 20%. These gut checks are loosely based on the business cycle. I say loosely, because the market is priced on future expectations and not on the present. The volatility and fluctuations are a function of people adjusting their viewpoint of the future.

Another 2008 Correction?

Okay, so everyone accepts that the market will normally fluctuate. The fearful question in your heart is whether or not this is going to be another 2008-2009 situation. It took four years to recover from that disaster and most people don’t want to have another ride like that again. I am going to try and combat the emotional fear with logic to explain why I believe this will NOT be a major correction like last time.

Earnings Estimates

In 2007, operating earnings for the S&P 500 were $82.51. In 2008, the operating earnings plummeted to $49.51. A 40% drop in earnings! In 2014, operating earnings were $113.01. The current estimate for this year’s earnings is $111.89. Part of the reason for this decline is that at the beginning of the year, the estimates for the earnings were in the low $130’s. Earnings estimates are typically very optimistic at the beginning of the year and then get revised downward as the year progresses. Even so, the downward revisions are not usually 15-20% like they have been this year. The major culprits for this downward revisions to earnings are currency exchange and the collapse of oil prices.

Currency Fluctuations

With 40% of the earnings for the S&P 500 coming from overseas, a strong dollar has a negative impact on those revenues. In the past year, the dollar has appreciated over 20%. Currencies do not usually fluctuate this much over this short of a time frame. The sudden change in currencies is due to the perception that our economy is doing so much better than other economies. If our economy is doing well, then the Fed will have the opportunity to raise rates away from zero to a more normal rate. Higher interest rates mean that global investors will have the opportunity to earn more money investing here than abroad. This leads to a stronger dollar, which puts pressure on our exports. Normally companies will hedge against currency fluctuations. These hedges are designed to protect against minor fluctuations and not significant moves.

Chinese Currency Impact

The Chinese Yuan is pegged to the dollar and does not free float like the other foreign currencies. The dramatic appreciation of the dollar created an imbalance and placed a large strain on the Chinese economy. Ultimately, it forced the Chinese government to devalue their currency in a surprise move. The concern is that their economy, which has been a significant driver of global growth, is barely growing at a 3-5% rate instead of the 7-10% growth rate of the past decade. The market HATES surprise shocks.

Oil Price Impact on Europe and China

Oil is priced in dollars. A significant part of the drop in oil prices is due to the appreciation of the dollar. The beginning of the collapse in oil started with Putin. His actions caused a world reaction of sanctions against Russia. Sanctions led Putin to retaliate by threatening to cut off the natural gas and oil supply to Europe. This threat caused a slowdown in the European economy.

China is a big exporter to Europe so the European slowdown caused a slowdown in the Chinese economy. When these two major economies started to slow down, the result was a drop in the demand for oil.

Combine the lower demand with a significant increase in supply from the US and Saudi Arabia, and lessening tensions in the Middle East. Add in the dollar appreciation, and you have a 60% plunge in the price of oil. Obviously, energy company earnings are significantly impacted when oil prices drop this far, this fast. Energy companies make up about 15% of the S&P 500.

Good News

Now for the good news. These short term hits to the S&P 500 earnings are long term benefits to our economy. Anybody who drives a car knows that low oil prices have a very positive effect on their wallets. Lower energy costs mean lower utility bills, lower transportation costs, etc. Companies and consumers alike around the world are getting more money in their pockets. Eventually, this money will be spent on goods and services. Greater revenues mean greater earnings. Greater earnings will drive up the market.

Chinese goods are now cheaper to buy. This means that companies that sell Chinese goods can make more profits and/or lower the prices to their customers. This means more money in everyone’s pockets. More money to spend; more goods and services sold. In my opinion, this positive cycle can last for several years.

What Now?

The final question is what should you do now? If I could convince you that 10 years from now the S&P 500 will be around 3500, would you want to own stocks today? Are you thinking that I am making a bold prediction based on wishful thinking? (Anyone who knows me, knows that I am very much an optimist!) Here is my logic behind that number.

Assuming that the earnings come in around $110 for this year and the companies achieve their historical growth rate in their earnings (see previous blog), the earnings for 2025 will be $220. The historical average P/E ratio for the S&P 500 is around 16. This equates to a 3520 valuation.

Am I guaranteeing this result? Of course not. Is it a reasonable assumption based on 200 years of history combined with a logical assumption that lower costs will increase earnings? I think so.