We’re finally coming to a close for 2015, and the final quarter will be the conclusion to a year that’s been defined by uncertainty and uneven performances. Mixed economic data haven’t given investors a clear vision of what the future will look like, while other regions around the world have shared in a global economic slowdown that finally culminated in a collapse in the Chinese stock market last quarter.
Volatility, which had remained relatively muted for most of the year, soared at the end of August through early October and could spike yet again before we see the end of the year. Of course the biggest news so far this year is the surprising move by the Fed to hold interest rates steady despite widespread belief by Wall Street that rates would be rising this year. While the Fed will meet again in December, based on lackluster data, it seems more likely that rates won’t see a lift until the end of the first quarter in 2016 at the very earliest.
Unemployment is a bright spot in the economy at just 5.1% as of September’s numbers but is somewhat mitigated by stagnant wages and persistently low inflation. GDP growth for the first quarter was revised higher to 0.6% while growth for the second quarter came in slightly higher than originally expected at 3.9%. We’ll have to wait to see what the figures for the third quarter will be, but so far it seems to indicate that the economy is actually still in a growth stage but at a much slower rate than investors want.
The Big Picture
It’s too soon to know what kind of growth we’ll see from the third quarter this year but some good news came out of China this month. Third quarter GDP came in higher than expected at 7%, helping assuage investor fears that China’s economy was facing imminent collapse. It could serve as a lesson, however, in reduced expectations that the global economy might not be as weak as previously believed.
Entering into the final months of 2015, we should see inflation steadily rising – finally coming off of temporary deflation earlier this year and slowly building up to the 2% target level the Fed had previously set. However, the Fed has stated that it won’t eye a rate hike until the inflation figure falls more in line with expectations, so it’s unlikely that inflation will rise far enough by December to see a rate hike for 2015.
The good news is that the fourth quarter has historically been the strongest quarter for growth with an average return of 5.15% in the past 20 years. While we don’t expect to see that kind of strength this year, the markets should still enjoy a strong bullish build-up in November and December. Still, stocks could end the year flat overall.
Corporate Earnings Will Continue to Be a Primary Driver of the Market’s Direction
According to FactSet, as of October 23rd, 173 companies have reported earnings for the third quarter with a blended earnings decline of 3.8%. If the trend continues with the index indicating a decline for the quarter, it will be the first back-to-back quarterly earnings decline since 2009. Twenty-six companies have issued guidance so far with 19 of them negative and seven of them positive.
Energy and materials are the biggest laggards while telecommunications and consumer discretionary lead the way for the highest earnings growth in the third quarter so far. Investors are responding to earnings misses and beats more than usual with the average price jumping 2.5% for companies who beat earnings and falling 3.4% for those that miss expectations. That’s higher than the 5-year average and suggests that volatility is still alive and well in the current marketplace.
Although there appears to be an earnings decline right now, only 34% of companies have actually reported. The decline of 3.8% is actually an improvement from last week of -4.9%. Positive earnings surprises by companies in the Information Technology, Consumer Discretionary, and Telecom Services sectors largely contributed to the decrease in earnings decline for the index this past week. Earnings beats by companies such as Microsoft, Amazon, Google, McDonald’s, and AT&T added to the rise in overall earnings figures and could set a precedent for improvements in large cap companies for the fourth quarter.
Looking ahead though, there are warning signs that all is not well with corporate profits. Wal-Mart issued negative guidance for FY2017, lowering EPS growth by 6-12% and full year earnings from $4.72/share to $4.20/share. It could be an indication of deeper weakness in the economy that hasn’t yet fully come to light. Considering that consumer discretionary has been a leader in earnings so far for the third quarter, investors will be closely watching to see if the miss is exclusive to Wal-Mart or signs of trouble in the retail sub-sector.
Next week, 118 companies listed in the S&P 500 are scheduled to report earnings, giving us a better idea of what the third quarter will look like and help illuminate what the fourth will tell us as well. Keep in mind that eight out of ten stock sectors have a P/E in excess of their 10-year average while just one sector, telecommunications, is below it with IT services trading on par with its 10-year average.
For the fourth quarter, we expect to see positive earnings from large cap companies further aided by good earnings in the technology sector. Positive earnings coming from auto manufacturers should carry over into the fourth quarter while energy companies, although still far below their averages, should report higher than expected earnings as oil seems to have come off its lows and will likely stay in the mid $40’s to $50 range by the end of the year.
Volatility should also ease as markets settle down this quarter and trading stabilizes. The markets have priced in a “hard” landing for the Chinese economy – a fear that will soon be realized as overblown with a “soft” landing far more likely. On Friday, October 23, 2015, China’s central bank announced a quarter-point cut in benchmark interest rates along with a half-percentage reduction in banks’ reserve-requirement ratios in order to lower corporate financing costs and pump liquidity into the economy. This news should help buoy stocks in the final quarter as well.
Oil and gas prices should likewise stabilize as the supply glut falls more closely in line with demand. However, global weakness will continue to plague the industry with lower energy demand both domestically and overseas. Gold could see a lift due to a “flight to safety” effect ahead of the Fed’s December meeting. However, as the dollar regains its footing and rates rise early next year, gold’s strength may well be temporary. The dollar has regained strength as central banks overseas are actively devaluing their domestic currencies. China, Japan, and Europe are all expected to do more quantitative easing in the fourth quarter.
Looking Ahead to 2016
While the fourth quarter may be a decent one for corporate earnings, enough companies are giving muted or negative guidance for next year that could indicate a bearish market on the horizon. More layoffs in multiple sectors are likely to continue if not increase.
The global economy is showing signs of a slowdown which means 2015 or early 2016 could be the moment when it hits its peak and begins a long reversal pattern back down. Compounding the problem is that there’s so much money currently invested in the markets that it will be hard to maintain these highs for much longer. Eventually when the market hits the top, there just won’t be enough buying pressure to keep markets from tumbling.
On a positive note, analysts do expect positive corporate earnings growth to return in the first quarter of 2016. Revenues are set to grow at 3.6% as opposed to a decline of 2.0% in the fourth quarter. However, it might only be enough to signal a market top before a bear market takes hold and drags the economy and the broader averages lower.
CEO, Elite Wealth Management
Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.