Dancing With the Stars

By David B. Armstrong, CFA | May 05, 2015 | Weekly Market Commentary

Not only were the major market indices down for the week, but I also feel like I lost $100 getting the pay-per-view of what was supposed to be the “Fight of the Century.” I’ve seen more action on Dancing With the Stars and better hitting in an episode of MTV’s The Real World than I saw in that fight. I guess it goes to show you when two guys who will each make over $100 million, regardless of the outcome of a fight, you can bet neither will fight hard. Good lesson. The only thing weaker than the hits in that fight was the data on first quarter 2015 GDP, which was a fizzle… but there is more to it than just the number.

GDP

It’s true that Gross Domestic Product (GDP) is a backward looking indicator (in this case January through March) but the first peek was well below what most analysts had expected.

GDP, which is the broadest measure of goods and services in the economy, slowed from fourth quarter’s annualized pace of 2.2% to just 0.2% in the first quarter of 2015, according to preliminary data compiled by the U.S. Bureau of Economic Analysis. Economists were expecting the first quarter reading to come in around 1.0%.

Remember that when GDP is reported, there is the initial report and then two more revisions – so it’s possible the reading will change as more data comes in. Especially March’s data.

Reasons for the first quarter slowdown can be primarily blamed on two key components of GDP. While consumer spending decelerated, a big drop in exports trimmed nearly one percentage point off GDP, and a contraction in business investment (capital expenditures such as equipment, structures, software, etc.) reduced growth by another 0.40 percentage points.

So What Gives?

Well, as we have mentioned in a few previous blogs, you don’t need to look any further than:

1. The strong dollar – It makes U.S. exports less competitive/more expensive.
2. The steep cutbacks in the energy industry – They are the result of falling oil prices.
   1. In fact, one measure of spending for capital equipment used in energy production fell at an annualized pace of nearly 50%.
3. Cold weather – Stuff just simply stops happening when it’s cold.
4. The port slowdown on the west coast – It did not receive the kind of news attention that Bruce Jenner has received, but it has caused some problems.

One important thing to keep in mind is that the first quarter GDP reports have been consistently soft relative to the rest of the quarters and the final year GDP figure dating back to 2009, so it’s not the greatest indicator out there in predicting how the entire year will end up. For example, we just had a final year 2014 GDP of 3.0% when the first quarter of 2014 was around -2.1%.

In fact, there was a report on CNBC that highlighted some of the first quarter’s lackluster performance and attributed it to seasonal oddities in the data. They reported that over the past 30 years, first quarter growth has been by far the weakest of the four, averaging just 1.87%, while the economy has grown 2.7% annually.

We will see how the revisions end up, but one thing the markets like is that weak GDP readings don’t favor quick, unexpected large rate hikes by the Fed. The first revision will be reported on May 29^th.

Cause for Optimism

Most economists and the Federal Reserve expect a modest pick-up in growth in the current quarter (second quarter). Although March is only one month, and it followed three previous months of weakness, we saw retail sales rebounding and both new and existing home sales gradually perking up. Oh, and for the first time in two months, claims for unemployment insurance have been trending lower.

As I alluded to above, the slowdown in growth has greatly reduced the odds that the Fed will apply its first rate hike in nearly 10 years at the June meeting.

April’s Fed Survey from CNBC.com shows 84 percent of those responding to a survey believe a rate hike will occur this year. But economists, analysts and money managers surveyed don’t see the Fed hiking until October, and I’ll bet that’s even looking to be a little early. Just a hunch.

Yet, the economic slowdown has done little to dent the equity markets! The NASDAQ Composite achieved a new milestone, surpassing the old record set in March of 2000, and I think that’s quite an achievement given what happened after the dot-com bubble burst. We also saw the S&P 500 Index close at a new high late in the month. True, most of the broader U.S. indexes have failed to post significant gains this year, in part because slower economic activity dented earnings expectations, but recent market action suggests the economy will continue to advance, even if it’s not at an impressive pace.

Earnings

Just about 1200 companies have reported their earnings and revenue for the first quarter (1Q) of 2015. This last week was a lot more negative than the week before.

According to Bespoke, here’s how we look:

The percentage of companies beating their revenue estimates for the 1Q of 2015 stands at 49.5 %, down from 52.3% last week. 49.5% is currently well below the average of 60% that we’ve seen since 2000 and well below the final 58.1% from the 4Q of 2014. Since the revenue readings bottomed out in the 4Q of 2011, quarter-over-quarter readings have ping-ponged but the trend has been positive for revenues. We will see how things end up.

The percentage of companies beating their earnings estimates stands at 62.5%, which is a big drop from the 66.5% from a week ago. 62.5% is just about dead even with the average of 62% dating back to 1998, and close to the 61.1% final reading from the 4Q of 2014. Bespoke also publishes a chart that shows the spread between companies guiding future earnings higher or lower on a percentage basis. Up until the 1Q of 2014, the spread had been negative for the TEN previous quarters, meaning there were more companies stating they would earn less in the upcoming quarter than the same quarter a year prior. That’s 2.5 years of pessimism coming out of corporate America.

After two flat quarters in the 1Q and 2Q of 2014, we saw the 3Q of 2014 revert back to a negative reading. The final reading for the 4Q of 2014 shows that the spread between companies posting negative guidance versus companies posting positive guidance in the 4Q was a whopping -9.4%! This was the worst spread reading since the last two quarters of 2008. The current reading continues to stand at -3.5%, which even though it is a negative reading, it’s a huge improvement from the 4Q reading of -9.4%.

What to do

I got an email last week from someone (who is not a client) basically saying, “Your advice never changes!” My response was, “I mean, what’s wrong with that?” We have not seen a whole lot change in the economy. We are not traders and our clients are not traders. What would it say about my advice if it changed without seeing a whole lot of change in the economy? We still have low inflation, low interest rates and economic growth (albeit it slow, it’s still growth).

Cyclical sectors, small-cap and mid-cap growth allocations are still the place to be in this environment… just because the advice seems boring or long in the tooth does not mean it is no longer good advice.

Please call with questions.

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