As it turns out, there weren’t too many April “showers” last month. US investors saw the Dow Jones Industrial Average and the S&P 500 turn positive while the tech-heavy NASDAQ Composite still remains negative for the year. International markets were mixed, but generally positive. More specifically, the S&P 500 was up 0.27% for April while the Dow Jones Industrial Average and the NASDAQ Composite were up 0.5% and down 1.94%, respectively. European markets were the clear winners with the MSCI Europe index up 1.86%. Of the news driving market movement last month, there were a few noteworthy items that we wanted to highlight in this month’s commentary. In particular, the U.S. GDP figures for the first quarter, sector performance dispersion and the price investors are paying for corporate earnings are discussed in greater detail below.
U.S. GDP and Consumer Sentiment
According to the U.S. Department of Commerce in its April release, U.S. gross domestic product (GDP) grew at an annualized rate of 0.5% in the first quarter, slowing from the 1.4% pace set in the fourth quarter of 2015 and marking the lowest in two years. Personal consumption, which accounts for more than two-thirds of economic output, still grew in the first quarter but at a slower rate. Consumer sentiment, a measure of consumers’ view on economic conditions, fell to a reading of 89.0 in April from March’s 91.0. This is the lowest score since September of 2015 and the fourth straight decline in consumer sentiment. The details of the report were mixed as consumers remain positive on current economic conditions but more wary of future growth expectations. Turning back to GDP, business spending fell sharply, down 5.9% for the first quarter. The low cost of oil has hammered energy companies, all but halting business spending in that industry while other sectors worked to reduce excess inventories. To put the impact of business spending into context, without the drop in business investments, GDP would have been 1.26% rather than 0.50%. While this news was less than stellar, it may be comforting to know that a lower first quarter reading is generally followed by stronger quarters. In fact, over the last five years, second quarter GDP was 2.3% higher than the first quarter on average. We can also note that the job market appears healthy with new unemployment applications near a 43-year low, bolstering the case for a stronger second quarter.
Source: Bureau of Economic Analysis
Large-cap, Mid-cap and Small-cap, Oh My!
We always find it interesting to dig into the markets and see exactly what’s driving returns. In this case, we wanted to look at what was driving the difference in performance between large-cap, mid-cap and small-cap stocks through the first four months of the year. To do this, we took three benchmarks that represent the market-capitalization spectrum. For large-cap stocks, we used the S&P 500 Index, which measures the 500 largest U.S. stocks. For mid-cap stocks, we used the S&P MidCap 400 Index, which measures the next 400 largest, and for small-cap stocks, the S&P 600 SmallCap Index, which takes the next 600 stocks below the previous two indices. Ultimately, this gave us a universe of 1,500 stocks with which to perform our analysis. As Figure One below points out, mid-cap and small-cap stocks have outperformed large-cap stocks by 3.91% and 2.93%, respectively. To determine what’s driving the discrepancy, we turned to sector analysis to highlight the differences between the market capitalizations. Year-to-date, the health care sector, plagued by bio-tech companies, and the technology sector were some of the worst performers while utilities, materials and industrials all posted strong, positive returns. Figure Two breaks down the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600 indices by their respective sectors and, interestingly, large-cap stocks had larger allocations to the sectors that were some of the worst performers this year. The real estate sector also contributed to the dispersion. While it wasn’t one of the top performers, its positive performance and sizeable overweight in the mid-cap and small-cap indices helped push them further above large-cap stocks. Ultimately, markets such as these with wide dispersion among securities provide fertile ground for active managers to outperform.
Figure 1
Source: Morningstar Direct
Figure 2
Source: Morningstar Direct
Overvalued?
Investors use many different ratios and measures to determine if the market is overvalued or undervalued. However, no ratio is likely used as widely as the price-to-earnings. This measures the amount investors are willing to pay for one dollar of corporate earnings. Now that we are a third of the way through 2016, we wanted to see how much investors are paying for earnings and how it compares to the historical average. To do so, we pulled up the S&P 500 and found that the price-to-earnings ratio is 17 on average, while the current reading is a little over 19. This indicates that investors are paying more per dollar of corporate earnings than the average as it stands right now. Could this lead to a lower price for the S&P 500 in the near future as the market adjusts? The difference is relatively small when looking at past ratios, but only time will tell. We would note that there are a couple market scenarios that could continue to drive prices up rather than down despite it being slightly overvalued. For example, if current earnings surprise on the positive side, the price investors are presently paying for those earnings could go up as they anticipate higher growth in the future.
In reviewing historical market performance and the price-to-earnings ratio for this exercise, we wanted to highlight some different scenarios and dynamics that can arise. One such scenario is where the price-to-earnings is below average and investors are paying less per dollar of earnings. In this case, one of the driving forces for market growth is investors driving the market price up because it is seen as undervalued. Another scenario is a corporate-earnings driven market. In this case, the price-to-earnings ratio may be higher or even above average, but earnings growth sustains the growth in price. Lastly, a general shift in investor expectations and willingness to pay for earnings can keep the ratio well above or below average. These markets can baffle even the most seasoned analysts as this is one of the most difficult to predict. The Tech Bubble is a good example where investors were paying large premiums for little or even no earnings, driving the price-to-earnings ratio to near record levels. These markets may be irrational in hindsight but that doesn’t mean there aren’t opportunities for those discerning investors.
As depicted in the chart below, one can see how the different market dynamics impact the ratio and how much investors are willing to pay for earnings. During the market collapse in 2008, the price-to-earnings ratio plummeted as the S&P 500 fell more quickly than corporate earnings, thus driving the ratio well below average. Coming out of the collapse, corporate earnings were still depressed but investors jumped back into equities, pushing the price-to-earnings ratio back above average. Since late 2011, the S&P 500 has climbed and its price-to-earnings has followed suit, indicating that investors’ willingness to pay for earnings is increasing faster than the growth in earnings and making the index slightly overvalued in the process.
Source: Morningstar Direct
Concluding Thoughts
The markets have had quite the ride this year. It was less than two months ago that U.S. stocks were down more than 10% and international markets were off as much as 25%. Some stocks have clawed their way back into positive territory but many still remain in the red and there are a number of events looming on the horizon that can turn the tide one way or another. New central bank actions and the upcoming “Brexit” vote are just two such examples. This is why we believe that now, more than ever, is the time to have a plan and stick to it. Financial plans are like a workout schedule or a diet; they can be difficult to start and maintain but easy to get sidetracked. However, just like setting appointments with a personal trainer or dietician can help keep one on track, a financial advisor can do the same for your investment portfolio.
Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. This newsletter was written and prepared by CWM, LLC.
DJIA
The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.
MSCI EUROPE INDEX
The MSCI Europe Index is a market capitalization weighted index which consists of stocks from 15 developed market countries within the European region.
NASDAQ COMPOSITE
The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.
S&P 500 INDEX
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
http://www.wsj.com/articles/u-s-consumer-sentiment-fell-in-april-1461938912
http://www.bea.gov/newsreleases/national/gdp/2016/pdf/gdp1q16_adv.pdf
http://www.cnbc.com/2016/04/28/us-advance-q1-2016-gdp.html
http://www.wsj.com/articles/u-s-first-quarter-gdp-advances-at-0-5-pace-1461846715
