S&P 500 won’t break out until earnings do – 3 things that could make it happen

By David Nelson, CFA

US markets have frustrated both bulls & bears over the last year with the index unable to break out and sustain a path in either direction. However, the chart below confirms the problem started somewhat sooner, half way through 2014. The blended 12 month forward earnings of the S&P 500 (SPY) peaked just as the energy complex was about to fall into the Abyss. Along with the price of crude, earnings for the biggest companies in the Energy Sector (XLE) fell off a cliff and only recently have exhibited some sign of bottoming.

Earnings are the life blood of any market so until they find a way to break out to the upside we’re likely stuck in market purgatory.

The Good News

It’s no secret the energy sector has been the biggest drag on overall earnings for the S&P 500 but a look at the 20 largest companies in the SPDR Energy ETF (XLE) shows some promise. Current estimates show all but 1 company Concho Resources (CXO) with up earnings year on year starting in 2017. Not all of the companies in the index will earn a profit but at least 14 out of 20 should be in the black next year. Of course, this forecast means nothing if crude prices revisit the January lows. None of this is meant to be a recommendation to pile into energy stocks but given the sector still represents over 7% of the index, earnings going green will be a big help.

Energy Sector(XLE) Earnings Growth

Financial Engineering is running out of steam

Even if the above scenario plays out it’s not a lock that earnings and stocks will break out to the Promised Land. CEO’s have been taking the easy way out for years and now some of those decisions are coming home to roost.

Financial engineering like stock buybacks helped propel stocks to all-time highs but of course it came at the expense of R&D, CAPEX and now finally sales. During the last 5 years the S&P 500 Buyback Index outperformed SPDR S&P 500 (SPY) by a wide margin. However, one look at the same spread chart over the last year shows the man behind the curtain was no wizard at all.

Election Rhetoric

We’re coming into the home stretch of maybe the most polarized election cycle in my lifetime. I don’t want to go into the pros & cons of either candidate but both sides of the aisle have increasingly turned to protectionism as a path to the White House.

Mr. Trump’s call for more tariffs as a weapon against countries flooding our shores with subsidized goods and Secretary Clinton’s abandonment of the TPP (Trans Pacific Partnership) a trade deal she originally endorsed speak to that end. With more than 30% of sales of S&P 500 companies outside the U.S., I think it’s a reasonable expectation that volatility will pick up heading into November. Post the election regardless of who is elected, it’s my hope the rhetoric will morph into something more workable like smarter trade deals rather than threats of all out trade wars.

The era of the Fed is over. Monetary policy has run its course and by the Fed’s own admission; economic growth can only take place if fiscal policy picks up the baton.

3 things have to come together for markets to break to new highs

• First, as stated earlier estimates for the oil complex have to hold and that can only happen with crude living in the 40’s or higher.
• CEO’s have to start re-investing in their company – Organic growth can only be achieved with an increase in R&D and CAPEX. New products and new customers are the life blood of growth.
• Finally, and without a doubt the most difficult of the three. Once the election has past, we’re going to have to find a way to come together as a nation and focus on what we have in common rather than only what divides us. From the market’s perspective that means sound fiscal policy that can and will drive the next leg of growth for the United States.