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Investing in a slow-growth world

The first quarter provided quite a ride, featuring a rapid equity downdraft and chaos in the high-yield bond market accompanied by irrational fear about another implosion in the financial system and a resulting recession. All of this was brought on by the rapid fall in the price of oil, something that ordinarily would be a positive for the economy. Indeed, it still is likely to be a positive for consumers in the U.S., and worldwide, just with a lag.

Since Feb. 11, the equity market has made a significant recovery, standing in positive territory for the year (S&P 500 up 0.8 percent as of March 31). Most of the negative sentiment is gone, the bears have returned to their caves and the media has ceased cheerleading a recession, with the last 35 S&P points due to recent dovish comments by Fed Chair Yellen.

But what now? The forward price-earnings ratio for the S&P 500 is up 2 points since the February lows, now standing at 17.2x (i.e., the current S&P 500 level — 2060 — divided by the 2016 expected S&P 500 earnings — $120). It is a stretch to use 15x as a normal P/E ratio for the S&P, but if we did, the earnings would have to be $136, or 13 percent higher than the consensus $120 forecast. The likelihood of this is remote, as Q1 earnings are estimated to be down nearly 7 percent (down nearly 2 percent excluding energy).

Even if we get rid of all of the external noise (ISIS attacks, refugees, American politics, Brexit, China’s debt issues, and Japan’s economic quagmire, to name a few), it would really be quite difficult for the equity markets to continue to advance without much stronger underlying economic and top-line revenue growth (top-line growth is estimated to be down nearly 2 percent in Q1, and up less than 2 percent excluding energy).

This is not to say a recession is coming, especially in the U.S. where labor markets are tight and where there is finally some upside to wages and inflation. But let’s face facts: The rest of the world is experiencing slow to no growth with severe recessions in some emerging markets. Although somewhat weak since Yellen’s Wednesday talk, the dollar will continue to strengthen when the Fed follows through with one or two rate hikes in 2016, making multinational profit growth difficult at best.

In the latest GDP release, the economy expanded in Q4 at a 1.4 percent rate, slightly higher than the previously estimated 1.0 percent, but still anemic. Almost all of the growth came from a strong consumer. Whether it be due to big government policies, the uncompetitive tax code or just the slowdown in worldwide growth, capital spending by business contracted in Q4 at a 2.1 percent rate, and January and February numbers were no better. Corporate profit margins are being squeezed from their record levels (14.2 percent in Q3 and 12.7 percent in Q4). Not that we should feel sorry for them, as some of that margin is going to increased wages and lower pricing which benefits the middle class. Still, we are talking about the equity markets, and businesses just don’t seem to have a line of sight or confidence that top-line revenues will grow going forward. Thus, the horrible capital spending numbers.

Markets are further compromised by the abdication by the major industrial powers of the use of fiscal policy as a tool of economic stabilization, leaving the entire burden to the monetary authorities, with the result being experimental policies (quantitative easing, or QE, and negative interest rates, or NIRP), the ultimate results of which are quite uncertain, if not outright scary.

Thus, the chances of $136 in S&P 500 earnings for 2016 are remote. This, together with all of the other burdensome and worrisome government policies likely produces a range-bound market fluctuating between a P/E ratio of 14x to 17.5x. Thus, ideally, an investor would be buying as the P/E approaches 14 and selling above the 17.5 mark — very difficult to do.

As a result, it is difficult for ordinary investors, who rely on indexes, mutual funds or ETFs, to earn significant positive returns — unless, that is, one has the fortitude to sell in a rising market and buy in a falling market (like in late January or early February). That means active management, something ordinary investors don’t have time to do. As a result, such investors are likely to be disappointed with their returns over the next several years. In fact, many macro studies from gurus like Bill Gross have suggested significantly lower equity returns for several more years.


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