The strong rise of global equities in July was followed by mostly flat returns in August and September. As we start the fourth quarter, earnings growth is slow to negative globally. In the U.S. for example, third quarter earnings that begin to be released in October are slated to be down about 2% year-over-year. While the energy sector continues to be the largest drag at down nearly 50%, the consumer discretionary sector should lead with a 5% growth rate. Interestingly, we feel these two sectors may be bottoming (energy) and peaking (consumer discretionary) at the same time. The negative 2% growth in U.S. corporate earnings may seem small, however it will be the sixth quarter in a row of earnings declines. If markets can move through earnings season unscathed, the fourth quarter may show the first signs of earnings growth in nearly two years.
Overall the valuation conundrum continues with the S&P 500. Currently around 2,168, the index trades at about 16.7 times forward earnings and 16.3 times 2017 full-year earnings. These valuations are slightly higher than long-term averages. However, as long as interest rates stay low, equities on an interest-rate adjusted basis can trade at higher multiples, even as high at 19-20 times earnings (assuming decent growth rates). So with the U.S. ten-year Treasury bond yielding 1.61%, we believe multiples can trade well above historic norms unless interest rates spike. At a yield above 2.00%, multiples begin to see reduced ceilings. For example, according to OPCM’s internal analysis, S&P 500 multiples can trade as high as a 20.5 trailing earnings multiple with present ten-year treasury yields (versus about 19 today on trailing earnings). However, if rates rise 1% or so, the interest rate adjusted upside vanishes. This is a main reason interest rates are so important in today’s environment.
Besides the election on November 8th and third quarter earnings season from mid-October to mid-November, the final three months of the year offer many market moving or volatility creating events. On November 30th OPEC meets to discuss the uniform curtailment of oil production. The Italian referendum is slated for December 4th. Italian citizens vote on a plan to reduce the size of the country’s legislature, with the goal of improving law-making abilities. This is a very spirited debate in Europe that may cause volatility. A few days later, on the 8th, the European Central Bank meets to decide on the future of monetary policy in Europe. Will they taper bond purchases or extend them? Finally, on December 14th, the U.S. Fed will announce their interest rate policy. Presently there is a strong likelihood of a Fed Funds interest rate increase to a higher range.
From earnings, to interest rates, to valuation, to a number of market moving events, the fourth quarter of 2016 will be one where nimble and disciplined investors can add high quality investments to multi-asset class portfolios.