Are We Experiencing a Correction or a Major Bearish Reversal?

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Are We Experiencing a Correction or a Major Bearish Reversal?

Daniel Cross Feb 29, 2016

After a lethargic 2015, this year seems to be signaling the beginning of a bear market. Economic data is becoming increasingly negative and even the Fed, after raising interest rates just a couple of months ago, seems to be indicating a concern that deflation could become a real possibility. Annual GDP growth has slipped for the past three straight quarters and corporate earnings haven’t helped bolster investor sentiment.
But the big question is whether the pullback in the markets is a temporary correction or the beginning of a long-term reversal trend that marks the end of a very long bull market. One way to determine the market’s direction and current mood is to look at the latest corporate earnings and guidance.

Interpreting Earnings Reveals Concern for Investors

As of February 26, 96% of companies in the S&P 500 have reported fourth quarter 2015 earnings. The result is a blended earnings decline of 3.3%, marking the first time since 2009 that the S&P has seen three straight quarters of year-over-year drops.

The two main culprits for the decline are energy stocks, which fell 74% in the fourth quarter and expected to fall 93% in the first quarter, and the strength of the U.S. dollar. Out of 30 companies listed in the DJIA, 11 provided revenue growth numbers from Europe, and nine of those showed a year-over-year decline. Companies that derived most of their revenue from overseas sales fell 11.2% in the fourth quarter.

Corporate guidance doesn’t paint a profitable picture for the first quarter either; 88 companies have issued negative guidance, while just 22 issued positive guidance. Energy and materials led the index for year-over-year declines, while health care and telecommunications were the largest gainers. Surprisingly, a large percentage (69%) of companies reported higher-than-expected earnings. Overall, however, earnings upside surprises are still coming in short of the five-year average – 3.7% higher compared to 4.7%.

Despite the continued drop in earnings and stock prices, the average forward P/E ratio is still higher than the five-year average at 15.7. That tells us that there is still further possible downside just to reach the average valuation levels of the S&P 500.

The news isn’t all negative, though. Lower energy prices should prove to benefit certain companies – especially those in the transportation sector. A fall in the U.S. dollar would also help boost earnings by reducing losses from foreign currency exchanges.


The Bottom Line

Investors might want to bunker down for the next few quarters based on the evidence piling up against a quick recovery. A bright spot for the economy is the fact that U.S. GDP growth estimates for 2016 are holding steady at 2.5%, while Europe is estimated to improve from 2015 to 1.7% GDP growth.

80% of companies issuing guidance are negative – above the historical average of 72%. Analysts don’t expect overall earnings and revenue growth to become positive again until the third quarter. For the year as a whole, earnings are expected to grow a total of 2.8%, while revenues are expected to increase 1.9% year-over-year.

We can expect the first half of the year to see high volatility and further declines, but after the summer months, we might finally start to see a recovery and bullish sentiment to return to the markets.


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