The Dow had its worst first day of the year since 1932. One day is the same as any other, so this is really just a headline, but not as good a headline as “the best first day…”
What drove this drop wasn’t news, but the same fundamental factors that have been spooking equity markets for months: global economic weakness, Chinese equities and fears of the end of the bull market.
For regular readers of The WIRE or attendees of our Smart Income seminars, this won’t be news. In fact, in the 2016 Smart Income Report due out later in January/ early February, we have extended our view of volatile equity markets that achieve sideways returns at best.
Extract from the draft of the 2016 Smart Income Report
Theme #1: Lowering expectations will hurt equity markets
The global economy remains in a restructuring phase unlike any before it. Government debt and an aging demographic in particular, but also financial regulatory change and slowing emerging markets, are creating an unusually prolonged recovery cycle. Each of these trends will take 10-20 years to pass. It is therefore likely that the economic cycle will remain slower than historic growth rates for up to 20 years.
The retiring baby boomers is the most certain of these: it is an absolute fact that the western world will see a higher percentage of its population retiring than at any point in history. The impact of high government debt and therefore lower government spending can be deferred, but not ignored. At some point in the next 20-30 years, western economies, particularly Europe’s, must address unsustainably high government debt. The longer they wait, their aging populations only make this worse as they will have less taxpayers and more pension and health system costs.
These fundamental factors must be accepted by equity markets, and their expectations must therefore be lowered
The biggest loser from this lowering expectations will be equities, particularly for markets and companies that are priced above normal levels. The biggest concern is the US equities market. We kicked off 2015 calling out a risk that the US market was approaching long-term record highs and that earnings expectations were too high. We similarly expected Australian corporate earnings to disappoint.
These forecasts were correct. Australian earnings per share fell 4%, compared to forecasts by the major banks and research houses of an increase of around 9%. In the US, analysts expected 11% growth, compared to the result of -9%.
The alarming point is that rather than adjust their expectations, Wall Street’s analysts are still forecasting 8-10% EPS growth for 2016. Illustrating how persistent this irrational optimism is:
- 25 companies issued earnings outlooks for the fourth quarter with every one of them falling short of analyst’s expectations
- Between 30 September 2015 and 31 December 2015, the average analyst forecast for earnings growth in 2016 was revised downwards in all 10 sectors of the S&P500
- Revenues per share (in other words the amount of revenue being bought when an investor buys the average share on the S&P500) are at the same level as they were in 2007. That’s nil growth in sales per share in 9 years and unprecedented. It means that any earnings growth achieve is purely from cost reductions, an unsustainable source of earnings increases. Despite that, analysts still believe that share prices will rise in 2016
This persistent bias toward assuming earnings growth will continue regardless of the economic fundamentals only really hurts investors. Researchers such investment banks and ‘independent’ research houses don’t get paid to forecast declining equity markets, but it is their clients that suffer when the biases cloud the reality of a challenging earnings environment.