Signs of Fragility in the Economy Point to an Impending Bear Market. What To Do Now To Protect Yourself.
- The last jobs report was good news but it also indicates higher costs and full employment.
- An “easy to hire, easy to fire” mentality is in the air.
- Healthcare, cash or short term trades should be the best options in this situation.
Last week the Nasdaq and S&P 500 reached yet another record high. Aggressive central bank stimulation pushes investors to disregard risks and look for any kind of yield or growth. Not looking at risk is the worst thing an investor can do, but they also shouldn’t fight the trend.
Even from a long term perspective the market is irrationally valued, and no one can know how long it will stay that way. Being in cash might seem logical but a 0.1% return looks much worse than the S&P 500’s 8.9% year-to-date return.
Today, we are going to analyze earnings as 86% of S&P 500 companies have reported them, but first take a look at Friday’s jobs report which sent mixed signals.
The Jobs Report
On Friday, the U.S. Bureau of Labor Statistics reported an increase in total non-farm payroll employment of 255,000 in July. The unemployment rate was unchanged at 4.9 percent which is great news for the economy but not so much for investors because it indicates that we are close to full employment. The unemployment rate has stabilized at 4.9% and wages have started to increase (2.6% over the year). Higher wages mean higher costs which have a negative effect on margins and earnings.
Figure 1: Unemployment rate. Source: Bureau of Labor Statistics.
Apart from the reach of full employment and higher wages, the fact that businesses prefer to hire more than to invest in equipment signals that corporations are not so optimistic about the future. They easily hire but know that they can fire with the same ease, if necessary. If you buy equipment, you are stuck with it in most cases.
Figure 2: Lower equipment spending in favor of labor. Source: Bloomberg.
The “easy to hire and fire” effect is even more pronounced by the increase in the number of people forced to work part-time for economic reasons, which rose from 5.84 million to 5.94 million.
All of the above means that job numbers are fragile and can quickly shift in the opposite direction. This, along with slow GDP growth, will probably keep the FED on hold or result in minimally increased rates to hold off inflation.
S&P 500 Earnings
The second quarter of 2016 is the fifth consecutive quarter with a decline in earnings.
Figure 3: S&P 500 earnings growth rate. Source: FACTSET.
The S&P 500 reported sales were flat in comparison to Q2 2015 which means that the increased hiring does not create growth but is necessary to merely keep up with the competition.
Analysts have postponed expected earnings growth to Q4 2016, which doesn’t mean much as they had expected earnings growth for this and for the next quarter. So, as always, analysts’ expectations have to be taken with a grain of salt.
From a sector perspective, consumer discretionary was the best performer with earnings growth of 10.7% which is logical seeing that consumer spending is the only growth segment of the U.S. GDP. But as consumer discretionary is not essential, any kind of bad news or tightening credit might quickly turn this trend around.
For investors interested in not taking on much risk if a bear market hits us, the healthcare sector continued its good news. Healthcare earnings grew 4.9% and revenue grew 9%. As we know that the global population is getting older, especially in the developed world we can expect demand for healthcare to stay stable, or fall the least in a recession or bear market. Therefore, finding good healthcare investments is essential for a defensive portfolio that is still open to growth in this bull market but limits the potential downside if things take a turn for the worse.
Figure 4: S&P 500 Earnings growth by sector. Source: FACTSET.
All other sectors are exposed to negative volatility because consumers are going to save on all things except for food and healthcare. With oil prices around $40 we cannot expect an earnings pickup in the energy sector.
The most important factor for long term investors is valuation. Lower earnings and higher prices have brought the current S&P 500 PE ratio to 25.25. If the FED is forced to increase rates due to high employment rates, corporate earnings will be further pressured downwards by the high debt levels and tightening credit will lower consumer spending.
Figure 5: S&P 500 PE ratio continues to grow. Source: Multpl.
We are in a situation where the S&P 500 is consistently breaking new highs while there have been 5 consecutive quarters of declining earnings, slow GDP growth, lower productivity and where bank credit, the main factor for GDP growth, is about to tighten due to increased interest rates and full consumer indebtedness.
We cannot know for how long such a surreal situation will last, but as smart investors we have to be prepared for the worst and still try to grasp the benefits of the upside. As Warren Buffett has $66 billion in cash on his balance sheet, we might to also want think about having cash on hand just in case a bear market comes that will enable us to buy the bargains. As earnings yields are at 4%, that would be the opportunity cost for holding cash but we can hold cash for 5 years and still break even if a bear market comes along. It is difficult to mentally accept such a strategy as we are in the 7th year of this bull market, but some returns have to be sacrificed in order to lower risks.
Another option for diversification is to use a part of your portfolio for well-placed short term trades. The S&P grew minimally in the last two years but in the meantime it gave great trading opportunities. With stop losses and by knowing what you are doing, you can limit the time you are invested, thus lower the risk of being caught in a bear market while still creating healthy returns on the liquid part of your portfolio.
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