As the first quarter of 2016 ends, the wide swings in both investor confidence and stock market valuation witnessed these past three months are notable. After spending a good deal of the prior year coping with historically elevated forward price-to-earnings (P/E) valuations just shy of 18x, which became increasingly difficult to justify heading into year-end because of suppressed economic activity in the U.S., Europe, and Asia, investors faced sharp declines in various global equity indices in the opening weeks of 2016.
The pullback in stock prices and market valuation was fundamentally justified, though, because calendar-year 2016 S&P 500 earnings per share (EPS) expectations have now retreated to $118.53 over the past six months from the much more optimistic and market valuation-supportive level of $129.30 recorded at the end of the third quarter of 2015.
If calendar-year 2016 S&P 500 EPS expectations had remained at $129.30 today, then the stock market would be currently trading at a 16.0x forward valuation multiple as opposed to the existing 17.4x multiple based on the current $118.53 S&P 500 EPS number.
Global investors' anxiety in the early weeks of 2016 was justified. At year-end, the average level of the manufacturing Purchasing Manager Indices (PMIs) for the U.S., Europe, and China had been in a constant state of decline since June and were at risk of falling below the neutral 50 level for the first time since May 2013.
Furthermore, spot West Texas Intermediate crude oil prices had fallen to the lowest level recorded since May 2003, and speculative-grade corporate bonds were trading at the lowest prices seen since the end of the recession at mid-year 2009. All of these developments generated a good deal of discussion among investors of whether the U.S. and global economies were spiraling toward recession or even something possibly worse.
While the fate of the industrial portion of the U.S. economy remains an open question as to whether we are exiting the recession-like conditions witnessed in 2015, the services-oriented portion of the economy appears to be growing at a satisfactory rate as we close the books on the first quarter.
As of the March employment report, the three-month average rate of job creation now stands at 209,000 new jobs per month, the unemployment rate is 5.0%, and we have seen 2.3%-2.6% growth in average hourly wages over the past six months.
On Feb. 11, the day the S&P 500 hit the year-to-date closing low price of 1,829.08, the index was valued at 15.2x expected 2016 EPS of $120.42. This 15.2x forward P/E valuation clearly reflected the investor angst.
With 2016 expected EPS having now fallen so far, amid some signs that the economy has at least stabilized and might even be improving, we can't help but wonder whether future earnings expectations have fallen too far. If the S&P 500 claws back just half of the $10.77 in expected EPS that has been lost since the end of third-quarter 2015, the stock market would actually be trading at a more reasonable and attractive 16.7x expected 2016 P/E multiple as of April 1.
Amid this stabilization, we continue to look to the consumer discretionary sector for indications of the economy's true underlying health and the outlook for corporate profits. The consumer discretionary sector generated 11.5% earnings growth in the final quarter of 2015, following chronological earnings growth of 8.5%, 10.4%, and 16.4% since the start of that year, which enhances confidence in the 10.7%-11.5% quarterly growth anticipated in 2016.
This healthy double-digit earnings growth is furthermore backed by a respectable trend in sector revenue growth as of year-end 2015. Consumer discretionary revenue growth steadily improved to 7.5% by year-end from 3.8% at the start of the year (see chart).
The prospect of sustained improvement in consumer discretionary revenue growth would also bode well for anticipated double-digit earnings growth throughout 2016 and even the healthier 14%-16% growth rate into 2017 according S&P Global Market Intelligence aggregate consensus earnings expectations data.