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Bull Market Waning as Barclays Sees 1% Gain for S&P 500

By Lu Wang
August 18, 2014 4:24 PM EDT 32 Comments
In July, Microsoft Corp. said it will reduce as many as 18,000 jobs as Chief Executive Officer Satya Nadella slims down the software maker.
Photographer: Akos Stiller/Bloomberg
In July, Microsoft Corp. said it will reduce as many as 18,000 jobs as Chief Executive Officer Satya Nadella slims down the software maker.

Five years of profit growth exceeding 17 percent is poised to slow in the Standard & Poor’s 500 Index, reducing returns as the bull market ages, according to Leuthold Group LLC and Barclays Plc.

Equity price gains approaching 25 percent annually will weaken to 3 percent over the next decade as the profit expansion reverts to its historic rate since 1929, said Doug Ramsey, the chief investment officer at Leuthold. Jonathan Glionna of Barclays says overseas markets are generating too little demand to push the S&P 500 up more than 1 percent in the rest of 2014.

While neither Ramsey nor Glionna sees the bull market ending, measures of sentiment are turning lower amid an advance that has gone virtually uninterrupted for more than two years. Investors are buying more hedges than any time since 2008 following a rally that has added $15 trillion to equity values.

“Temper expectations over the next several years,” Ramsey, who oversees about $1.7 billion at Leuthold in Minneapolis, said in a phone interview on Aug. 13. “It’s dangerous to assume that we’re going to have above-average earnings growth from current levels. Earnings are not depressed like where they were in 2009.”

Interest Rates

The S&P 500 (SPX) rose 1.2 percent last week as signs of a slowing economy stoked bets central banks will leave interest rates near record lows for longer, overshadowing escalating tensions in Ukraine. The benchmark measure for American equity climbed 0.9 percent to 1,971.74 today in New York and is about 1 percent away from a record close of 1,987.98 reached on July 24.

Cisco Systems Inc., based in San Jose, California, last week announced a new round of job cuts totaling 6,000 as the world’s largest networking-equipment maker forecast little to no sales growth.

In July, Microsoft Corp. (MSFT) said it will reduce as many as 18,000 jobs as Chief Executive Officer Satya Nadella slims down the software maker. Profit from the Redmond, Washington-based company fell short of estimates in the fiscal fourth quarter, weighed down by the acquisition of Nokia Oyj’s handset unit.

The S&P 500 has climbed 5.8 percent in 2014, compared with 16 percent at this time last year and 12 percent in 2012. While the index has closed at record highs more than 20 times this year, the advance is slowing with valuations at the highest levels since 2010 and investors preparing for the withdrawal of Federal Reserve stimulus known as quantitative easing.

Nice Tailwind

“QE has been a nice tailwind and as the tailwind begins to fade, top line growth needs to pick up,” David Lafferty, the chief market strategist for Natixis Global Asset Management in Boston, said by phone on Aug. 14. His firm manages about $867 billion. “We’ve returned to trend earnings and future expectations for stocks should mirror earnings growth.”

Strategists who have predicted weakening earnings growth would sink stocks have repeatedly been proven wrong since the bull market began. At the start of 2010, Marc Faber, publisher of the Gloom, Boom & Doom report, said the S&P 500 was at risk of ending that year with a loss amid economic and profit slowdowns. The equity gauge completed the year up 13 percent.

Gina Martin Adams, an equity strategist at Wells Fargo & Co., echoed the same concern at the end of 2012, forecasting that “a trifecta of major macro drags,” including deterioration in Europe, a contraction in business spending and a retrenching U.S. consumer, would hurt earnings and send stocks lower in 2013.

Shallow Pullback

That year, the worst decline lasted from May to June, when the S&P 500 slipped 5.8 percent. The loss was reversed in July and the market finished the year with a 30 percent rally.

Investors betting on a slump will be disappointed because any pullback will be shallow as the economy gathers momentum, according to Donald Selkin, chief market strategist for New York-based National Securities Corp. U.S. gross domestic product will expand 2 percent this year and accelerate to 3 percent in 2015, according to the median forecast from 91 economists surveyed by Bloomberg.

“The people who buy protections really have to be adept and take profits at a 3 or 4 percent decline, not hold until the end,” Selkin said by phone on Aug. 13. “If you’re holding for a bigger drop, you’re not going to get it.”

Sales, Margins

The S&P 500 has posted the equivalent of annual gains of 24.2 percent since falling to a 12-year low in March 2009, a period that coincided with yearly increases of 17 percent in profits, according to data compiled by S&P Dow Jones Indices and Bloomberg.

Per-share net income for the index rose to $103.28 in the 12 months through June 2014 from $50.97 four and a half years earlier, giving the index a price-earnings ratio of 18.9, compared with its average since 1937 of 16.9, the data show.

Sales growth has been slower at about 5.2 percent a year, meaning companies have relied on cost reductions and share buybacks to make up the gap in earnings. Margins in the S&P 500, the difference between revenue and expenses, reached a record 9.8 percent in the last three months of 2013 and may have gotten to 10.2 percent in the second quarter, according to estimates from Howard Silverblatt, an index analyst at S&P.

“U.S. equities are transitioning out of a recovery rally and into a period of lower returns as the benefits of margin expansion and share repurchases prove to be already priced in,” Glionna at Barclays wrote in an Aug. 12 report. He forecasts the S&P 500 will reach 1,975 this year. “A return of faster revenue growth becomes a prerequisite” for higher valuations, he said.

Leuthold’s Study

While analysts surveyed by Bloomberg expect earnings to expand by more than 8 percent a year through 2016, Ramsey at Leuthold said investors should prepare for profit growth to have less of an impact on prices. Using a formula that smooths out income over five years, the S&P 500 is trading at a price-earnings ratio of about 21, his data shows.

In the eight decades ending in 2008, American companies expanded earnings at an annual rate of about 5.3 percent, according to data compiled by Leuthold. Should that rate prevail over the next 10 years and profit multiples revert to the median level of 16.7, the S&P 500 would reach 2,646 by 2024 -- an annual price appreciation of 3 percent, Ramsey said.

“Valuations are already pretty elevated,” he said. “It’s dangerous to assume normal stock market returns over the next 10 years, normal being 10 percent, because valuations put forward some of the future returns into the present.”

Put-Call Ratio

Investors are boosting protections against losses after the S&P 500 has gone without a retreat of 10 percent since 2011. About 27 percent of respondents said they have taken hedges against a slump over the next three months, the most since 2008, according to Bank of America Corp.’s Aug. 1-7 survey of 224 money managers with a combined $675 billion.

For every 100 bullish calls trading on the Chicago Board Options Exchange in the 10 days through Aug. 14, 70 puts to sell changed hands, the most since June 2013, data on options for individual equities compiled by Bloomberg show.

“The market is up almost 300 percent in five short years,” Justin Golden, a New York-based partner at Lake Hill Capital Management LLC, wrote in an e-mail on Aug. 13. His firm trades options on equity indexes and commodities. “Any number of events could send the market into a downward spiral and no one wants to be the last one out.”

Toppy Market

The best quarterly earnings growth in three years wasn’t enough to fuel stock rallies as violence erupted from Iraq to Ukraine, threatening the global recovery. The S&P 500 has added 0.4 percent since July 8, when Alcoa Inc. reported results. Profits from S&P 500 firms climbed 10.4 percent in the second quarter, the most since 2011, data compiled by Bloomberg show.

“Earnings were pretty good, but nothing that’s going to set this market on fire,” Randy Bateman, who oversees $2.8 billion as chief investment officer of Columbus, Ohio-based Huntington Asset Advisors, said by phone on Aug. 13. “It might be a little toppy in the marketplace. There are geopolitical risks that nobody can assign a measure to.”

While persistent gains that lifted the S&P 500 25 percent above its previous peak in 2007 are spurring anxiety among investors, this bull market now relies more on sales and earnings to stay in course than multiple expansions, according to David Kahn, managing director at Convergent Wealth Advisors, which oversees about $8.5 billion.

“There is just a lot of defensiveness,” Kahn said in a phone interview from Los Angeles on Aug. 13. “Five to 10 percent annualized return over the next couple years in equities isn’t bad and is enough to keep investors engaged. Ultimately we’re going to have to pay the piper through either a market correction or real top line growth to get the market to move to the next phase.”

To contact the reporter on this story: Lu Wang in New York at lwang8@bloomberg.net

To contact the editors responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net

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