Despite Record Levels, Stocks Poised to Turn Bearish

S&P 500 Soars to Record Levels…But Will It Last?

It’s been a rough year for the S&P 500. First the index tanked in early January after economic data suggested the U.S. economy wasn’t as strong as previously thought and over fears of a global recession. After rebounding, the S&P 500 spiraled again in late June after the U.K. voted in favour of leaving the European Union. North American investors quickly shrugged off the Brexit vote and the markets rebounded—but only so far. The S&P 500 had been flirting with a new record high since May 2015. But with nothing to propel it higher, it continued to linger, frustrating investors. North American markets hit a wall in early June after the Bureau of Labor Statistics announced that the U.S. economy had added a meagre 38,000 jobs in May—the smallest number in about six years.¹ This came on the heels of weak jobs figures from March and April. This spurred fears the U.S. economy was headed for a recession. Months of bad economic news were washed away after it was announced on July 8 that U.S. employers had added 287,000 jobs in the previous month.² This beat market expectations of around 175,000. Optimistic investors sent the S&P 500 soaring into record territory. The index is currently near 2,175 and has advanced 6.7% year-to-date. But will the optimism last? Earnings season has begun in earnest and will provide investors with a sense of where the broader U.S. economy is heading. If S&P 500 companies report solid earnings and a strong outlook, the S&P 500 is expected to rally. But that’s a big if.

U.S. Earnings Recession Hits Five Consecutive Quarters

While June’s jobs data was encouraging, it’s hardly symptomatic of a strong U.S. economy. Most of the jobs that were created in June came from low-paying sectors: leisure and health care. In June, the leisure and hospitality industry added 59,000 jobs and health care added 39,000 jobs. For the U.S. economy to show real sustainable growth, there needs to be serious hiring in manufacturing and construction. And that just isn’t happening. You can’t hang the U.S. economic recovery on leisure and health care. Nor can you hang an economic recovery or record S&P 500 run on weak fundamentals—which is what’s been happening. In fact, we’re currently in an earnings recession. The blended earnings decline in the first quarter was -6.7% and marks the first time the S&P 500 has seen four consecutive quarters of year-over-year declines in earnings since 2008.³ For the second quarter, the blended earnings decline is -5.5%.⁴ If the S&P 500 reports a decline in earnings in the second quarter, it will mark the first time the index has recorded five consecutive quarters of year-over-year declines in earnings since the third quarter of 2008 through the third quarter of 2009. This suggests U.S. economic growth and the overall U.S. economy remains fragile. And the earnings recession shows no signs of slowing down. This does not bode well for the stock market. Why? The S&P 500 is in record territory despite being in a prolonged earnings recession. As a result, stocks are overvalued. At the same time, investors are increasingly optimistic. Ignoring fundamentals like sustainable earnings and revenue growth leads to complacency and irrationality. This is the perfect recipe for a stock market correction and stocks turning bearish.

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1. “US created 38,000 jobs in May vs. 162,000 expected,” cnbc.com web site, June 3, 2016; https://www.cnbc.com/2016/06/03/us-nonfarm-payrolls-may-2016.html.
2. “Employment Situation Summary,” Bureau of Labor Statistics web site, July 8, 2016; https://www.bls.gov/news.release/empsit.nr0.htm.
3. “Key Metrics,” FactSet web site, May 27, 2016; https://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_5.27.16.
4. “Key Metrics” FactSet web site, July 15, 2016; https://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_7.15.16.