- Correlations have plunged, leading to wider sector dispersions and a “cancelling out” effect on volatility
- Earnings are moving from a four-quarter recession to strong double-digit growth in 2017
- Forward valuation looks reasonable when looking through an inflation-filtered lens
Much ink spilled these days—including by yours truly—tends to be of the macro variety. This is for good reason as studies have shown that macro forces have been greater determinants of asset class performance than traditional underlying fundamentals. This was corroborated by high correlations among and within asset classes. But this has recently changed; and we’ve been arguing that traditional fundamentals like earnings, valuation and (as always) sentiment will be more dominant market drivers.
Volatility low, but for an interesting reason
Correlations have come down markedly, especially among sectors. In fact, one of the reasons why volatility has been so low is due to the “offsetting” effect. The spread between sectors’ performance has widened, which means for sectors displaying strength, there are offsetting sectors displaying weakness. Year-to-date we’ve seen strength in Technology and Consumer Discretionary in particular; which has been offset by nearly-equivalent weakness in Energy and Telecom Services. In essence, sectors have been washing each other out, resulting in suppressed volatility.
One way to think of it is that the market has gone from a “risk on, risk off” environment (with high correlations) to a “Trump on, Trump off” environment (with low correlations). And it’s not just the performance of sectors which has diverged—the spread between the winners and losers in terms of earnings growth has widened out.
Earnings: from recession to recovery
The chart below looks at the trajectory for S&P 500 earnings growth back to 2012 and including estimates for the next four quarters. From the earnings recession—which spanned four consecutive quarters and ended in the third quarter of 2016—earnings are expected to rebound back into double-digit territory in 2017.
Source: Thomas Reuters, Yardeni Research, Inc., as of February 9, 2017. 4Q16-4Q17 based on estimated earnings growth.
The chart below looks at quarter-by-quarter estimated earnings growth for the five quarters beginning in last year’s fourth quarter (its reporting season is still underway). As is abundantly clear, the turn in the energy sector from deep negative territory in 2016 to massive year-over-year growth in this year’s first half has been the largest contributor to the S&P 500’s earnings rebound.
Source: Thomson Reuters, as of February 9, 2017. *Prior year’s earnings are negative.