The most important event in March was the FOMC meeting concluding on the 16th. The voting members of the Fed decided with a 9 to 1 margin to leave its benchmark interest rate unchanged. It also lowered its target interest rate projection for 2016 to 0.875% from 1.4% and the 2017 projection was also changed from 2.4% to 1.9%. The dovish tone of the Fed echoed Ms. Yellen’s counterparts across both the Pacific and the Atlantic. We are once again reminded that the stock market had become a captive domain of the central bankers.
Some commentators pointed out that FOMC’s latest punt on interest rate hike is nothing but an acquiescence to market tantrum since both core CPI and unemployment rate had crossed the Fed’s self imposed threshold. If history is a guide, bear markets are often caused by recessions and recessions are often caused by Federal Reserve’s premature tightening of its monetary policy. In a world where GDP is still growing south of 2% and inflation quite benign, we think Fed is right to err on the side of caution. The Fed’s goal in terms of number of tightening has consistently exceeded market expectation. So far in 2016, it has given in to market demand. Whether this scenario continues remains an important issue for the near future.
It must also be pointed out that a market beholden to the Fed is not a healthy one. Earning growth has just been too anemic to escape from the orbit of the Fed. For the market to move higher from this point, a dove is necessary yet insufficient.
An Earnings Conundrum
On March 25, the Commerce Department released data on 2015 4th quarter and full year profit. You can read a summary in the Wall Street Journal here. Profit after tax without inventory and capital consumption adjustment fell 3.6% during the 4th quarter and grow 0.1% for the full year 2015 compared to corresponding periods in 2014. This figure is consistent with the earnings picture presented by the S&P 500. According to Factset Research, S&P 500 earnings was down 3.3% for Q4 2015. This came after earnings decline during Q3 2015 of 1.5% and Q2 2015 decline of 0.7%.
As we approach Q1 2016 earnings reporting season, current estimate calls for an earnings decline of 8.5%. While it is a near certainty that we will have another quarter of earnings decline, actual earnings will likely not decline nearly as much. The earnings game dictates that stocks are rewarded for exceeding earnings expectation. So for the closest future quarter, earnings expectations are invariably underestimated. Yet investors are also interested in companies that carry higher earnings growth rate. So distant quarters are always overestimated. With such constraints in mind, it is no surprise that nearly 70% of the companies each quarter beat earnings expectation and numbers for future quarters are adjusted downward as time span to the quarters get shorter. Even with the ample application of greasy massage oil, a rather ugly earnings picture has emerged.
With the certainly of a down Q1, we would have 4 consecutive quarters of such occurrences. Last such event happened back during Q3 of 2009 when the economy was beginning to emerge from the depth of the great recession. It is possibly unprecedented during presumably the late cycle of economic expansion. The Yellen Fed seems to have assumed the mantle of her predecessor in providing stocks with a put. But the lack of earnings growth also serves as the upward bound.
In the afternoon of March 31, the California State Assembly and Senate both passed minimum wage measures. It sets the state minimum wage at $10.50 effective January, 2017. It would then rise to $11 in 2018 and by $1 each subsequent year until it reaches $15 in 2022. There had been various city mandates to raise the minimum pay. Notable among them include New York, Seattle, San Francisco, Oakland and Los Angeles. But California is the first state to enact such measure.
During the Q4 2015 earnings reporting season, a few retailers and fast food companies were asked about labor cost pressure. All indicated that such did seem like the future trend but it had yet turn into something unmanageable. Thus one may conclude, with the rising labor cost, that software and hardware engineers everywhere should rejoice as the ongoing trend of capital for labor substitution may very well accelerate. Two fully automated restaurants have already been opened in San Francisco. Alas, the celebration may not extend to investors of high tech companies. As the cost of capital becomes cheap, capital must swing for home runs to obtain decent returns. It seems one of the great beneficiaries of Fed’s largess is the technology industry. It was so in the late 90’s and it is so today. There had been much anecdotal evidence that software engineers are in great demand in the Silicon Valley. Freshly minted CS Majors are commanding low six figure cash pay packages and experienced and proven code masters are in for mid to high six figure cash pays. In addition, stock options are generally showered upon employees. A recent Wall Street Journal report highlighted that stock based compensation accounts for fully 30.8% of Twitter’s revenue. It is 17.1% at LinkedIn, 16.6% at Facebook, 9.6% at Pandora, 9.3% at Yahoo and 7% at Google. Yet all these stock based compensations are generally omitted from the so called adjusted earnings when companies report. Such adjustments may be masking the labor cost pressure at all these highly valued companies. Corporate profit margins currently stand at historical peak. The Fed’s easy money policy has so far accrued largely to asset holders. The changing return distribution between capital and labor will have far reaching implications for selecting the winning investments over the next few years.