So far, 2015 has not been kind to U.S. large-cap stock bull market optimists.
During the first three months of the year, the S&P 500 Index has barely budged, providing zero upside for investors pegged to this leading benchmark measure of the U.S. domestic equity market.
Lofty valuations, a strengthening U.S. dollar, sharply lower oil prices and the continued uncertainty of when the Federal Reserve will finally begin to hike interest rates have weighed heavily on the most heavily traded U.S. stocks.
All of these factors combine to make for a challenging backdrop as we head into the next big catalyst for stocks — the beginning of Q1 earnings season, which kicks off in earnest during the next several weeks.
Gone are the days when companies could financially engineer a boost in their earnings and share prices via mere cost cutting or share buybacks.
For this bull market in large-cap equities to get a second wind, the market will need to see real growth reflected in higher revenues.
Get Ready for Lousy Earnings
Sadly, there’s little to be excited about for the bulls as we head into reporting season.
According to FactSet, on a per share basis, aggregate earnings estimates for the first quarter already have fallen by 8.2% since the end of 2014.
That’s the largest decline in quarterly earnings estimates since the aftermath of the financial crisis during the first quarter of 2009.
Moreover, rather than getting a much-needed boost from Q1 results, earnings are expected to fall nearly 5% year over year, while revenue is expected to decline by 2.7%.
The one caveat?
The dramatic plunge in the price of oil during Q1 certainly has had a disproportionately negative impact on the energy sector — itself a chunky portion of the S&P 500.
Exclude energy, and earnings are expected to rise 3.4% while revenue is projected to increase 3.1%.
But don’t pop the champagne just quite yet.
Consider that these estimates have tumbled from just three months ago, when analysts were predicting earnings ex-energy to rise 8.9% and revenue to grow at a 4.7% rate.
Then there is the issue of valuation.
Heading into what will likely be a tough earnings season, this bull market also faces the headwind of a market that is by no means trading at bargain basement prices.
Stocks in the S&P 500 currently trade at a somewhat lofty 17 times forward earnings per share.
On a CAPE (cyclically adjusted price-to-earnings ratio) basis, the picture is much worse, with the large-cap U.S. equity market trading at around 28.
Only the pre-meltdown years of 1928 and 2007 saw stocks trade at higher CAPE valuations.
Money Getting Small and Traveling Abroad
As falling oil prices have slammed large-cap stocks in the energy sector, we’ve also seen the value of the U.S. dollar surge versus rival foreign currencies. In fact, the value of the U.S. Dollar Index ($USD) (a measure of the dollar versus six major overseas currencies, with the euro accounting for nearly 60% of the index) is up nearly 20% over the past 12 months.
My own recommendation to my Alpha Investor Letter subscribers of PowerShares DB US Dollar Bullish ETF (UUP) is up 12.63% since October.
The soaring U.S. dollar has lowered foreign-based revenue for many large-cap U.S. companies among firms that derive a substantial portion of their revenues from abroad.
To avoid the negative impact of a rising dollar and plunging energy prices on large-cap U.S. equities, investors have rotated away from the behemoths and opted to play “small ball.”
This rotation has been the only real bright spot in the U.S. equity market over the past several months as small caps have handily outperformed their larger brethren so far in 2015.
For example, the iShares Russell 2000 (IWM) was up nearly 4% during the first three months of the year versus the flat performance of the S&P 500.
But for the really serious outperformance, you need only look across the pond to see where the big money has landed.
The iShares Europe (IEV) is a good bellwether for stocks in the Old World, and this measure of the large-cap European equity market is up nearly 7% year to date.
An even better way to play the European market is the WisdomTree Europe Hedged Equity ETF (HEDJ), which is designed to give investors the upside in European stocks without the negatives of a falling euro. With the decline of the euro hedged out, HEDJ has generated year-to-date gains of nearly 21%.
And investors are voting with their wallets.
According to data from research firm Markit, investors pulled more than $11 billion from exchange-traded funds invested in U.S. stocks during the first quarter. That’s a reversal from three consecutive quarters when the asset class recorded $138 billion of inflows.
Where has that money gone? Well, some of it has gone into the small-cap segment of the U.S. market.
But more has gone into international funds. According to Markit, there were $42.6 billion worth of withdrawals from funds invested in North American equities during the past year (through March 25), compared with $61.3 billion that has moved into Asia-Pacific and developed Europe equity funds over the same period.
One look at the earnings picture for Europe and you can see yet another reason for this rotation. Earnings for the S&P Europe 350, the index that IEV is pegged to, are expected to climb 14.1% in 2015 over the prior year. That estimate includes double-digit percentage gains forecast for each sector of the index except for energy, according to S&P Capital IQ.
Finally, consider that stocks in Europe have the tailwind of the European Central Bank’s recently implemented quantitative-easing (QE) program.
Compare that with a Federal Reserve policy that’s finished with QE and with U.S. central bankers who now are looking for any excuse to raise interest rates after seven years.
The bottom line?
The backdrop for the United States versus the rest of the world in 2015 hardly could be more different.
So if you want to stay a bull market optimist, turn your gaze away from U.S. large-cap stocks toward international markets.
You’ll be glad you did.
In case you missed it, I encourage you to read my e-letter column from last week about exponential investing. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.
