INSIGHTS

On May 09, 2016

AAM Viewpoints - Can Oil Help the Market Breakout?

Over the last year or so the equity markets have been provided with many motives for resistance. Interest rate hikes, a slowdown in China, and a possible recession, to name a few. The latest is a jobs report that seems to have disappointed as headlines focus on the fact that the United States added the fewest jobs in seven months. It’s worth noting that there were 160,000 jobs added in April, a pretty good clip, in my opinion, but still less than the consensus estimate of 200,000. While jobs data, interest rates, and global growth all play an important role in the equity markets, one underlying cause of market behavior over the past year or so is much more fundamental: the market has a valuation problem being driven by a lack of earnings growth.

Step one is admitting you have a problem. The current P/E (price to earnings) ratio for the S&P 500 is the 18.99 compared to the five-year average of 16.42 and the 10-year average of 16.60. If we separate the P/E ratio, the high valuation is not being driven by the numerator (price) as the S&P 500 on a price basis is essentially flat from the end of 2014 (-0.59% 12/31/2014 – 5/6/2016). The denominator (earnings), on the other hand, is on track to post its fourth consecutive quarter of year-over-year earnings decline, the longest losing streak since Q4 (4^th quarter) 2008 through Q3 (3rd quarter) 2009.

The result is the S&P 500 has been stuck in a trading range and has been met with resistance once the P/E ratio of the index gets around the 19.00 mark. As you can see in the chart below, we have approached this level six times over the last year and each time it has been unable to breakout. Last week the P/E hovered around 19.00 and the index moved lower four out of five trading days.

Source: Factset

The solution to the valuation dilemma most likely needs to come via a return to corporate profitability growth, preferably through revenue gains as opposed to cost cutting and productivity initiatives that have been the trend of late. The sector that could have the biggest impact on the valuation for the overall market is energy. The energy component of the S&P 500 has a trailing 12-month P/E ratio of 42.86. If you back out the energy sector, the P/E ratio for the S&P 500 Index falls to 18.11, and over the next 12 months analyst expect the P/E ratio for the S&P 500 (excluding energy) to be 16.24; in line with the five-year and 10-year averages for the aggregate index. In other words, the equity markets outside of the energy sector are not overly expensive and if earnings can increase in this sector alone the overall index becomes more fairly valued.

What’s the best way for energy companies to increase earnings? Higher oil prices. Higher oil prices would allow energy companies to take the same amount of volume, turn it into higher profits, and support valuations. Perhaps this helps explain the increase in correlation between equity prices and the price of oil which over the past two years has shown a clear upward trend (table below.)

*Daily, as of 4/27/2016

Sources: Bloomberg, Factset

While there could certainly be others, the price of oil might be one catalyst needed for the equity markets to sustain a rally and breakthrough the top that has been put on the market.

CRN: 2016-0502-5323R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.