Tag Archive | "Is The Stock Market Forming a Top"

Is The Stock Market Forming a Top

Is The Stock Market Forming a Top

RiskWith 2015 off to a volatile start and fourth quarter corporate earnings coming in weaker than expected, the question on many investor’s minds is whether the stock market forming a top? Of course, that is a hard question to answer, but taking a look at the underlying fundamentals that cause the stock market to move can provide some clues to the answer. There are numerous indicators that can be assessed to determine if the stock market is forming a top. It is important to take a look at the most important indicator to get a sense about whether the stock market is in the process of forming a top.

Is The Stock Market Forming a Top | The Key To Answering This Question

Stock Market TopWhile there are many variables to focus on when looking for an answer to whether the stock market forming a top, there is one key variable that stands out above the rest, because it is what ultimately drives the stock market higher. Conversely, it is also the main reason why the stock market experiences sustained sell-offs, particularly during recessions. This key variable is corporate earnings.

While the stock market is pushed up and down by a variety of factors and news events over the course of a year, it is ultimately reported and projected corporate earnings that drive stocks higher and lower over the medium and long terms. Earnings have been increasing steadily since the March 2009 stock market bottom, albeit slower than the rate of increase in the stock market itself.   This increase has provided the foundation for the stock market rally since 2009.

What does the earning picture for 2015 tell us about whether the stock market forming a top? Earnings estimates for 2015 by stock analysts have come down considerably since the spring of 2014. They have gone from projected earnings growth year over year of nearly 12% in early 2014, down to estimate of an approximately 7% increase in earnings more recently.

The current earnings estimates for all of the companies in the Standard and Poors 500 index (S&P 500) combined for fiscal year 2015 is $123 per share, which is up from combined fiscal year 2014 earnings of $115.   Sounds like impressive earnings growth at first glace, but if earnings for fiscal year 2015 come in at $123, the price to earnings (P/E) ratio for the S&P 500 index combined will be over 16 at the end of 2015. That leaves little room for stock market appreciation during 2015, since the long-term average for the S&P 500 index price to earnings (P/E) ratio is 15.

Complicating the picture is the fact that energy companies make up 20% of the $123 estimated combined S&P 500 earnings for fiscal year 2015. Given the drop in oil prices, energy company earnings are likely to come up short, lowering the actual S&P 500 combined earnings for 2015. A strengthening United States dollar and fourth quarter 2014 earnings misses by some key Dow Jones Industrial Average companies, such as Microsoft (NASDAQ: MSFT) and Caterpillar (NYSE: CAT), are also troubling developments on the earnings front. A strong United States dollar means companies that earn money overseas have to reduce their earnings when they are converted to dollars from a foreign currency. Another Dow Jones Industrial Average component, DuPont (NYSE:DD), lowered forward guidance for fiscal year 2015 by a whopping 60 cents per share, citing concerns about the strong dollar’s impact on the company’s earnings. Lowered earnings expectations by companies doing business overseas may quickly become common in the stock market, threatening the earnings growth rate for 2015.

Earnings growth would need to be considerably higher during 2015 to support higher stock prices. That is not to say that the stock market will not disconnect from the earnings backdrop and continue to rally higher, as it has in recent years.   During 2014, the soaring stock market often traded with an S&P 500 index price to earnings (P/E) ratio above 17. However, that was during times when the Federal Reserve was supporting the stock market with Quantitative Easing (QE). 2015 does not have Federal Reserve Quantitative Easing support and will likely be the first year in many years in which the Federal Reserve starts raising interest rates. Based on these factors, especially earnings slowing their increase, a medium-term stock market top may very well be in for now.

Is The Stock Market Forming a Top | What To Expect

Stock Market Forming a TopThe Federal Reserve will not be there to backstop the stock market this time around, unless they undertake an unprecedented fourth round of Quantitative Easing (QE 4). While that may be possible under extreme financial duress, the political winds do not favor the Federal Reserve implementing QE 4 during an orderly stock market sell-off. In fact, it appears the Federal Reserve is intent on raising interest rates, starting some time during 2015, which will be yet another headwind that will work against the stock market making new highs during 2015.

If the stock market is in fact forming a top in 2015, then expect choppy trading throughout 2015. Instead of growing earnings driving the stock market higher, the stock market will be driven by news events. Down hard one day, due to weak economic numbers or earnings, up hard another day, due to stimulus by countries around the world or perhaps surprise upside economic numbers.

For a stock market top to be confirmed, earnings will have to fall from current levels. While earnings growth has slowed, corporate earnings are still growing and are projected to grow during 2015 by about 7%. What is most likely for 2015 is that the stock market will trade sideways, as gains over recent years are consolidated and digested. Stock market participants will wait for signs regarding earnings and economic forecasts for 2016.

For a true bear market sell-off to take hold and a 2015 medium-term stock market top to be confirmed, the economy would have to fall into recession, taking corporate earnings down with it. Given the fact that the current economic expansion is in its sixth year, which is a long time for an economic expansion, the likelihood of a recession in 2016 has to be considered, which would be accompanied by a stock market sell-off. At that point, investors would be wise to start looking for a stock market bottom towards the middle of any recession that occurs.

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