AlphaProfit Sector Newsletter: February Indicator Update

February 1, 2016

Dear Valued Subscriber,

Concerns on weakness in China’s economy and slide in oil prices dragging global growth pressured stock prices in January.

Shortly after the turn of the year, China’s central bank cut the currency reference rate to devalue the yuan and support exports. China’s overt preference for a weaker currency reignited worries that its economic slowdown is deeper than widely believed.

Affirming these fears, Chinese economic data showed gross domestic product expanded 6.9% in 2015, short of the government’s 7.0% annual growth target. The Institute of Supply Management’s U. S. manufacturing index also contracted in December, suggesting lower overseas demand is impacting orders at U. S. factories.

Meanwhile, surging oil supplies along with tepid demand pressured the commodity’s price below $30 a barrel, a 12-year low.

The free fall in global stock prices subsided only after U. S. stocks lost nearly $2.4 trillion in value and the S&P 500 swooned to a 21-month low.

Hopes of global central banks taking steps to shore up growth and oil producing nations curbing output helped to improve stock price stability towards to the end of January.

The European Central Bank signaled it might boost stimulus as early as March. The Bank of Japan adopted a negative interest rate. These actions give investors comfort that central banks are ready and willing to combat slowing economic growth.

Fourth quarter earnings reports that had hitherto been ineffective in lifting stock prices proved potent at month-end after Internet and software companies delivered a string of better-than-forecasted reports.

U. S. stocks ended their worst January since 2009 with the best one-day gain in over four months.

Performance Data

U. S. stocks ended well below the flat-line despite recording sizeable gains on the last day of January. The large-cap S&P 500 benchmark ended lower by 5.0% while the small-cap Russell 2000 benchmark ended lower by 8.8%. Highlighting the grim market milieu, the price of oil dropped 9.2% in January while China’s Shanghai composite index tanked 22.6%.

While none of the AlphaProfit model portfolios could muster gains, three of them lost less than the S&P 500 in January. The AlphaProfit ETF Focus model portfolio lost fractionally more than the S&P 500. The following table shows returns as of January 31 for the model portfolios as well as the S&P 500 and Russell 2000, respectively:

Market Outlook

At the turn of the year, companies exposed to the U. S. consumer are faring well while those dependent on exports are facing headwinds from weaker growth in China and a stronger U. S. dollar.

Reversing policies set forth to increase liquidity since 2008, the Federal Reserve is looking to drain liquidity by raising short-term interest rates in 2016. The central bank has stated that pace of subsequent rate increases will depend on economic data.

As such, movement in stock prices is likely to align more closely with earnings growth and valuation expansion prospects than in recent years.

Although the S&P 500 has barely advanced in 2015, its forward P/E ratio has now increased to 16.2 from 15.8 at the end of 2014. A drop in expected forward earnings causes the forward P/E ratio to increase.

Earnings have declined year-over-year for the past two quarters. If forecasts for fourth quarter earnings come through, this would mark the third straight quarter of declining year-over-year earnings. Earnings are expected to drop 0.6% in 2015.

Analysts forecast year-over-year earnings comparisons to turn positive starting in the first quarter of 2016. They forecast earnings to grow 7.6% in 2016.

We believe stocks can gain in 2016 if year-over-year earnings comparisons turn positive relatively soon and profits rise meaningfully this year.

Rating Sector Portfolio Indicator ‘Buy on Dips’

Helped by favorable job and housing markets, the consumer segment of the U. S. economy is faring reasonably well. Consumer confidence has improved in January to a three-month high.

Concurrently, the manufacturing segment of the U. S. economy is feeling the impact of slowing Chinese growth and contraction in commodity-related industries.

Meanwhile, Federal Reserve policy makers have indicated their inclination to raise borrowing costs at a gradual pace if they have adequate confidence in the U. S. economy maintaining its growth trajectory. The median projection of Fed policy makers’ forecasts in December called for four quarter-point rate increases in 2016.

The Bank of Japan’s decision to use negative interest rates and concerns of sluggish overseas economies impacting the U. S. economy can however compel the Fed to delay its gradual exit from ultra-low interest rates.

As for valuation of U. S. stocks, the January decline has cut the forward P/E on S&P 500 stocks to 15.2 from 16.1 on December 31. Yet, the forward P/E exceeds its prior 5- and 10-year average of 14.3 and 14.2, respectively.

On the earnings front, fourth quarter earnings reported to date suggest S&P 500 companies earned 5.8% less during this quarter than they did in the fourth quarter of 2014. Looking ahead, analysts forecast aggregate profits to decline 3.8% during the first quarter and grow 0.8% in the second.

U. S. stock market valuation metrics and near-term earnings trends are not attractive enough to justify high allocations to stocks in this macroeconomic milieu.

While expectations for prolonged ultra-low U. S. interest rates and stimulus from foreign central banks can push stock prices higher in the near-term, the likelihood of earnings declining year-over-year in the current quarter is an impediment to upside.

On the flip side, escalation in worries of China’s slowing economic growth can cause U. S. stocks to drop. This can prove to be a good buying opportunity as the U. S. economy is reasonably shielded from the Chinese economy.

We recommend investing 30% to 55% of total investable assets in equities at current stock prices, the specific percentage being dependent on investment objective and risk tolerance. The S&P 500 dipped below 1835 intraday on January 20 but failed to close below this level to trigger our recommendation on January 12 to increase allocation to stocks by 5%.

We rate the AlphaProfit Sector Portfolio Indicator ‘Buy on Dips‘ and iterate our recommendation to raise equity allocation by 5% to the 35% to 60% range if the S&P 500 drops below 1835. (On January 29, the S&P 500 closed at 1940.24.)

Model Portfolio Composition and Investment Recommendations

We are not making any changes to the sector and industry recommendations or the model portfolios. Model portfolio compositions as well as exchange-traded fund (ETF) and mutual fund recommendations are available in the Subscriber Login area of the website. View Current Model Portfolio Composition

Stock Recommendations

Stock recommendations will be included in the February Report due for publication on the 12th.

We welcome your comments.

Best regards,
Sam Subramanian PhD, MBA
AlphaProfit Investments, LLC
Ideas. Insights. Results.
http://www.alphaprofit.com