Pulling the Rug Out from Under Us

Written By Adam English

Posted February 24, 2015

As much as small investors love Apple, there is another group out there that loves it even more right now.

They are the managers, brokers, and institutional investors that depend on client fees.

I’m not referring to the fees and commissions that undoubtedly came pouring in as investors chased the gains in Apple’s share price though.

I’m talking about the rose-tinted view of the broader stock market that Apple sustains.

The S&P 500 is almost entirely dependent on Apple at this point to make the market look like it is growing.

Back in late January the earnings growth rate of the S&P 500 stood at a mere 0.2% — hardly the kind of data people want to see while a bull market appears to stall.

Then Apple released its earnings report. Instantly, the S&P 500 earnings growth rate shot up to 2.1%.

Strip out Apple’s results entirely and the S&P 500’s overall growth would have dropped to 0.3%.

This is exactly what people who are paid commissions based off of client fees and net inflows depend on to keep their jobs.

They need to keep people chasing gains by trading and moving between positions, and to keep all their funds in play.

If they had to admit to clients that there is little impetus for the market to do anything but tepidly move sideways, their paychecks would take a hit, along with their job security.

Here is what they don’t want to tell you, plus how you can beat them — and the market — with a low-risk technique.

Stalled Out

There are a handful of pretty solid indicators that are giving investors a pause, and that is before macroeconomic and geopolitical considerations come into play.

For the sake of keeping this clean and short, we’ll just stick to the bottom line — earnings.

The trailing 12-month price-to-earnings ratio is just a hair under 20 (19.89). Compare that to the average P/E ratio at market peaks since 1957 (18.7) and we’re in historically dangerous territory.

S&P 500 earnings growth was weak enough, but new analyst estimates compiled by Reuters now anticipate no earnings growth at all for the first quarter of 2015.

That would be the worst quarter for S&P 500 earnings since Q3 2009, nearly six years ago, right in the shadow of the Great Recession.

Then there are the multiples. As of Thursday, the forward 12-month price-to-earnings ratio for the S&P 500 has hit 17.1, putting it at the highest value since 2004.

Note that this is with expectations that Q3 and Q4 are going to be extremely strong periods of earnings growth. Q4 expectations are nearly 20% higher than Q1.

If that doesn’t materialize, the forward P/E ratio would go ever further up.

Of course, this doesn’t mean a correction or crash is imminent, but we’re looking at multiples that should — and are — making investors nervous.

Tag on some more info and the market outlook gets worse.

Pulling the Rug Out

Somehow, this late-year earnings growth boom is supposed to happen in spite of the fact that earnings and revenue are trending down.

Data compiled by FactSet — a leading financial data and software company — shows 2015 revenue growth projections dropping from 2.8% down to 10.3% between December 31st and Feb. 20th.

If this comes to be, it’ll be the first time since Lehman Brothers imploded.

Earnings per share growth projections for 2015 dropped by about two-thirds, from 8.2% down to 2.8% over the same three-week period.

On Dec. 31st, the forward 12-month P/E ratio was 16.2. The S&P 500 went up 1.9% through Feb. 20th, while the forward 12-month EPS estimate has decreased by 3.3%.

forward EPS v. price change chart

In essence, the rug is being pulled out from under the equation. Valuation via P/E ratios can quickly skyrocket as earnings shrink, even with prices remaining the same.

So it is quite likely that today’s mildly overvalued stocks will appear even more expensive within several months, even if the price stays exactly the same.

Needless to say, that won’t be doing the market, or our retirement and investing accounts, any favors.

There is a way around this though, and it means pulling an old trick out of our playbooks.

Safe and Lucrative

We’re in a stock pickers’ market now. Gains from individual positions will have an outsized influence on portfolio performance, especially compared to the easy market-wide gains over the last six years.

The stereotypical stock picker goes after high risk, short-term, massive growth plays, but that isn’t the way to go.

The trick will be to pick a handful of growth stocks with strong fundamentals and clear catalysts for the position to work in your favor, and pair them with unique low-risk stocks that promise very strong income.

Dividends are going to be a major component of market-beating portfolios this year.

Consider this: The S&P 500 only has to drop 0.65%, or just under 15 points and the year-to-date returns will match the 1.82% dividend yield of the SPDR S&P 500 ETF Trust.

As it stands right now, that small dividend yield represents 42% of the gains a SPY investor sees on paper.

This will be a theme for most, if not all of this year. Dividends and income investments now represent a far more lucrative, potentially market-beating tool than they have for years.

The trick is finding the best yields while retaining the advantages of low-risk positions, which isn’t particularly easy.

With the Fed keeping interest rates pinned next to zero, there is little incentive for many companies to pay out much at all. 2% is pretty solid right now, in spite of it barely beating official inflation figures.