Market Declines & Options on The S&P 500 Explained
Sometimes I hate being right.
As first-quarter earnings season was getting under way in April, I warned that weakness in corporate earnings that was supposed to be confined to the energy sector had now infested the broader economy … and I was right.
So far, 87% of S&P 500 companies have reported earnings, and corporate profits are expected to decline by 7.1%. This will mark the first time since the 2008 global financial crisis that we have seen four straight quarters of negative earnings growth.
But it won’t end here…
Earnings are a broad indicator of the economy. So, with four straight quarters of decline, I would expect to see the S&P 500 down more than 1% during this time frame. What’s more, corporate profits declined by more than 7% in the first quarter, but, year-to-date, the S&P 500 has climbed 2.5%! Apparently, Wall Street is discounting the previous four quarters and looking ahead to future growth.
Unfortunately, when I look to other economic indicators, such as housing or jobs data, for reassurance on the health of our economy, it doesn’t help. In fact, another corporate-earnings data point tells me that there is more pain yet to come. However, if you are prepared, there is plenty of profit potential.
The End of Fuzzy Earnings Math
Earnings are a fuzzy spot on a company’s income statement. In fact, a company can literally move numbers (not actual profits, revenues or expenses) around to conjure up a completely different bottom line than what it should actually report.
But there’s another data point that is a little less fuzzy and no less important — revenue.
If revenue isn’t rising, the only way a company can boost earnings is by reducing expenses. This often means opting for slower long-term growth in order to cope with challenging market conditions.
According to FactSet, revenue is set to fall for the fifth straight quarter for the first time since FactSet began tracking the data in 2008.
As I mentioned above, investors on Wall Street are forward-looking. With the S&P 500 up in 2016, these investors clearly see revenue turning around … but, while this may be true, I don’t believe corporate earnings will immediately follow suit.
Over the past few years, the main sources of rising corporate bottom lines have been reductions in expenses and a touch of financial wizardry (i.e., share buybacks). But companies have all but exhausted those accounting tricks. Assuming revenue does start to increase, once spending and expenses ramp up again, it could take a year or two before we see improvements in company bottom lines.
That’s why now is a great time to own protection on your portfolio, like the S&P 500 put option position I recommended in early April.
If I am right again, and the U.S. earnings recession continues for another year or so, there is one particular sector that will still prosper — utilities.
While now is not the time to buy stocks blindly and wish for the best, there are still opportunities. For example, one of the best-performing sectors in times of market uncertainty is the utilities sector.
Take a look at how WEC Energy Group (NYSE: WEC), a Wisconsin-based electric company, performed when the S&P 500 dropped more than 10% from its August highs.
This stable utility stock actually rallied 15% as the S&P 500 fell. And when the S&P 500 regained its feet, WEC joined in, logging a gain of 20% overall.
Utilities hold up so well because they have solid top- and bottom-line results that generate consistent shareholder returns through stock appreciation and/or dividend yield. In fact, WEC pays a 3.3% annual yield that helps cushion your portfolio in volatile times.
If you’re looking to benefit regardless of whether the market falls, goes sideways or rallies, utility stocks like WEC offer returns in each scenario. In short, it pays to own stability in periods of market volatility, and utilities are among the best at filling that role.
Editor, Pure Income – the most profitable investment service.