After many months of trending steadily higher from late 2012 through year-end 2014, U.S. equities have generally entered a quiescent state. In our previous note, we pointed out that the small-cap Russell 2000 had been within a narrow range since Q4 of 2013. As the S&P’s Q1 2015 return indicates, the large cap index has now entered a similar range.
Although the equity indices lacked any clear direction, the S&P 500 has experienced significantly more day-to-day fluctuation in the past two quarters than in the eight quarters that preceded them.The chart below demonstrates that the index’s recent increase in realized volatility to more typical historical levels is consistent with the end of U.S. quantitative easing.
Recall that our strategies are designed to use implied volatility, not realized, as a measure of institutional investor sentiment and therefore as a proxy for potential large imbalances in supply and demand for equities. We consider S&P 500 put option implied volatility to indicate a normalized price that institutional investors are willing to pay for downside protection. Despite the increase in realized volatility during the quarter, implied volatility remained predominantly at below average levels, consistent with bullish institutional investor sentiment. As such, aside from four days early in the quarter, our strategies maintained an offensive positioning toward U.S. equities.
Given the negative S&P 500 company Q1 guidance, analyst projections, and actual performance, we were surprised by the generally static condition of the S&P 500 index.According to Factset’s April 24th Earnings Insight, Q1 2015 S&P 500 revenues declined 3.5% from the same period a year ago, and aggregate earnings have declined 2.8% (based on the 40% of companies that have reported).If the remaining companies’ Q1 reports are consistent with this trend, Q1 2015 will be the worst quarter for the S&P 500 since the third quarter of 2009.Furthermore, the report indicates that consensus analyst estimates show revenues and earnings continuing to decline on a year-over-year basis through at least Q3 2015. There are several possible reasons to explain why the index hasn’t fallen:
Investors could be pricing the S&P 500 based on their performance expectations for 2016 and beyond.
Earnings per share have continued to increase, despite falling aggregate earnings, thanks to companies’ ongoing share buybacks.
Investors believe that as long as the Federal Reserve remains accommodative, it is unwise to bet against equities.
Perhaps each of these factors, among others, is important. They all depend to some degree on a continuation of the Federal Reserve’s current accommodation. In this context, it is important to note that broad inflation continues to be absent from the U.S. economy, despite nearly full employment and a burgeoning rebound in oil prices. In fact, Institutional Investor recently ran a short piece titled, “Deflationary forces are gaining strength around the world.” It demonstrated that since 2012, many developed economies around the world have been experiencing outright deflation, and many more are experiencing inflation rates below 1%.
Our conclusion is that, with U.S. company revenues and earnings likely to fall through the remainder of 2015, plus persistent general deflationary forces around the globe, we believe it is unlikely that there will be any meaningful change to the current interest rate environment this year. It remains to be seen whether bullish U.S. equity sentiment will persist. We continue to monitor equity markets daily, as we endeavor to position our clients to benefit should a downturn arrive.