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LPL’s Final Four: Which Factor Will Move Markets Most?

By Janet Levaux

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Click to enlarge. Source: LPLThe Final Four of the 2015 NCAA College Basketball Tournament are set, with Kentucky facing Wisconsin and Duke playing Michigan State this Saturday. But which “teams” are likely to win the current game of stock-market investing?

Burt White, chief investment officer for LPL Financial (LPLA) just shared his views on the market’s Final Four: the economy, earnings, valuations and technicals.

“Based on our assessment of these four factors, we expect stock market investors may be ‘cutting down the nets’ due to potential high-single-digit stock market gains in 2015,” he explained in a report issued Wednesday.

Semifinalist #1: Economy

Due to the impact of falling oil prices and the strengthening U.S. dollar, the economy has weakened in the first quarter.

“Cheap oil has led energy producers to cut spending. The strong U.S. dollar has reduced the attractiveness of U.S. exports, contributing to a slower pace of growth,” White explained.

Plus, a tough winter and a work slowdown at West Coast ports hurt economic activity. Still, U.S. gross domestic product is on track to grow 1%-2% in the first quarter of 2015, experts say.

“We expect the reversal of some of these factors should help GDP growth return to 3%-plus in the coming quarters. Better weather should be a given. Consumer spending is beginning to benefit from lower fuel prices, while transportation costs have come down,” White said.

There’s some pickup in economic activity in Europe, and China is expected to enact more stimulus measures to achieve its 7% growth target.

The bottom line, says White, is for a continuation of economic expansion in 2015 after the first-quarter dip. Furthermore, there’s little to no evidence of excesses that could suggest an impending recession.

Semifinalist #2: Earnings

Earnings growth appears to have “stalled” in early 2015, according to LPL, “but we continue to see earnings as a key driver of our positive stock market view.”

Earnings could fall 3% year over year in the first quarter, points out Thomson Reuters, as a result of the drop in oil prices and the strong U.S. dollar.

“We estimate the drag on overall S&P 500 profits from energy-sector earnings during the first quarter of 2015 to be roughly 4%-5%,” White said.

Since S&P 500 companies generate about 35%-40% of their sales overseas, there’s a strong drag on revenue earned in foreign currencies with a strong dollar. “We estimate that currency represented a roughly 3% drag on S&P 500 earnings during the fourth quarter of 2014, based on a 9% rise in the dollar during that quarter vs. the year-ago period (Q4 2013),” he added.

A 6% drag on earnings from current currency levels is “a reasonable expectation” for Q1’15, White notes.

“We expect market participants to see these two earnings drags as mostly temporary and look beyond them to better earnings growth later this year,” he said.

Semifinalist #3: Technicals

Stocks have been in a solid uptrend, judging by the slope of the 200-day moving average.

In terms of their formation of a series of higher highs and higher lows (a bullish trend), the S&P 500 Index weekly price chart has been stellar, White points out, “indicating a long-term bullish trend may remain in place for U.S. equities.”

Plus, LPL doesn’t believe investor sentiment is overextended based. A recent survey found the level of bullishness, 38%, to be in line with the long-term average.

“This amount of margin debt has not derailed this bull market in recent years, and we do not expect to do so this year,” White explained.

Semifinalist #4: Valuations

After a six-year bull market, valuations are above average, which means there’s a reason to be cautious. The S&P 500 trailing price-to-earnings (PE) ratio is 17.5, whereas the forward PE — based on the next year of estimates — is 17.0, the expert states.

“At these levels, valuations are slightly rich, but not high enough for us to change our positive outlook for U.S. stocks for 2015. Valuations have historically not been a reliable predictor of shorter-term stock market performance over periods such as a year, while low interest rates, low inflation and a lack of attractive investment alternatives help justify a modest valuation premium,” according to White. Semifinal Matchup #1: Economy vs. Earnings

Earnings are likely to improve later this year, LPL’s CIO says, along with the U.S. economy. The underlying earnings power of corporate America, after stripping out temporary factors, “is pretty good.”

Excluding the energy sector, average earnings growth for the other nine S&P sectors is 2.7%. In addition, similar periods of earnings weakness in 1986, 1998 and 2012, White says, came during strong years for S&P 500 performance.

Semifinal Matchup #2: Valuations vs. Technicals

Since valuations are above average, they lose the matchup against strong technicals, the expert concludes. “Momentum for the S&P 500 remains strong, and until we see technical evidence to the contrary, we would prefer a ‘buy-the-dip’ strategy,” he explained, though that approach may not be suitable for all investors or necessarily yield positive returns.

Championship: Earnings vs. Technicals

Although it’s a tough call, LPL’s CIO says the firm believes “the classic investing adage that earnings drive stock prices.”

Today’s bull market has been supported by a 133% increase in S&P 500 profits since 2009, and the underlying earnings power of corporate America “should carry the day.”

The LPL CIO concludes that earnings should do “much of the heavy lifting in driving stock market gains” this year. The firm’s experts expect improving earnings throughout 2015 “as some of the temporary drags reverse, and prospects for accelerating growth entering 2016 [should] keep this bull market going.”

— Check out March Madness: Kleintop’s Sweet 16 Bracket for the Stock Market on ThinkAdvisor.