Market Bulletin. 4Q15 earnings recap: The never-ending story of oil and the dollar. February 16, In brief. Earnings recap

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1 Market Bulletin February 16, Q15 earnings recap: The never-ending story of oil and the dollar In brief The 4Q15 earnings season has been disappointing, with earnings per share (EPS) expected to decline by 1.8%. 1 This caps a difficult year in which macroeconomic headwinds reduced earnings growth and resulted in a flat stock market. Despite these near-term difficulties, full-year 2016 earnings growth expectations are still positive. This should be supportive of market returns, especially if the dollar continues to stabilize and if oil can find a bottom. Market risks have worsened this year, but are now shifting to the upside. Sentiment is at cycle lows, valuations are below historical averages and a large proportion of the stock market is on sale. This should benefit active managers who can identify mispriced stocks. Earnings recap U.S. earnings continued to disappoint in the fourth quarter of 2015, more than a year after the headwinds from oil and the U.S. dollar emerged. This slowdown in earnings growth has added to the cloud of uncertainty facing equity markets. Unlike in years past, when geopolitical and global growth concerns had been allayed by strong U.S. earnings, these disappointing results have provided little comfort during this difficult start to the year. However, full-year 2016 estimates are still positive, and this is what should drive long-term investment views. James C. Liu, CFA Global Market Strategist 1 Figures in this bulletin are based on the S&P 500 Index, are on a quarterly basis and growth rates are yearover-year (y/y) comparisons, unless stated otherwise.

2 MARKET BULLETIN FEBRUARY 16, 2015 Thus, while risks to the equity story have clearly increased, there is potential upside from here. Markets are pricing-in extreme scenarios, with nearly 65% of S&P 500 companies in bear market territory and sentiment at cycle lows. 2 Our base case is that the U.S. economy continues to grow and that earnings can recover from macroeconomic headwinds. With the market effectively on sale, we believe there are significant stock-picking opportunities for active managers. With 82% of the S&P 500 reported, we estimate that EPS growth declined -1.8% in the fourth quarter to $ This is a worse-than-expected revision from initial estimates of positive growth, and has spilled over into 1Q16 projections. Profit margins have fallen to 9.2%, compared to the peak of 10.1% in Perhaps more disappointing is that only 38% of companies are beating already-battered revenue expectations. Additionally, we argued in last quarter s Earnings Recap that analyst expectations of full-year 2016 earnings were likely too lofty. This has indeed turned out to be the case with 2016 operating earnings estimates revised down by over $5. EXHIBIT 1: S&P 500 EARNINGS PER SHARE QUARTERLY, OPERATING EARNINGS $34 $32 $30 $28 $26 $24 $22 $20 Reported and current estimates Forward estimates 4Q15: $26.27 $18 '11 '12 '13 '14 '15 '16 Sources: Standard & Poor's, J.P. Morgan Asset Management. Third quarter earnings per share are estimates from J.P. Morgan Asset Management. Prior year estimates are Standard and Poor's estimates as of October 30, All other data are as of February 11, For illustrative purposes only. However, we still maintain a moderately positive outlook on earnings growth in Operating earnings are still expected to grow by 4% over the full year, and headline earnings by 15%. In fact, there is the possibility of further upside if the market has overestimated the impact of the stronger dollar (discussed in the next section). The fact that mediumterm projections are higher than short-term ones suggests that most analysts continue to believe that these headwinds will subside, despite their stubborn longevity. EXHIBIT 2: S&P 500 FULL-YEAR AND NTMA EARNINGS GROWTH EPS GROWTH FOR ALL SECTORS AND EXCLUDING ENERGY $155 $150 $145 $140 $135 $130 $125 $120 8/2014: $ /2014: $ /2014: $ Source: FactSet, J.P. Morgan Asset Management; data are as of February 11, For illustrative purposes only. NO REST FOR THE WEARY NTMA The high U.S. dollar and low oil prices are still the culprits of weak U.S. earnings. One clear result of these macro uncertainties is the wide range of Wall Street earnings estimates. Differences in methodology around the treatment of operating earnings and asset write-downs, in addition to the projected path of the dollar and oil, have led to wildly divergent earnings numbers. 2 We compare each S&P 500 constituent to its high since Sentiment is measured using the AAII investor sentiment index. $ $ $115 $ Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 2 4Q15 EARNINGS SEASON RECAP

3 MARKET BULLETIN FEBRUARY 16, 2015 The best way to cut through the methodological confusion is still to examine earnings projections that exclude the energy sector. Operating EPS ex-energy is expected to grow by over 6% in This suggests that the core earnings potential of U.S. companies is still strong and should be supportive of market returns if the dollar and oil effects stabilize. Fortunately, the pace of dollar strength is decelerating. At its peak, the dollar rose 18.2% y/y, but this decelerated to 12.8% in the fourth quarter. If the first quarter were to end today, the y/y change would be approximately 6.2%. In fact, by most measures, the dollar has weakened since the Fed increased rates in mid-december. Even if the level of the dollar remains strong, stability in its direction should allow companies to adjust. Oil prices, on the other hand, have provided no such respite. After bottoming around $45 per barrel in early 2015, WTI recovered above $60 during the summer. Since then, global oversupply and fears of reduced demand have led oil to plumb new depths below $30. Energy companies have cut costs, reduced production and consolidated, all of which should help profit margins over time. Unfortunately, oil prices are only expected to recover slowly from here. Since the possibility of the energy sector returning to its former profitability is essentially zero, the market is simply looking for stability in oil prices. U.S. EQUITY OUTLOOK The risks to the U.S. equity outlook have clearly increased, especially with uncertainty in China. However, the market has already reacted to these developments by falling over 14% from last year s peak. The market is pricing-in extremely negative scenarios, many of which are possible but unlikely. The balance of risk is beginning to be skewed to the upside. For example, investor sentiment is at its lowest point this cycle (Exhibit 3). This has more often been a contrarian indicator than a leading one, since buying when others are fearful has been a key attribute of successful long-term investors. In fact, sentiment has fallen below levels witnessed during the eurozone crisis when, similar to today, prospects for the global economy were in question. As was the case then, if the U.S. economy continues to grow, the market should see cooler heads prevail. EXHIBIT 3: AAII INVESTOR SENTIMENT BULL MINUS BEAR ONE-MONTH MOVING AVERAGE (10) (20) (30) 1 (40) Jan '09 Jul '09 Jan '10 Jul '10 Jan '11 Jul '11 Jan '12 Jul '12 Jan '13 Jul '13 Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 1. Financial crisis; 2. Flash crash, Deepwater horizon, Euro crisis; 3. U.S. debt downgrade; 4. Euro crisis; 5. Taper tantrum; 6. China, Commodities, Global growth Sources: AAII, J.P. Morgan Asset Management; data are as of February 11, For illustrative purposes only. In the long run, valuations matter more than prices. Valuation multiples have fallen below their historical averages, even after adjusting for lower earnings expectations. At a forward price-to-earnings ratio of 14.8x, the S&P 500 is 2.5 multiple points cheaper than at its peak last year, and one multiple point lower than its long-run average. In fact, we estimate that 65% of S&P 500 constituents are trading in bear market territory and 86% are in correction territory. Two factors that typically result in protracted market corrections extreme valuations and irrational exuberance are clearly nowhere to be found today. J.P. MORGAN ASSET MANAGEMENT 3

4 MARKET BULLETIN J.P. MORGAN ASSET MANAGEMENT Investment Implications The equity outlook has been obfuscated by global uncertainty and volatility. Markets have reacted swiftly, resulting in cycle lows for sentiment and belowaverage valuation levels. Despite negative earnings growth in 2015 due to macroeconomic drags, we continue to forecast a rebound in 2016, which should support equity returns. These facts, along with the large proportion of individual stocks trading at bear market and correction levels, suggest that the markets are on sale. Active managers should be able to find significant long-term opportunities in this environment. 4 4Q15 EARNINGS SEASON RECAP

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