New Highs for the S&P 500

Well, well. The *ahem* good people at OPEC just changed everything. Last Wednesday, against all odds, OPEC, along with Russia, agreed to cap oil production to a range of 32.5 to 33 million barrels a day. In August, OPEC pumped 33.69 million barrels a day. (No word on what concessions Russia made.) 

This is big news. If you recall from our earlier discussion of the oil production situation, the oil markets were oversupplied by at least 1 million barrels a day. That oversupply led to record amounts of oil in storage, low gasoline prices, and a slew of bankruptcies at U.S. shale oil companies.

Now, two years later, the U.S. has lost around 1 million barrels of daily oil production. And now that OPEC is cutting another million or so barrels a day, well, the overproduction is basically gone. I’m sure you’re aware of much of this. It’s a truly significant change. Stocks rallied, especially oil stocks. My favorite oil play, Oasis Petroleum, jumped from just over $9 to around $11.50 in three days. 

The S&P 500 jumped, too, from around 2,150 to 2,170. That 20-point move may not sound like much. And really, in and of itself, it isn’t a particularly big move. Think of it as an appetizer, a little taste of what’s to come. Because we are now set up for a really nice rally that could take us into the end of the year. 

To show you why that’s true, I’m going to share some research that I sent to my Wealth Advisory subscribers as part of their September issue…

Recession Fears Fade in the Blink of an Eye

Last month, the odds of recession were rising. And I told Wealth Advisory readers this: 

On Tuesday, September 20, Deutsche Bank strategists released a report to back up their assertion that there’s a 30% chance the U.S. economy will enter recession in the next 12 months.

The good people have a formula for predicting recessions. There are four key conditions that must be in place. Those four conditions are listed in this table Deutsche Bank provided:

 [Click Image to Enlarge]

FYI, the Fed’s LMCI is the Labor Market Conditions Index. And it turned negative in August. Corporate profits have been falling for two years. Capital expenditure (CAPEX) spending is down 2% from last year. And finally, default rates for high-yield bonds are at 5.7%.

As you can see from the table, all of these conditions have lined up five times in the last 30 years. Only once, in 1986, did the U.S. economy manage to keep its head above water.

I like this analysis, I really do. Each of these indicators shows an economy that is not strong and may actually be slowing down.

Still, there are a couple points that need to be added to this work. I will give Deutsche Bank credit for pointing out that the declines in CAPEX are being led by the oil sector.

But what it fails to point out is that the oil sector is also contributing to the decline in profit margins and the rise in the high-yield bond default rate. That’s important to know. We need context for this type of research, some way to understand just how each data point is affecting the big picture.

When we see that the price of oil is a common denominator, well, it puts a different spin on things. I continue to say that low oil prices are temporary, due to Saudi market manipulation. And so the threat of recession may be temporary too…

The point here is that if you change one variable, the other variables change, too. And let’s face it: the price of oil is a pretty big variable because it affects so many things. But the biggest impact, at least so far as I’m concerned, will be on earnings for the S&P 500. 

Oil and Earnings

Earnings for the S&P 500 have been declining for six straight quarters. It’s been almost entirely due to oil company earnings. And it’s made stocks in general look kind of expensive. After all, a trailing price-to-earnings ratio of 24 for the S&P 500 is not cheap. It should be around 18 to 20…

Now, here’s the thing: The forward P/E for the S&P 500 (based on 12-month estimates) is 18.4. That’s not so expensive. 

Of course, investors should be asking themselves why earnings would jump so much. After all, analysts have been calling for a pretty aggressive 13% jump in earnings for the fourth quarter alone…

Up until last week, there has been no reason for earnings to jump that much. The economy is still weak. And that’s why analysts have been cutting third-quarter earnings estimates. But they haven’t started in on fourth-quarter earnings, and that was causing concern. 

But now, with the potential for oil company earnings to actually be better than expected, there’s a legitimate case to be made that stocks can rally for fundamental reasons. CAPEX in the oil space could increase, and jobs growth could return to the oil space as well.

If we assume a reasonable P/E of 20, then the S&P 500 has 8% upside to 2,335 over the next year. That’s a solid 200 points on the S&P 500!

Of course, let’s not get all wide-eyed bullish right away. The market still has things to deal with. The ongoing issues at Deutsche Bank and the potential for interest rates to get hiked come to mind. 

Still, the simple fact is this: there is upside for earnings. And that means there is upside for the S&P 500. This should be a pretty good few months for stocks, so make sure you get positioned.

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.