A quick look at a timely topic of interest – with a brief review of why it could matter to investors.

Chart of the Week
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February 17, 2014

US earnings: strong, but with an asterisk
S&P 500 earnings and P/E ratio: actual & forecast

chart

Source: Standard & Poor's, as of 1/31/14. Data for 4Q 2013 through 2014 is based on S&P estimates. Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance. This information cannot be guaranteed and all liability is disclaimed on S&P's own behalf and on behalf of its information providers for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Bottom Line:

  • The market's rocky start to 2014 came in spite of solid results for many US companies - with weaker-than-expected economic data and emerging market turmoil obscuring the strength of earnings.
  • Indeed, with more than 3/4 of S&P 500 companies reporting, this earning season appears on track for the fastest year-on-year growth in seven quarters.
  • That's a positive for investors: one of the bigger challenges posed by the market is that stock prices have been increasing at a faster pace than corporate earnings for nearly two years.
  • The result of that mismatch: a higher price/earnings (P/E) ratio—now above 16x, up from 13x two years ago.
  • That's not necessarily bad. It could reflect optimism on the part of investors now willing to pay more for a dollar of current earnings
  • But it could also signal increased sensitivity to earnings disappointments, if lofty hopes of future earnings growth are dashed.
  • The challenge of higher multiples reinforces the importance of experienced stock pickers focused on companies with strong businesses. The hope: the less likely a company's earnings are to disappoint, the less opportunity there is for the stock to be punished by the market.

The chart:

  • The chart shows S&P 500 annual earnings (green columns) on a quarterly basis from December 2011 through September 2013 and expected annual earnings (yellow columns) for December 2013 through December 2014.
  • It also shows the trailing 12-month P/E ratio for December 2011 through September 2013 (solid blue line) and forward P/E ratio (dotted blue line) for December 2013 through December 2014.
  • Expected annual earnings and the forward P/E are based on S&P estimates as of January 31, 2014.
  • Note that annual earnings fluctuated between $96 and $100 between December 2011 and June 2013 even as the P/E rose from 13x to above 16x.
  • According to S&P, estimated earnings acceleration that began in September 2013 could continue for several quarters.
  • Based on current expectations for $120 in earnings at the end of 2014, the markets forward P/E is about 15x.

Context & Perspective:

  • The latest update from Standard & Poor's shows S&P 500 operating earnings for 2013 expected to rise to $108.3 from $96.82 in 2012. That would mark an increase of nearly 12% from 2012, following 5 consecutive quarters of year over year increases below 5%.
  • If the forecast pickup in earnings growth in the latest quarter – and the current forecast that operating earnings reach $120 by the end of 2014 – come true, it could help explain the market's strong advance during 2013 despite lackluster annual earnings growth for the first three quarters of that year.
  • The question for investors now becomes whether companies can deliver on expected 2014 earnings. Potential tailwinds include:
    • A broader economic recovery that raises prospects for better overall revenue growth
    • Continued monetary accommodation
    • Putting corporate cash to work—increasing capital expenditures; share buybacks and dividend increases
    • Continued improvement in housing and commercial construction
    • A pickup in global growth that could benefit companies' sales abroad—hundreds of millions of new middle class consumers in the developing world
    • A continued reallocation of assets from fixed income to equities
    • Valuation opportunities—P/Es have expanded in the aggregate, but the gap between secular growth and traditional value holdings remains wide and some sectors/industries continue to trade near multi-decade low valuation levels
  • Potential Headwinds
    • Profit margins could decline from record high levels as the relationship between capital, investment and labor normalizes
    • Unintended consequences in the eventual unwinding of unprecedented monetary policy
    • Interest rates could rise faster than expected—inflation accelerates or foreign buyers sour on US Treasuries, weakening the US dollar
    • Housing and employment growth may not pick up, undermining revenue growth and increasing deflation concerns
    • Geopolitical flare ups and beggar-thy-neighbor devaluations and trade policies are always a risk factor

Definitions:

The S&P 500 Index is an unmanaged index of common stock performance. Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

The price-to-earnings (P/E) ratio, also known as the multiple, is a stock's price divided by its earnings per share.


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Poll

Go for growth: Where will a global recovery be strongest this year?








Poll

Go for growth: Where will a global recovery be strongest this year?

Europe, as countries emerge from bailouts
(45%)
US, as consumers regain optimism
(36%)
Japan, as stimulus programs begin to bear fruit
(7%)
China, as reform and pro-growth policies continue
(12%)



Previous month Poll

Expect the unexpected:
Which of these outcomes
do you think is the most likely
in the coming year?

US: economic surge spurs Fed to begin raising interest rates
(27%)
Japan: return to recession despite Abe's continued aggressive stimulus policies
(12%)
China: negotiate with neighbors over its territorial claims in the South China Sea
(5%)
Europe: Italy forms a government that lasts the entire year
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None of the above; business as usual worldwide
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