As we enter August, a bit over half of the S&P 500 companies have reported their 2nd quarter 2013 financial results. So far 65.2% have exceeded their earnings estimates, about in line with the average for the last 3 years, which is not a surprise (source: Raymond James Investment Strategy 7/29/13). What is a surprise is that 56.3% of the companies are beating their revenue estimates and total revenues are on pace to grow 6% year over year (source: ISI Money Management 7/29/13). Why is this important?
Companies can increase earnings in two ways: (1) Grow revenues and/or (2) reduce expenses. Coming out of the financial crisis in 2009/2010 most companies were able to increase earnings by drastically cutting costs. Then during 2011/2012 we saw both growing revenues and continued cost cutting leading to increased earnings. At the start of this year concern that costs had been cut to the bone and revenue growth would slow contributed to a forecast for reduced earnings growth. Based on results to date that concern seems unfounded, as it appears that companies have been able to continue to grow their revenues while holding their costs down thereby further increasing their earnings. How does this impact the markets?
Stock prices are predominantly driven by two factors: (1) earnings growth and (2) price / earnings multiple. The P/E multiple is the value the equity market puts on earnings. Below are 2 charts which highlight this. The first chart shows the relationship of yearly earnings from S&P 500 companies to the value of the S&P 500 Index. As you can see, since 2003 they track very closely (rising earnings lead to a rising stock market while declining earnings lead to stock market declines). Of note is that starting in 2012 yearly earnings are growing at a faster pace than the increase in the stock market.
This second chart (courtesy of Riverfront Investment Group) shows the trend in S&P 500 price/earnings multiples. Please note the spikes in the late 1990s/early 2000s and again in 2007/2008 that precipitated major declines in the equity markets. Alternately, the current P/E multiple is right at the long-term historical average of around 16.
So what does all this mean? In my opinion, it means that the equity market, despite being at all-time highs, is not significantly overvalued but rather is fairly valued based on earnings. Having said that, for the past 10 years, nine of ten S&P sectors (industrials, energy, healthcare, etc.) have declined from mid-July through mid-August. Therefore I am cautious short-term but bullish long-term on equities.
Contrasting the positive fundamentals in the equity market is the slow growth rate of the US economy. On July 31,2013 the first estimate of Real 2nd quarter 2013 Gross Domestic Product (GDP) was announced at 1.7%, which combined with the current inflation rate brings total GDP growth to just 2.9% year over year (source: ISI Money Management 7/31/13). The chart below (courtesy of ISI) shows that GDP has hooked down in 2013 and is well below the long-term average of 4.5% to 5%. Also on 7/31/13, the Federal Reserve Open Market Committee completed its most recent meeting. Fundamentally, they left their current low interest rate policy unchanged. However, they changed their description of US economic growth from “moderate” to “modest” (source: Federal Reserve Press Release 7/31/13)
While these words are synonymous in the dictionary, they have distinct meanings in the Fed’s carefully crafted communication suggesting the Fed is concerned about continued lackluster economic performance. My interpretation is that the Fed is going to remain aggressive in stimulating the economy via low interest rates and pumping money into the economy via continued bond purchases, at least through the end of 2013.
The Big Picture:
I expect choppiness in the financial markets over the short term. Beyond that, I feel that low interest rates, improving housing and labor markets, and an abundance of cash on the sidelines will be supportive of values for equities and dividend paying investments. Fixed income (bond) investments values will likely stabilize from recent declines but returns will be limited to the interest generated. Cash will likely continue to loss value on a purchasing power basis.
Hopefully you find this information useful. Please call me if you have any questions or concerns.
Although the information included in this report has been obtained from sources we believe to be reliable, its accuracy and completeness are not asserted. All opinions and estimates included in this report constitute the judgment of the financial advisor as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
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