Wall Street’s Focus Will Return to Earnings

by Daniel Putnam | October 21, 2013 10:18 am

After months of news-driven action in the markets, it might be time for investors to get back to basics.

The confusion surrounding tapering, followed by the uncertainty regarding the government shutdown and debt ceiling issue, has injected substantial headline-related volatility into the market since the early summer. Now, all of these factors have largely moved into the background. This leaves us with a market that should return its attention to traditional drivers of performance — namely, earnings and valuations — once this relief rally runs its course.

Therefore, he most important question right now is whether these measures are sufficient to support the market through 2014.

The short answer? It depends on what happens in the economy.

Here’s why: If economic growth is too soft, 2014 earnings estimates could take a substantial hit — a development that would undoubtedly take the market out of rally mode. On the other hand, growth that’s too fast will bring the “taper” issue back on to the table. This indicates that the economy needs to continue threading the proverbial needle with Goldilocks-type growth in the 2% to 2.5% range, or perhaps as far as 3% on the outside. Move out of this range, and the market is no longer in the sweet spot.

Within this range, however, there’s certainly room for additional upside in the next six to 12 months. The same factors that have helped drive the market higher this year — most notably, accommodative global central banks and the relative attractiveness of stocks vs. bonds — remain in place, and valuations aren’t especially commanding on a forward-looking basis.

According to Standard & Poor’s[1], S&P 500 companies are on track for operating earnings growth of $107.58 in 2013 and $121.67 next year. (Operating earnings, as opposed to reported earnings, strips out non-recurring items.) With the index at about 1740, this puts large caps’ trailing P/E at 16.2 and their forward multiple at 14.3. While higher than one year ago, this isn’t especially imposing on a historical basis — especially for a period of low interest rates and low inflation.

Further, both the price-to-sales and price-to-book ratios for the S&P 500, while having risen substantially in recent years, are only now back to their pre-crisis levels — as shown here[2] and here[3].

That’s the good news. The flip side of this equation is that trailing reported earnings growth for S&P 500 companies is 3.4%, according to Barron’s[4]. With the market up more than 20% so far this year, this indicates that valuation expansion, rather than earnings, has been the key driver of performance. And that’s just the large-cap space — these numbers don’t even account for the dramatic valuation expansion that has occurred in small caps and various momentum names.

As a result, it’s a long shot to expect a similar expansion in the year ahead without meaningful fundamental improvements.

This is where economic growth comes into play. The $121.67 estimate for 2014 S&P 500 earnings, which represents an expansion of 13.1% over this year, could prove aggressive without robust growth given the increasingly difficulty of boosting earnings through incremental cost-cutting. This estimate can slip to some degree in the months ahead — and it most likely will, as estimates typically do heading into the next calendar year — with the current forward estimate at a modest 14.3x.

At the same time, there’s only so much downward earnings momentum the market can absorb after a year of hearty multiple expansion already in the rear-view mirror.

The Bottom Line

The markets clearly are pricing in an environment of stronger growth for 2014, as evidenced by the strength in European stocks, the recent rebound in the emerging markets and the outperformance of the economically sensitive materials, industrials and energy sectors in the past three months. If the global recovery story indeed plays out as anticipated, stocks can keep humming along. But if there’s any disappointment that threatens to feed through to earnings, this bull market could come to screeching halt.

Now that headlines out of Washington are finally dissipating, 2014 estimates are what matters most for this market.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Source URL: https://investorplace.com/2013/10/stocks-fairly-valued-2014-earnings/

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