First quarter earnings look OK but not great and broadly consistent with Wall Street strategists’ expectation of $108 for S&P 500 EPS this year. That’s bad news for bears who expect weak profits to derail the rally. Despite mediocre profits, the “valuation levitation” we have been writing about for months should continue, because the stock market rally is not being driven by “better than expected profits” but, rather, by the fact that stocks are “too cheap” in an age of sub-2% bond yield. It’s a replay of the 1980s. Look for the S&P 500 to be above 1650 by the end of this year, which would imply a trailing PE ratio of just 15.2x, and a prospective dividend yield on 2014 DPS of 2.4%– attractive when the 10-year Treasury bond yields 2%.
Though CEOs are no more clairvoyant than economists, they do have an insider’s view of order books, customers’ psychology, and the state of the world economy. Here are seven themes:
- Europe’s recession is severe and there is little reason to believe it will end later this year. Companies are already cutting forecasts for H2 2013 sales. As we have often noted, the continent is plagued by structural problems going way beyond a dysfunctional currency.
- The U.S. is chugging along, powered by housing, autos, and energy production. But higher taxes, sequestration, weak exports and Obama’s anti-growth policies are keeping the economy stuck in second gear.
- Emerging markets are fairly healthy but, unlike 2010 and 2011, are not strong enough to power many positive EPS surprises.
- Capital spending is soft, to judge by the reports out of IBM, Accenture, Caterpillar, the big Telcos, and others. This does not bode well for hiring by large firms.
- Despite the headwind of a strong dollar, many “defensive” companies in consumer staples and healthcare have come through with decent earnings, including Coke, Pepsi, JNJ, Abbot, Baxter, Philip Morris, KMB, etc. Declining commodity input costs help. (This does not mean they are necessarily great stocks to buy at today’s lofty PE multiples.)
- Companies have become very good at scratching out modest profit growth in a weak macro environment via restructuring, acquisitions, share buy-backs, cost-cutting, and modest organic growth. Profit bears (such as Bill Gross and sundry Financial Times pundits) have been worrying for years, if not decades, that profits’ share of national income was “too high” and would decline as wages rebounded and margins were squeezed. It will happen eventually, but maybe not any time soon.
- In this tepid environment, there are not many fast growing markets, or large companies with solid double-digit revenue growth. Exceptions are U.S. housing, on-line advertising, biotechnology (if you have the right drugs), fracking, and a few exceptionally well-positioned consumer companies—think EBAY, GOOG, GILD, SBUX, etc.
Weak Commodity Prices—Negative for Profits Short-term, but Positive Long-term
For this year lower prices for oil, copper, and other commodities are bearish for profits, because they shift national income from companies to consumers—when oil prices drop ExxonMobil earns less but Jane Doe spends less at the pump. But although it may take a dollar or two off of 2013 S&P 500 EPS, the recent drop in oil prices is positive in that the consumer relief allows the economy to keep growing; it cuts the risk we will tip over into recession. Thus weak commodity prices increases the probability that profits will keep growing in 2014 – which is more important to investors than whether profits this year are $107 or $110.
The drop in oil prices is positive for airlines and broadly positive for consumer-oriented companies (particularly vendors of commodity-intensive products such as soap), both because their customers have more discretionary income and because input costs decline. The profit impact is not huge but does help companies like P&G “make their numbers” in a soft economy. In addition to energy producers, lower commodity prices hurt industrial companies that supply compressors, trucks, graders and other equipment to energy and mining companies.
Copyright Thomas Doerflinger 2013. All Rights Reserved
