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September 17, 2013 10:07 am
Tap an equity bull these days and just like Frank Sinatra, they’ll hum: “The best is yet to come.”
Equity investors are renowned for their optimism. Yet now, more than at any time since the market hit its nadir in March 2009, plenty is riding on an economic recovery gathering enough pace to justify buying stocks at current levels.
At around 1,700 the S&P 500 is just shy of record territory and up nearly 20 per cent so far this year.
The broad market is up more than 7 per cent since bond yields started climbing in May and a number of economic bellwhether companies have charged ahead.
Ford is up 30 per cent, FedEx and Harley Davidson have both risen about 20 per cent, while in the technology sector Facebook has surged 58 per cent and LinkedIn has gained 26 per cent.
It is a performance that many on Wall Street expect will run further, with some forecasting a rise above 1,900 in 2014 for the benchmark.
Empowering the bulls is a market that has absorbed a sharp rise in bond yields, which move inversely to prices, this summer and appears sanguine about the Federal Reserve announcing a likely reduction – or tapering – of its monthly $85bn of bond buying on Wednesday.
A decision to scale back its emergency asset purchases would suggest that the Fed is confident about the strength of that US economic recovery. As interest rates slowly normalise, the thinking among equity bulls goes: the allure of equities can only improve.
Carmine Grigoli, chief investment strategist at Mizuho Securities, expects the S&P 500 will reach 1,850 next spring: “We would ignore the correction chatter and remain invested as long as liquidity continues to be ample, valuations are favourable, profits are rising and economic growth is positive.”
Indeed, a modest Fed taper that keeps market volatility subdued is also seen accelerating what since June has been a modest rotation by investment funds out of bonds in favour of equities.
“Investors have just started to reposition out of bonds and into equities,” says Robert Doll, chief equity strategist at Nuveen Asset Management. “Relative valuations continue to strongly favour equities despite the recent rise in bond yields and forward price/earnings ratios.”
The strong performances in industrials, consumer discretionary stocks, financials and materials sectors point to a growing conviction among investors that the US recovery is building.
As such, assuming monetary policy is tightened as a result of that recovery, higher interest rates are seen by some as unlikely to derail the rally in stocks.
Chris Watling, chief market strategist at Longview Economics, says: “We are at the point where the US economy is starting to gain momentum and your strategy for the next year or two is to rotate into your classic growth sectors.”
That is fine if revenues start growing and quickly. But, with that growth increasingly priced in, the market will soon need to see evidence of it in reported profits. Nicholas Colas, chief market strategist at ConvergEx Group, says the forthcoming earnings season will focus attention on revenues and a lack of top line growth. Those earnings reports “will probably decide the market’s direction for the balance of the year”.
Over the past year, revenue growth for the big 30 blue-chip companies in the Dow Jones Industrial Average has dropped 0.3 per cent, well below the average top line growth of 9 to 15 per cent in 2010 when the economy was emerging from the global financial crisis. “You are buying equities exclusively for the revenue growth to come, and we have not seen it for the past four quarters,” says Mr Colas.
You are buying equities exclusively for the revenue growth to come, and we have not seen it for the past four quarters
- Nicholas Colas, chief market strategist at ConvergEx Group
For the fourth quarter, analysts expect S&P year-over-year earnings growth will rise above 10 per cent, while revenues are estimated to expand just 1 per cent, according to FactSet. Such a divergence suggests either earnings estimates need to come down, or that revenues will rebound in the final three months of the year.
The S&P is expected by analysts to post record earnings per share of $110.06 for 2013, followed by $122.18 in 2014. Such lofty expectations underpin high price targets for the index at the end of this year, and particularly for 2014, by the leading 18 banks and brokerages. The median year end target for the S&P is 1,730 and 1,875 for the end of 2014, a rise of 10 per cent from its current level.
A look at price to earnings ratios, though, raises questions over the scope for further gains.
John Butters, senior earnings analyst at FactSet, estimates the S&P 500 price to earnings ratio, based on the next 12 months of forward earnings of $118.53 per share, at 14.3 times. That figure is slightly above the average of 14 for the past decade. “We are at peak for the forward estimates going back the last ten years,” says Mr Butters.
Another measure of the S&P is the Shiller P/E, based on the inflation adjusted earnings of S&P 500 companies over the past ten years, seen as being far more robust than relying on a much smaller period of one year. Known as the cyclically adjusted price/earnings multiple of Cape, it currently pegs the multiple at 24 times, well above its historical mean of 16.5 times.
Much of the case for buying stocks now will therefore depend on companies generating stronger revenues to cope with more normal interest rates. Even then, equities bulls say the bigger long-term worry for stocks is the timing of the first rate increase by the Fed.
“We would plan to head for the exit once the first federal funds rate increase is on the horizon,” says Mr Grigoli, who notes the P/E multiple fell in 11 of 14 prior tightening episodes. “Given today’s anaemic profit outlook, the stock market is in no position to withstand a tightening cycle.”
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