Wednesday, August 07, 2013

Cross Currents Aplenty, Improving Fundamentals Will Prevail

Earnings Growth: Modest Growth, but Better-Than-Expected
Company earnings and revenue growth for the S&P 500 during the 2nd quarter have both surprised to the upside. Earnings growth, as reported so far, has been about 3% higher than the 2nd Quarter in 2012 – led by Financials up nearly 9%. Revenue growth so far has been just under 1.5% – despite the Energy sector reporting 9% lower sales than a year ago.

Prior to the release of 2nd quarter earnings, the expectations were very low. While these revenue and earnings growth appear to be modest, they were better than expected – which gave the market a lift. Nearly 70% of companies beat expectations.

Companies are Not Cutting Back
There is little evidence that businesses have achieved earnings growth from cost-cutting. According to JPMorgan research, only 9 of the 228 companies that have reported thus far have boosted earnings based on higher sales and lower expenses. Companies have grown earnings by increasing revenue, investing in new technology, research and advertising – not by reducing expenses as many analysts had feared.

Businesses have come out of a treacherous economic environment and would not be spending money if they did not have confidence their investments would pay back in the future. Companies appear confident in future growth, which is a good sign for revenue, earnings, dividends and stock prices over the long-term.

Stock Prices Driven Higher on Rising P/E Multiples
The price-to-earnings (P/E) ratio is a metric used to determine how much investors are willing to pay for one dollar of earnings. After the financial crisis of 2008-09, the P/E ratios for nearly all companies were driven as low as 10 (which means investors we were willing to pay $10 for every $1 dollar of company earnings).

The approximate 150% price appreciation for the S&P 500 since March of 2009 is a result of rising earnings and expanding P/E ratios.  Since the bottom of the market, P/Es have risen from 10 to the current level of 15.5.  Investors are now willing to pay more for earnings, which is indicative of increasing confidence in the U.S. and global economies.

P/Es have moved back to the level they averaged between 2003 and 2007, but from a historical perspective, they have room to move even higher. According to the statistical relationship between inflation and earnings growth over the past 53 years, the best statistical fit based on current earnings and inflation is somewhere between 17 and 18 times earnings.

Even though we believe earnings growth will continue to be modest through the end of the year, stock prices can still rise as P/Es move back to their long-term historical relationship to inflation and earnings. 

Market Paying for Quality Dividends
The sell-off in defensive stocks that many predicted has not happened. Instead, many of these companies have been pushed to fresh highs.

The market is showing its willingness to sacrifice a bit of growth for less risk, more predictability and higher dividends. As time passes and interest rates continue to stay low, these companies will be increasingly attractive to investors looking for income in a world where U.S. Treasuries are yielding less than 3%.

Upcoming Hurdles May Present Buying Opportunity for Stocks
Over the coming months, there are some hurdles facing the stock market. A political stalemate will make the 2014 budget agreement, debt ceiling, and sequestration difficult to resolve. In addition, talk of the Fed’s tapering on Quantitative Easing will continue to affect the market.

We anticipate these events may cause some short-term volatility, which we would view as opportunities to buy new companies or add to existing holdings at more attractive prices.

Neither Republicans nor Democrats want the economy to slip back into recession. The Federal Reserve does not want to see a stock market correction. The market has pushed through events like this in the past, despite a much weaker economic environment. With each passing month, the economy becomes stronger and more resilient. It is stronger than it was 6 months ago, a lot stronger than 2 years ago, and even stronger compared to 4 years ago.

The institutions that caused problems in 2008-09 are under more strict standards than before. Banks are stronger and leaner than ever. Tax revenues are up and deficits are down for local, state and Federal governments. Foreign problems still exist, but appear to be stabilizing. Companies are looking strong and investing in the future. They have consistently raised their dividends over the long-term and pushed them even higher over the past year.

News and current events involving politics, central banks and global markets can bounce around prices without having any real effect on the fundamental value of companies.   
Dividends and earnings drive long-term stock performance - not governments, debt ceilings or squawking on CNBC.

These are the opinions of the Donaldson Capital Management Investment Policy Committee.  Take Aways from the IPC's weekly meetings are also posted here.