Keep a wary eye on U.S. earnings trends

U.S. stocks have done well, but these three points bear watching.

Michael Leonard 7 January, 2015 | 6:00PM
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For investors in both Canadian and U.S. stocks, particularly those of us whose home currency is the Canadian dollar, it is easy to be complacent about the U.S. equity market these days while spending much time and energy fretting over Canada -- maybe too easy.

After all, U.S markets followed up the bonanza that was 2013 with healthy double-digit gains in 2014 for the S&P 500 and NASDAQ indexes (although the Dow trailed them both by about 6oo basis points for the year).

Meanwhile, cliff-diving world oil prices have little negative effect on the U.S. equity indexes, given that there is so little weight in oil and gas stocks. Many pundits and observers believe that consumers and corporations alike will benefit enough from lower energy prices that the nascent economic recovery will be given a significant boost in coming months.

And with the U.S. dollar rising steadily for about two years now, any unhedged investments in U.S. markets held by Canadian investors are enjoying significant currency gains to boot.

While it remains the case that there are no glaring signals that scream "SELL!" when assessing the current state of U.S. equity markets, there are three points that bear mentioning.

1. Lofty valuations

Valuations remain at the top end of their normal range over the past 25 years. Other than the three-times price-to-book (P/B) multiple investors paid for the median stock at the height of the 1998-1999 tech bubble, there are many instances through this period where the market has topped out at about 2.6 times book.

The median stock has traded in a tight range between 2.4 and 2.55 times book value over the past 16 months, currently sitting at 2.45 times. This says two things: 1) there really is little realistic opportunity for significant multiple expansion from here, and 2) should market sentiment and/or fundamentals turn decidedly negative for any reason, U.S. equities have plenty of room to fall from these heights.

2. Earnings growth is slowing

Assuming analysts' fourth-quarter earnings estimates are realized, year-over-year earnings growth will fall from 10.5% currently to about 7.5%. Make no mistake, 7.5% earnings growth is terrific, especially if it could be generated in perpetuity. While it has become unlikely that analysts will miss quarterly earnings projections en masse, that 7.5% could prove to be overly optimistic if there are negative earnings surprises.

More than that, though, is the trend: 10.5% to 7.5% earnings growth is absolutely fine if this value levels off, but if subsequently another 300 basis points get lopped off each quarter, corporate America collectively will have negative earnings growth on its hands by Labour Day 2015. At current market valuations, investors standing still in that scenario would get trampled under the stampede for the exits.

And a further note about the U.S. dollar: it's not just rising against the Canadian dollar. It has been strengthening significantly against most global currencies, notably the euro. Should this continue, can we count on 5% to 7% earnings growth given that more than 40% of sales by S&P 500 companies are generated abroad?

3. Earnings revisions may cause worry

Since the middle of 2011, the average three-month revision of analysts' earnings projections has oscillated between -2% and -6% for U.S. stocks. This represents a normal state of affairs. Some cuts to earnings projections are fine, so long as they remain moderate.

The current value for three-month revisions is -5% and has been receding very gradually for the past five months. If this value gets no worse than about -6% in the short run before oscillating again toward less negative territory, equilibrium will remain. If, however, estimate revisions break through to the downside and head toward negative double digits, investors will lose confidence quickly, resulting in many more sell orders than buy orders. (This is the exact issue that plagued Canadian equities for much of 2012 and 2013.)

None of these three issues are cause for immediate concern. However, as investors in Canadian stocks are being forcefully reminded these days, it doesn't take long for smoke to become fire. Prudent investors need to be particularly vigilant in monitoring U.S. earnings growth and estimate revisions in the coming months.

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About Author

Michael Leonard

Michael Leonard  Michael Leonard, CFA, is chief equity strategist at Morningstar Canada.

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