Is it good enough?
That is, were the fourth-quarter US earnings reports good enough to support a price/earnings multiple on the S&P 500 index that is nearly 25% above the long-run average?
At first glance, US earnings were generally solid
Profits for the 406 of the 500 companies that have reported so far were up by 7.7%, and forecasts for the full set of S&P 500 companies come out at +7.2% year-on-year. As revenues advanced by just 4.8%, this means US companies managed to increase their margins yet again despite persistent market worries that margins have peaked.
A closer inspection, however, raises concerns about the sustainability of this profit growth. The bulk of the gains, 42%, came from the information technology sector and the failure of Alphabet’s [GOOG] earnings to match market expectations highlights the risk that IT companies may not be able to continue generating double-digit EPS expansion (see Exhibit 1).
Exhibit 1: Contribution to Q4 2016 S&P 500 EPS growth
I-T = information technology, FIN = financials, HLT = healthcare, C-S = consumer staples, C-D = consumer discretionary, UTY = utilities, RTS = real estate, MAT = materials, EGY = energy, TEL = telecommunication services, IND = industrials.
Source: Thomson Financial, BNP Paribas Investment Partners, as of 16 February 2017
The second key sector was financials
Here, the earnings landscape has indeed improved thanks to rising interest rates improving margins and the rally in US equities since Donald Trump’s election last November which boosted trading revenues. Given the prospect of reduced regulation, US earnings could improve further. The concern is how much of this has already been priced into the market.
Since the US election, the financial sector has gained 27% compared to a 9% advance for the market as a whole. The S&P 500 banks index has powered ahead by 40%. The price-to-book value of the index has risen to 1.3x from a global financial crisis (GFC) low of 0.6x. Whether the current price-to-book metric means banking stocks are expensive or cheap depends on whether the future resembles the pre-GFC or post-GFC world. Before the global financial crisis, the average price-to-book multiple for the index was 2.3x, which compared to the current 1.3x would suggest banking stocks are still attractively valued. But the multiple since the GFC has been just 1.2x, suggesting that stocks have become slightly pricey. Though there is still a significant degree of uncertainty about the prospect of regulatory reform, in our view there is still some value in the sector.
Healthcare sector earnings were resilient in the last quarter of the year, in contrast to the 15% underperformance of the sector index relative the S&P 500 for 2016. The future, however, is clouded. The timing of any repeal of the Affordable Care Act is uncertain, let alone the configuration of what might replace it. Expectations of increased competition and pricing pressures have damped pharmaceutical earnings forecasts, while healthcare providers and services companies should still benefit from an expanding and aging population. Maximising profit from the healthcare sector’s transformation will require identifying the winners and the losers rather than betting on the whole industry.
Outside of the IT and financial sectors, earnings still looked good generally, averaging 5.6% growth over the same quarter of 2015. Weakness was notable for industrial stocks, which saw aggregate profits drop by 0.5% (largely due to airlines), but to some degree these results had been expected and earnings still surpassed analysts’ forecasts. Infrastructure spending this year and next should provide a boost to companies in the capital goods industries.
As important as earnings are, markets trade on expectations of the future. Business surveys since the election have generally been positive (e.g., the recent Philadelphia Fed Business Outlook Survey jumped to its highest level since 1984), but actual guidance from companies has been more muted (see Exhibit 2).
Exhibit 2: Positive corporate guidance (% of total)
While CEOs may feel more optimistic about the future, they are unlikely to begin revising profit forecasts until there is more clarity on any corporate tax reform and deregulation. Guidance so far for the latest quarter is below average, but it is actually in line with the same quarter a year ago. There appears to be a seasonal pattern where CEOs are more circumspect at the beginning of year and this quarter seems to be no different.
Equity analysts have reacted to the US earnings releases so far by revising more of their forecasts for 2017 downward (58%) than upward (42%), which is another reason for investors to be cautious after the recent strong performance in equity markets (see Exhibit 3). On a sector basis, telecomm services, real estate, consumer staples and healthcare have seen the majority of negative revisions, while energy, utilities, financials, and technology had have a majority of upward revisions.
Exhibit 3: Revisions year-to-date in 2017 earnings estimate
Returning to the question, are US earnings good enough? We worry that they are not
Multiples for large-capitalisation equities are high, earnings growth is good, but not spectacular, and there is still significant uncertainly about the shape of economic policy in the US and the spillover to global sentiment from political risk in Europe. Investors may wish to consider safer havens in anticipation of bumpy times ahead.
Written on 17 February 2017