Why events Stateside could determine the upside in clients’ portfolios

By the end of Friday 15 April, 15 members of America’s elite S&P 500 index will have reported first quarter numbers. Within the next fortnight, 300 more will divulge how well (or badly) they did between January and March and also potentially how they see the rest of the year panning out.

Throw in the latest US Federal Reserve meeting on 26-27 April and events in the USA, the world’s largest economy and home to its deepest and most liquid stock and bond markets, could go a long way to setting the tone for the rest of the year, when it comes to how clients’ portfolios could perform.

The early signs are mixed. Metals and aluminium giant Alcoa reported a 75% drop in first-quarter profits and lowered growth full-year forecasts for key end markets, but still managed to beat the analysts’ estimate for Q1 earnings. Megabank JP Morgan also recorded a year-on-year drop in Q1 earnings per share (EPS) but joined Alcoa in beating the consensus.

Meanwhile the economic picture looks cloudy. Wednesday’s retail sales figures were very disappointing and the weakness in autos a particular concern, as car sales have been a huge driver of consumer and industrial growth over the past five years.

Despite such worries, the International Monetary Fund still expects 2.4% GDP growth from the US in 2016, a figure ahead of every developed Western nation bar Spain.

US economy is expected to outpace nearly all developed peers in 2016

Source: International Monetary Fund

The fact that the IMF was expecting 2.8% in October and 2.6% in January appears to have been forgotten by global equity investors, who are apparently preferring to latch on to America’s relative strength rather than absolute forecast downgrades. Key US equity indices continue to outperform, as measured in sterling terms, as the table below suggests:

US economy is expected to outpace nearly all developed peers in 2016

Source: Thomson Reuters Datastream

Should advisers and clients prefer to take the glass-half-full view, the good news is there is a wide selection of active and passive funds available, as a means of embracing the economic and corporate muscle of Uncle Sam:

Best performing US Large-Cap Blend Equity OEICs over the past five years

Source: Morningstar, for US Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.

Best performing North American investment trusts over the past five years

Source: Morningstar and the AIC, for North America and North American Smaller Companies Categories. * Includes performance fee

Best performing US Large-Cap Blend Equity ETFs over the past five years

Source: Morningstar, for US Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.

Low base

As first out of the blocks each quarter Alcoa is closely watched when it releases its earnings. Unfortunately, the Pittsburgh-based corporation got the reporting season off to a soggy start.

The aluminium and engineering expert – which is soon to break itself up into two parts – last night unveiled a 15% year-on-year drop in first-quarter sales and a 75% plunge in “underlying” earnings per share to $0.07 from $0.028.

Alcoa’s shares fell 4% after the US close, though given the cautious nature of the outlook statement it could have been worse.

The good news therefore for clients and advisers with exposure to US stocks is that expectations are fairly low for Q1, as Alcoa demonstrates. The analysts’ consensus was for EPS of $0.02 and the company delivered $0.07.

Earnings for the S&P 500 index overall are expected to show fairly flat operating profits for the January-March period after five consecutive drops, according to research from Standard & Poor’s.

Consensus is for a weak start to 2016 for US corporate earnings but with a big second half-pick up …

Source: Standard & Poor’s Research

Greater expectations

The bad news is that the consensus still calls for a huge acceleration in US corporate profit growth. In 2015, operating EPS fell by 11% but analysts are looking for increases of 17% in 2016 and 15% in 2017.

… a view which underpins the consensus view of double-digit earnings increases for 2016 and 2017 …

Source: Standard & Poor’s research

The 2016 forecast may not seem aggressive but it does rely upon a huge pick-up in corporate earnings momentum. After flat operating EPS in Q1, research from Standard & Poor’s shows the consensus is looking for EPS increases of 11%, 22% and then 39% for Q2, Q3 and Q4 respectively.

This may explain why Alcoa slumped after the close, as CEO Klaus Kleinfeld downgraded his growth forecasts for several key end markets for the company, including aerospace and trucks.

If other firms follow Alcoa’s example and start to talk down the rest of 2016, earnings disappointments could hold back the S&P 500 index as it seeks to continue the double-digit percentage rally seen since February’s low. Analysis of consensus operating EPS forecasts from 12 and six months ago shows substantial estimate cuts. Q4 2015 came in 27% below the forecasts of a year ago and Q4 2016 estimates have fallen by 10%.

… although analysts have consistently cut their numbers over the past year

Source: Standard & Poor’s research

While stocks for the moment seem relatively unconcerned by the manner in which analysts’ profit forecasts have sprung a leak, there is evidence available from the real world that American corporate earnings are coming under greater pressure.

The chart below comes from the St. Louis Federal Reserve’s database and it shows US corporate profits as a percentage of GDP. To the best of this column’s knowledge, and using the timelines as a guide, this indicator only tends to turn down just ahead of, or during recessions, which is a sobering thought:

US corporate profits could be topping out, as a percentage of GDP

Source: St. Louis Federal Reserve

This would be of less concern if two well-tested metrics were both suggesting that current US stock valuations are cheap. Alas, they both imply the opposite, namely that stocks are potentially expensive, particularly if currently very high levels of profitability prove difficult to maintain and earnings begin to revert to the mean (as they have had a habit of doing over the last fifty years or so).

First, Professor Robert Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio still suggests US stocks are very expensive relative to their history, as they trade on 26 times, compared to a post-1881 average of nearer 17. Note that the current multiple was exceeded only in 1929, 2000 and 2007, none of which live in the memory for the right reasons.

CAPE analysis suggests US stocks are pricey relative to their history

Source: Professor Robert Shiller: www.econ.yale.edu

Second, Warren Buffett’s preferred measure, market cap to GDP, also leaves the US market trading at or near record high multiples. Using the market cap of the broad Wilshire 5000 index, the aggregate stock market value of public American firms looks to represent around 120% to 130% of GDP, depending on whether you use the Q4 2015 or forecast Q1 2016 GDP figure:

US stocks also trade expensively against history using market cap-to-GDP ratios

Source: Thomson Reuters Datastream

It is possible to justify the CAPE and market-cap-to-GDP multiples, if you believe profits will stay at what may prove to be abnormally high levels. But the downside risks are clear if earnings start to slide and forecasts are not met.

Russ Mould
AJ Bell Investment Director

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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