Federal Reserve Supports Marietta's Positive Outlook for U.S. Economy and Stock Market

On March 21, the Federal Reserve Open Market Committee reiterated its positive year-end forecast for U.S. economic growth in 2014 and 2015. In a subsequent press conference, Fed Chair Janet Yellen stated that weak U.S. economic data in January and February was due primarily to bad weather and would pick up in coming months. She emphasized that "the Committee's views are largely unchanged" since December and confirmed the Fed's prior prediction of 2.8-3.0% GDP growth and 1.5-1.6% inflation in 2014. With this promising outlook, the Fed expects to continue its tapering policy to completion in September. It will proceed to raise its base short-term interest rate after a pause if inflation and employment data continue favorably.

Marietta's January 3 Outlook emphasized the importance of economic acceleration and corporate profit growth in extending the 5-year bull market through 2014. The 29.6% surge in the S&P 500 index in 2013 was driven in part by a 10.8% increase in S&P 500 corporate earnings but even more by an increase in the market's P/E valuation. This "multiple expansion" has resulted in a rise in the Index's current P/E ratio on trailing 12-month earnings to 16.5, which is above the last 10-year average of 14.7 We consider the market to be fully valued rather than overvalued, but we think a further advance should be fueled by earnings growth rather than multiple expansion. Hence, our bullish view relies on our favorable 2014 forecast of 3.0% GDP growth and a rise of 7-9% in corporate earnings.

We are encouraged by the 4th quarter corporate earnings reports released during the 1st quarter. According to Howard Silverblatt at Standard & Poor's, 64% of S&P 500 companies reported earnings above Wall Street estimates and an additional 11% met expectations. He also indicates that company research analysts are currently estimating an increase of 12.1% in aggregate operating profits for all of 2014. Assuming the S&P 500's P/E valuation remains constant through 2014, this increase in profits would reward investors with another year of double-digit returns. We think this scenario is reasonable because the market's valuation multiple is unlikely to contract as long as the expected return on money-market funds and bond alternatives remain unattractive.

A concern for some investors is that the Fed's statement is actually negative for the stock market because it hastens the date of an increase in historically low 0-0.25% short-term interest rates. We are not persuaded. The Fed has clearly indicated that it will not raise rates until it is convinced that economic growth has achieved healthy, sustainable growth, which in turn will increase investor confidence in further profit growth. Our view is that investors will not become excessively alarmed as long as inflation and interest rates remain below long-term norms of 2% and 4% respectively.

U.S. Stock Market Rally Supported by Economic Data and Corporate Profits

The 11.7% rally of the S&P 500 Index in the 4^th quarter through November 11 is part of a global stock market advance that includes Europe and the emerging economies. Most market observers attribute the gains primarily to developments in Europe, where policy makers have made progress in containing the sovereign debt crisis. Not to be overlooked, however, is the contribution made by encouraging economic data and strong corporate profits in the U.S. and by signs of ebbing inflation in some of the leading emerging countries, especially China.  

U.S. economic reports in October and thus far in November have been surprisingly good, especially in relation to the rising fears in September of an imminent and severe double-dip recession. Last week’s news, for example, reveals that small business optimism ticked up, consumer confidence indices rose, weekly initial unemployment claims continued to fall, mortgage applications rose, the trade gap narrowed, consumer credit expanded, and import prices declined. Despite a faltering Euro-Area economy, the U.S. economy continues to grow, although at an anemic pace.

U.S. corporate profits have also defied pessimists’ forecasts. Over 90% of companies in the S&P 500 have reported earnings so far this quarter, and over 70% have exceeded Wall Street estimates. International Strategy and Investment (ISI), a widely respected research firm for institutional investors, reports that S&P 500 earnings are running 5.8% above projections, and they are expected to be up about 18.3% year over year when the remaining companies report.   

We pointed out in our October 4 Outlook that global stock markets were “very oversold.” At the time, the markets reflected a recession-level collapse in economic growth and corporate profits despite a significantly more positive consensus forecast of economists. We view the market’s recent rally as only a partial adjustment to this oversold condition. During the last year, when S&P 500 profits soared about 18%, the S&P 500 Index rose only 4%. As a result, the P/E ratio of the S&P 500 Index based on consensus 2011 earnings estimates is now 13.1x, which is still below the past recession average of 13.7x. The consensus estimate of a further 7% profit advance in 2012 would further improve the market’s valuation.

Our conclusion is that if the U.S economy continues to avoid recession, as most economists expect, then the U.S market is still oversold.           

U.S. Corporate Profits and Stock Prices

Our forecast for the U.S. economy, corporate profits, and stock prices in 2011 supports a positive if cautious outlook:

• The U.S. stock market’s rally since 3/9/09 rests on a solid foundation of rising corporate earnings.

• The market is not currently overvalued, and there is room for a further advance if the 2011 profit expectations of market strategists and research analysts are valid.

•  We caution that these 2011 earnings estimates underlying a further U.S. bull market advance rest on shaky economic ground. If the economic outlook deteriorates further, companies with excessive exposure to the U.S. and other developed countries may report earnings disappointments and suffer stock price declines. We recommend investors take a global perspective and emphasize markets in fast growing economies and the stocks of multinational companies in the developed countries that have strong business opportunities in these fast growing economies.

Despite an anemic, subpar economic recovery, the Standard & Poor’s 500 Index has soared 74.9% since hitting bottom on March 9, 2009. The headwinds have been and remain formidable: weak consumer spending and confidence, sky-high unemployment and underemployment, a soggy housing market flooded by foreclosures, a troubled financial system that continues to restrain credit, and a nagging fear in business circles that Washington not only can’t remedy the problems but may make matters worse. On the other hand, the roster of positives boosting the market has evidently more than offset these negatives. These include strong corporate profits, low inflation and interest rates, a very accommodative Federal Reserve policy, an attractive market valuation coming off recession lows, and the relative lack of appeal of money market funds, bonds, and real estate.

In our view, the most important ingredient in the bull market recipe has been surprisingly robust corporate earnings. According to First Call, the trailing 4-quarter earnings per share (EPS) for S&P 500 companies rose from $62.85 as of March 31, 2009 to $79.05 on September 30, 2010, which is an increase of 26%. This includes an estimated 13% gain in year-over-year profits for this year’s 3rd quarter. Bloomberg reported on October 4 that more than 70% of S&P 500 companies have exceeded the average analyst profit projection for 4 consecutive quarters, which marks the longest streak since Bloomberg began tracking corporate earnings in 1993. We are convinced that positive earnings surprises and upward revision of future earnings estimates are the most powerful catalysts in lifting stock prices. The jump in earnings also keeps the market’s valuation attractive despite the huge run up in stock prices: the P/E ratio of the S&P 500 Index based on trailing 4-quarter earnings was 15.0% on September 30, which is close to the long term norm.

The key question now is whether 2011 profits will be strong enough to sustain the bull market. Clouding our optimism is that many economists are now predicting GDP growth next year to slow from its current sluggish rate. In The Economist’s latest polling of economists (10/23/2010), the consensus trimmed its 2010 U.S. forecast to 2.6% and predicted a further slide to 2.4% in 2011. We pointed out in our October 21 blog that in early October the International Monetary Fund (IMF) issued a similar 2011 GDP slowdown to 2.2% for developed countries as a group (the U.S. Europe, Japan, Australia, et.al.). As the IMF sees it, the economic recovery over the past 15 months has been driven by fiscal stimulus and inventory accumulation, and both are coming to an end. In the future, growth will have to come from consumption and investment, which in the developed countries are weak and not expected to improve much. A possible income tax increase in the U.S. and budget austerity programs in Europe would exacerbate the already meager 2011 prospects for growth.

There are two ways to measure 2011 S&P 500 profit expectations. A top-down forecast of market strategists, based on fundamental economic and financial market assumptions, is rosy: experts canvassed by First Call foresee a 14% advance, whereas the participants in Bloomberg’s poll anticipate a 9% rise. Even more optimistic is the bottom-up aggregate outlook provided by research analysts estimating company profits: 8,500 analysts tracked by Bloomberg expect a 15% increase. It is noteworthy that these 3 EPS estimates, which range from $87.34 to $95.95, are all above the pre-recession level of $86.20 reached in 2007. Also noteworthy is Bloomberg’s assessment that the S&P 500 is currently valued at 12 times projected income for 2011, which is “the cheapest level since 1988 (excluding October 2008 to March 2009 after New York-based Lehman’s bankruptcy), relative to reported profit from the past 12 months.”

Corporate Earnings Season

The corporate earnings season is fully underway and we are tracking closely the results on a company-by-company basis. We have combed through the S&P 500 Index and the S&P 400 MidCap Index and have selected 134 stocks that meet our criteria for inclusion in client portfolios. We have similarly screened over 440 international stocks that trade with American Depositary Receipts (ADR’s) and have market capitalization of at least $1 billion, and have identified 116 stocks that merit close attention. In coming days and weeks we will review carefully the revenues and earnings progress of the 250 companies in our “universe,” together with the CEOs' comments on business conditions and future expectations. We will also monitor the response of research analysts and the reaction of the markets. Our review will have a direct and immediate bearing on our purchase and sale of stocks in client portfolios.

Most U.S. corporate 4Q2009 revenues and earnings’ comparisons with a year before will show considerable gains in part because the economy continued its recovery from recession in the 4Q2009 and in part because the 4th quarter of 2008 was the trough in corporate earnings during the recession. For the S&P 500 companies, aggregate earnings per share are expected to climb from $12.42 in the 4Q2008 to $17.57 in the 4Q2009, according to mean estimates of Wall Street research analysts measured by First Call. Although expectations are high, corporate CEOs are experienced and adept at guiding these estimates of research analysts, and typically 65-70% of S&P 500 companies “beat the street.”