Stocks follow earnings—meaning that the direction of stock prices tends to coincide with the trajectory of corporate earnings growth. That’s an overarching investment philosophy in Fidelity’s equity division. And it has generally played out over time. During the past 23 years, the price of the S&P 500® Index, a common measure of large-cap U.S. stock performance, has been closely correlated to the earnings of the companies in the index.
Since the end of 2008 and the global financial crisis, the S&P 500 Index has rebounded strongly, returning 106% through Sep. 30, 2013, and surpassing prior index level peaks in 1999 and 2007. At this point, the bull market in U.S. equities is now 4.6 years in length, above the 3.5-year average length (median is 2.7 years) of all bull markets since 1928.1
Is it sustainable?
Some market participants have begun to question whether the current pace of strong earnings growth for U.S. companies during the past few years can continue in 2014 and beyond. Some are concerned that cost cutting—a major contributor to earnings growth in recent years—has run its course amid moderating revenue growth. With the Federal Reserve starting to taper its asset purchases, as well as rising interest rates, others point to potentially higher corporate borrowing costs and a subsequent slowdown in share repurchases.
Despite some concerns about the sustainability of U.S. corporate earnings growth in the coming quarters, there are some compelling reasons why U.S. companies could maintain a healthy rate of growth over the near-to-intermediate term. Here are four:
1. Reasonable corporate profitability
In the third quarter of 2013, a key indicator of profitability, earnings relative to shareholders’ equity, (the aggregate corporate return on equity) for S&P 500 companies was 14.1%, slightly above the index’s 13.6% long-term average. From 1990 to 2013, the maximum trailing annual ROE for the S&P 500 Index was 18.8%, while the minimum was 4.1%. Based on this measure, profitability for the U.S. equity market looks reasonable relative to history, and there is potential for further upside.
Looking more closely at individual sectors (see chart, right), returns on equity (ROE) in the health care, telecommunication services, consumer staples, energy, utilities, and financial sectors were below their long-term averages during the quarter. Average profitability for information technology, consumer discretionary, industrials, and materials, were above their long-term averages. This suggests that while profitability in some sectors is above average, there is room for higher earnings and returns to shareholders in others. In addition, the ongoing globalization of businesses and their diversified earnings streams could also contribute to further improvement in ROE.
Some market commentators have noted that wages, capital investment, and interest expense for U.S. public companies remain low relative to previous economic recoveries. They cite these low levels as unsustainable and forecast deterioration of operating (profit) margins as the costs move to normalized levels. While it is reasonable to expect some wage inflation and that capital investment will accelerate if the economic recovery continues, we believe an increase in these costs will only happen if underlying demand accelerates, driving higher revenue growth and sustaining overall earnings.
2. Overseas revenue is an increasing contributor to U.S. earnings.
During the past decade, foreign sales have represented more than 40% of total revenues for S&P 500 companies, and the proportion has grown (see chart, right). The growing global diversification of the revenue stream for U.S. companies could continue to provide a positive influence on earnings going forward, for two reasons. First, sales growth in some emerging market sectors continues to be higher than the growth in developed economies, in part due to the burgeoning middle class populations in countries like China and India. Also, if the economic stabilization in Europe and China2 continues, it would provide higher future profit growth.
3. Prudent capital allocation
U.S. companies have been disciplined with their use of capital in recent years, and a continuation of this trend could support future earnings growth. In particular, merger and acquisition activity has been subdued, and overall capital expenditures as a percentage of sales have remained at a moderate level.
Corporate America is also flush with cash, allowing many S&P 500 companies to increase dividend payout ratios or initiate/increase share buyback programs, which reduce the outstanding number of shares and effectively increase earnings per share. During the second quarter of 2013, the dollar-value of share repurchases for S&P 500 companies amounted to $122.8 billion, the highest amount since the third quarter of 2011. In addition, the number of S&P 500 companies engaging in both a dividend and a share buyback during the past 12 months (353, or 71% of index) reached its highest level since 2005.3 Furthermore, despite increased share buyback activity and dividend payouts, corporate cash balances are at elevated levels, providing managements with a cushion with which to further increase capital returns to shareholders.
4. Reasonable valuation
During the post-2008 period, the 106% upward move in stocks (through Sep. 30, 2013) has coincided with a 111% increase in corporate earnings.4 At the same time, U.S. economic conditions have been stable, if unremarkable—the nation’s nominal GDP growth has been 16% since the end of 2008 (see chart, right). Since the 1999 peak in the stock market, the disparity between subsequent stock prices and earnings is far more dramatic. Since Dec. 31, 1999, the S&P 500 Index has returned only 48%, while S&P 500 earnings and GDP have grown 114% and 70%, respectively. The key difference is that in December 1999 the market traded at an elevated valuation level. In December 1999, the equity market’s price-to-earnings (P/E) ratio using trailing earnings was 28.4, implying unsustainably high earnings growth. Comparatively, at the end of 2008, the S&P 500 Index’s aggregate trailing P/E ratio was only 18.2, below the historical average of 19.5.5
Today, the equity market’s valuation is still quite reasonable and somewhat below its long-term average, despite the market’s significant move during the past four-plus years—implying that investors generally expect a moderate level of earnings growth. Multiple compression, which occurs when earnings grow faster than stock prices, is the primary reason why the equity market’s valuation has remained reasonable since the recession and financial crisis in 2008. As stated earlier, since December 2008 the stock market is up 106% while trailing earnings have increased 111%, indicating modest multiple compression based on historical earnings growth.
While the market’s P/E ratio (or multiple) on the surface indicates valuation, it also reflects investors’ expectations of earnings growth. As of Sep. 30, 2013, the P/E ratio of the S&P 500 Index using trailing earnings was 17.6, compared with 18.2 at the end of 2008 and an average of 19.5 since 1995. Note the multiple on trailing earnings has compressed slightly because earnings growth has increased more than the market. The below-average P/E of the equity market today (17.6 on trailing earnings versus the average of 19.5) suggests that investors are anticipating only modest earnings growth in 2014 and beyond, which may bode well for stocks if companies surprise on the upside. Moreover, the equity market’s below-average P/E ratio also reflects uncertainty regarding the economy and a variety of political issues.
Using a simple dividend discount framework, the expected long-term earnings growth rate priced into equity markets remains at a low level following the financial crisis (see chart, right). This valuation level (and implied rate of growth) also suggests that there is potential for further earnings upside and multiple expansion in stocks.
Forecasts for solid earnings
At the end of October, Wall Street analysts expected a 10.98% earnings growth rate for the S&P 500 from 2013 to 2014.6 The view of Fidelity’s equity research analysts also forecasts solid earnings growth in 2014. Although there are some valid concerns about the ability of corporate America’s largest companies to maintain a strong rate of earnings growth over the coming years, our proprietary bottom-up view, combined with the four factors presented in this article, suggests there is also a reasonable possibility that the pace of earnings growth—and the strong performance of the equity markets—could be sustainable.
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