Sent: 12-09-2013 10:08:03
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Sales Growth not Strong Enough to Support Rising US Markets
US company revenue improvements will be vital if US equity markets are to sustain an upward price trajectory. Without stronger revenue growth, currently forecast earnings objectives will be unachievable and companies will have to work hard to manage expectations.
With 99% of the S&P 500 companies having reported earnings and financial results for the June quarter, nearly three quarters have met or beaten the earnings forecasts immediately prior to the results.
Earnings outcomes have also met or beaten estimates by almost identical proportions in the prior four quarters. At face value, the tendency for companies to perform better than expected could be taken as a positive market indicator. This would be a mistake.
The frequently better than expected earnings reflects the skill of those managing earnings expectations rather than actual business outcomes.
A 65/10/25 distribution of beats/meets/misses against pre-announcement estimates of earnings is pretty much the norm. Analysts should not be impressed by what is now par for the course. Significant deviations from this pattern which might hint at the possibility of a change in the direction of the earnings flows would be a more meaningful investment guidepost and one to watch carefully.
The 4% earnings rise over the last 12 months had been wound back considerably as the June quarter came closer. Earlier estimates had put the prospective rise for the 12 months to June as high as 17-18%. Beating the final estimates ended up jumping a pretty low hurdle.
A similar process of expectation adjustments is already at work for the upcoming third quarter. Third quarter estimates have been wound back by more than 10% from those that had prevailed prior to the June 2012 results season.
Right now, S&P 500 earnings are forecast to rise by 14% over the coming year, despite the already reduced estimates. If the same pattern of downward revisions occurs in the year ahead as we have just experienced, the S&P 500 could easily start to look expensive leaving the market to struggle.
Fully meeting the currently expected earnings gain in the coming year would imply a price of 14.4 times earnings over the year to June 2014 compared with 15.7 based on annualised earnings in the June quarter of 2013. What had been a cheap market has become fully priced and risks being expensive without validating earnings gains.
The record high earnings achieved in the second quarter were not accompanied by similarly high sales. Since the June quarter of 2007, the previous peak in earnings before the onset of the 2008 financial crisis, earnings have made a net gain of 9.6%. Sales per share, on the other hand, are essentially flat. While there is considerable margin variation from quarter to quarter, the net earnings gains over the course of the economic recovery have been sourced from lower costs.
Any good businessman will say there is no end to the task of rooting out costs. Nonetheless, relentlessly doing so without a break to reassess progress or to permit adoption of new technologies is tough. Revenue building, even if predominantly cyclical, is an important respite from the drudgery of cost cutting.
At a macro level, business sales grew 4.9% over the year to June. Growth had topped 11-12% during the recovery from the financial crisis but, more recently, seems to have been anchored in the 3-5% range. There is a chart of changes in business sales drawn from data compiled by the US Department of Commerce in my Market Diary for 20 August at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm.
At the recent rate of sales growth, a top down earnings outcome in the vicinity of 7% would be a notable achievement and, in any event, would require some continuing cost cutting benefits. Although such an outcome, if realised, would be better than the performance of companies in the last 12 months it would still be only half the rate of earnings growth currently forecast by company analysts.
In other words, expectations management would again have to play an important role in setting the market tone in the year ahead.
(John Robertson is a director of E.I.M. Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, corporate business strategist and investment market professional for over 30 years after starting his career as a federal treasury economist in Canberra. His daily Market Diary - Brief Thoughts on Current Issues is available at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).
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