As earnings season unfolds, we’re seeing how the big banks fared in the final quarter of 2013. As their earnings reports have demonstrated, the year was a good one for most of the giant financial institutions.
True, the mortgage businesses hit some tough headwinds, but cost cutting and being able to free up capital previously set aside to provide against loan losses has helped Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC) post more solid numbers.
Related: JPMorgan Profits Falls, but Still Tops Expectations
Still, the stock market looks forward, not back. And the question on everyone’s mind right now is how well banks – and the nine other sectors of the S&P 500 – will do when it comes to generating earnings growth in the new year.
After the eye-popping market gains recorded in 2013, there’s a lot of chatter about whether or not we’re in bubble territory. The pundits at Goldman Sachs have put forward several reasons why that isn’t the case, but even within that single firm, there seem to be varying degrees of enthusiasm for stocks. Goldman’s portfolio strategy research folks noted late last week that “S&P 500 valuation is lofty by almost any measure” and that it’s going to be tough for stock prices to rise still further this year based only on higher price/earnings ratios.
Digging down into the nitty gritty… Right now, the S&P 500 trades at about 15.9 times earnings, and the median stock changes hands at a price that is the equivalent of paying $16.80 for every $1 of corporate earnings. Only during the tech stock bubble of the late 1990s (and for a few months in 2003-2004) has the S&P 500 price/earnings multiple ever exceeded 17. The Goldman Sachs team notes, wryly, that this is one of those factoids that “most investors are surprised to learn.”
In other words, anyone betting that stock prices will romp higher at a significantly higher pace than the growth rate of corporate earnings may want to pause and rethink their assumptions. And the guidance delivered on this quarter’s earnings calls will be crucial in helping sustain any advances.
According to Thomson Reuters estimates, fourth-quarter profits for the S&P 500 will end up being about 7.3 percent higher than they were in the final three months of 2012. That’s respectable – indeed, it’s a very solid number compared to recent quarters (third quarter growth came in below 6 percent, for instance.) But it doesn’t begin to compare to the growth in the S&P 500 index, which soared nearly 30 percent higher over the course of 2013.
In other words, investors were happy to price in future rates of earnings growth, to the point at which the index was so far ahead of those earnings that even the bullish folks over at Goldman Sachs believe multiples are close to maxing out.
The phenomenon of multiple expansion is over, but is earnings growth about to ignite and take the market higher still? That’s a big unknown, and if you’re looking to market strategists and “bottom-up” industry analysts for help figuring it all out, you may still find yourself puzzled.
Not that those pundits have a tremendously impressive track record, mind you. FactSet, for instance, noted that strategists were calling for the S&P 500 to rise only 1.8 percent last year to end at 1452.50. (Its actual close? 1848.36.) This year, strategists are once again bearish, to the point where they actually are predicting that the S&P 500 as a whole could end up closing lower by December 31, 2014.
It all boils down to what happens to earnings. And industry analysts happen to be pretty upbeat on that front, FactSet reports, predicting that S&P 500 corporate profits will surge to $119.81 a share in 2014, a record.
Then again, Factset notes that historically, analysts have tended to be too bullish when it comes to trying to predict what the companies they monitor will generate in the form of profits. And the overestimates are in the neighborhood of 9 percent, on average. That’s a significant gap and one that could make a big difference in this kind of “fully valued” market.
Add to that the inherent difficulty of forecasting a company’s earnings. Civil wars, earthquakes, terrorist attacks, hedge fund meltdowns, political upheavals at home or abroad: all have shown an uncanny ability to deliver “earnings shocks,” derailing the best of models.
Bullish analysts this year are anticipating that all ten S&P 500 sectors will report higher earnings and revenues this year. And even though the forecasts for the energy group are the lowest of all sectors, FactSet reports that it also has the highest percentage of “buy” ratings from analysts.
Hard on the heels of such a big rally and in light of the premium market valuations, if you’re nervous about what comes next, well, that just shows that you’re sensible. Especially since, as strategist Barry Knapp of Barclays noted, “attitudes toward stocks are very bullish, perhaps overly so.” While sentiment and momentum help explain that, the relationship of those factors to stock market profits that you can take to the bank is “ephemeral,” he cautions.
With so much riding on corporate earnings announcements this year, there is going to be even less tolerance than usual if a company reports results that fall short of expectations. That in turn can add to the kind of volatility that we’ve already experienced in the first two weeks of the year.
Still, despite the cautious notes on valuation being sounded by Goldman Sachs pundits in their weekly note, a recent 2014 outlook, “Within Sight of the Summit” by Sharmin Mossavar-Rahmani and Brett Nelson of Goldman’s Investment Strategy Group notes that they don’t yet see any signs of “the typical triggers that have ended past bull markets in the U.S.” It isn’t just sentiment (or momentum) that is responsible for the rally, they write. Inflows into stocks haven’t been “excessive” and while stocks are pricey, that alone isn’t enough of a reason to recommend underweighting U.S. stocks.
If anything, the odds are that you’re already under-invested in stocks and over-invested in bonds, where the headwinds you face already are far stronger and are only likely to intensify this year. While corporate earnings may grow at a fast enough clip to make stocks more attractive, it’s virtually certain that rising interest rates will make most bonds less appealing.
The key, as always, is to not dump all your eggs in a single basket. Odds are that if you’re diversified, you’re better positioned to ride out any future storm, especially if those bearish strategists are correct in their forecasts.
“Diversification doesn’t guarantee positive returns in any and all markets,” says Jeffrey DeMaso, director of research at Adviser Investments in New York. “It also isn’t about trying to pick the best performing asset – that’s about market timing.” Rather, it’s about owning stuff that zigs while other areas zag.
Keep calm, and carry on.
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