US markets have touched eight-month highs on a wave of economic optimism, boosted by strong home sales which have risen for the third consecutive month, and forecast-busting results from a number of US household names such as Intel, Goldman Sachs, 3M and AT&T.
July was particularly strong with the Dow Jones Industrial Average climbing almost 1000 points in two weeks. By late July, the index closed above the 9000-point mark for the first time since January. But while that marked a turning point in confidence, the bull run is unlikely to be maintained.
Cutting costs
The reality is that earnings surprises are coming from cost cutting rather than revenue growth. While chip maker Intel Corp and Wall Street powerhouse Goldman Sachs bucked the trend, most earnings announcements were a déjà vu of the first quarter, when tough cost-cutting boosted bottom lines while sales growth remained elusive.
By mid-July, 75 S&P 500 companies had reported earnings and they exceeded their earnings estimates by an average of 16.1 per cent, but revenue has beaten forecasts by just 4.4 per cent, according to Brown Brothers Harriman, showing that the improvement is largely a result of cost-cutting.
With an unemployment rate of almost 10 per cent and one that is likely to remain high into 2011, sales growth on the back of consumer spending looks unlikely. Moreover, job insecurity is combined with declines in home values and tight credit, and the deleveraging process of the over-indebted US consumer is far from complete.
“Earnings surprises have been a feature of the US market for the last three quarters, but US companies cannot cut costs much more,” warns Seung Minn, lead portfolio manager of the Allianz RCM US Equity fund.
“It’s a complex market situation. US companies have shown amazing flexibility and resilience in dealing with fading demand for products by cutting costs, but companies will now have to gain revenues from the top line,” he explains.
“What worries me is the comparison between current profit margins and the previous worst periods. For example, in 1991 and 2001 profit margins dropped to 4 per cent, but as a country we’re still making 6 per cent, excluding financial and utilities, so there might be even poorer profit margins coming up. If I see a decline to a 4 per cent level or lower, then I might feel that the market has finally bottomed,” adds Mr Minn.
Various surveys have suggested that more than half of US corporate chiefs still plan to cut costs for the next six months, and nearly half anticipate a further decline in sales. Nevertheless, there is a groundswell of opinion that the business world has proved more robust than expected, and might even be on the road to recovery.
Missouri-based Daniel Becker, vice president of Waddell & Reed, who co-runs the Pictet US equity fund, points out for example that cash earnings have not fallen as sharply as the stock market.
“The market is down 60 per cent peak to trough, but free cash is generally not down nearly as much, so corporations are doing much better than the market,” says Mr Becker.
“This makes the snapback somewhat rational, because the market correctly figured out free cashflow is good and the margin structure of these companies is exceptional.”
Return on equity (across the market, ex financials) is 15 per cent, adds Mr Becker. “We’re in the worst recession since the Great Depression but we can still generate 15 per cent with a shrinking sales base – that might be entirely cost base savings but it shows how strongly and aggressively managements have attacked cost structures,” he explains.
“Although valuations are higher than six months ago, the market is still cheap,” he adds. “Historically the free cash flow yield (per share) has averaged 4.5-4.6 per cent but it peaked at 9 per cent, and is now on around 7, so gains may be possible just to get back to the long-term average.”
Investors circling
Investors have been moving back into the sector in anticipation of an inflection. “We’ve seen a recovery in sentiment that had been so negative and in prices that had been so beaten down,” says John Carey, fund manager at Pioneer Investments.
“A surge of people have moved out of fixed interest to reposition themselves in the market. While GDP and corporate earnings have bottomed out, it may be six to nine months before the economy recovers but it is best to get positioned now,” he says.
“We’ve studied market results over long periods, and much if not most of the gains come before the turn in earnings, so if you sit on the sidelines and wait, you will miss out on the rally,” Mr Carey adds.
