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A trader is reflected in a screen on the floor of the New York Stock Exchange at the opening bell in New York, January 2, 2014. (CARLO ALLEGRI/REUTERS)
A trader is reflected in a screen on the floor of the New York Stock Exchange at the opening bell in New York, January 2, 2014. (CARLO ALLEGRI/REUTERS)

Stocks

Declining earnings forecasts challenge market optimism Add to ...

U.S. companies are set to start reporting their quarterly earnings next week and investors should be bracing themselves.

Forecasts are falling, creating a potential obstacle to further stock market gains after the benchmark S&P 500 index recorded its best annual performance in 16 years.

According to S&P Capital IQ, 100 companies within the index have provided some guidance on what their earnings are likely to be, and the vast majority of them – 80 – have lowered their forecasts.

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That produces a so-called negative-to-positive ratio that is above average over the past 15 years and suggests that the various economic improvements celebrated by investors over the past year are not translating into robust profit growth.

Indeed, strip out financial companies and earnings are expected to rise just 3.7 per cent in the fourth quarter, according to Bloomberg News – a marked contrast to the 30 per cent gain in the S&P 500 in 2013.

The fading optimism over earnings comes as Alcoa Inc. gets ready to report its fourth-quarter results on Jan. 9, followed by American Express Co., JPMorgan Chase & Co. and Wells Fargo & Co.

The mood among analysts is also growing darker: They now see earnings growing 5.7 per cent in the fourth quarter, or about half the pace of growth they were estimating in July.

While that’s not exactly gloomy, it offers a sobering comparison when put next to the record-high level for the S&P 500 at the end of 2013. The benchmark index delivered its biggest annual gain since 1997, enticing more investors to join the bull market with bigger investments in stocks and equity mutual funds.

The market gains reflected improved U.S. employment numbers, economic expansion, fading risks of a prolonged recession in the euro zone and encouraging signs from Japan as it struggles to emerge from decades of economic stagnation.

The U.S. Federal Reserve’s decision in December to start winding down its bond-buying stimulus program, known as quantitative easing or QE, did not derail the widespread enthusiasm for stocks but was greeted as another indication of an improving economy.

However, with earnings rising at a moderate pace and companies reducing forecasts, the stock market’s gains have been feeding into concerns about valuations. The S&P 500 now trades at 17.3 times trailing earnings, up from 14.5 times earnings at the start of 2013.

Few, if any, observers believe stocks are now cheap. For markets to turn in another year of impressive gains, the earnings multiple will have to rise well above its historical average or earnings growth will have to accelerate.

The odds are slim in either case. Wall Street strategists predict the S&P 500 will end 2014 at 1,950, on average, for an annual gain of just 5.5 per cent, according to Bloomberg News.

Bloomberg also calculated that analysts expect the average stock to rise just 4.8 per cent this year, which is the least optimistic forecast among analysts since the end of 2004.

That said, the S&P 500 was then in the midst of a multiyear bull market that propelled the index up another 30 per cent by 2007, suggesting that a lack of optimism has an upside: It lowers expectations.

Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America, noted that the average equity allocation recommended by Wall Street strategists is 53 per cent, or well below the historical equity weighting of 60 to 65 per cent.

“Historically, when our indicator has been this low or lower, total returns over the subsequent 12 months have been positive more than 95 per cent of the time, with median 12-month returns of 27 per cent,” she said in a note.

However, Ms. Subramanian has tempered her enthusiasm with a year-end target of 2,000 for the S&P 500, implying a gain of about 8 per cent from the end of 2013.

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