Coming off a year of unrestrained celebration, the new year brings a cold sobriety to markets.
Stock euphoria is beginning to wear off in the early days of 2014, a trend set to continue as the next earnings season kicks off this week.
But the turbulence doesn’t necessarily foreshadow a brutal reckoning. As long as the economy continues to improve, 2014, while unlikely to match the endless party of 2013, could be festive in its own right.
Fourth-quarter earnings season gets under way on Thursday, when Alcoa Inc. reports its results. To soften the blow of earnings disappointments, an unusually high number of companies have already warned investors to lower their expectations.
According to FactSet Research Systems, of the 107 companies in the S&P 500 index that had issued Q4 forecasts by year end, 88 per cent of them revised estimates downward, the highest such proportion the firm has reported since it began tracking guidance data in 2006.
A bad quarter for U.S. companies would compound fears that share prices have risen too far, too fast.
The S&P 500 increased by 30 per cent last year alone, the single best year since 1997.
This is a bull market driven not by companies increasing their revenues, but primarily by rising price-to-earnings ratios. As of the fourth quarter, the S&P 500 traded at 17.4 times earnings, which can’t exactly be considered cheap.
Companies have carved out profits wherever possible, raising margins to record highs by cutting costs, improving productivity, and often buying back their shares to boost earnings per share by reducing the outstanding share count.
The expansion of earnings is bound to run out of steam. But there’s an antidote, said James Telfser, portfolio manager at Caldwell Investment Management.
“Revenue growth has been very hard to come by and that’s got to be the next story to come out of this,” Mr. Telfser said.
For that to happen, the economy needs to take over as a key support for corporate America. And on that front, there are modest signs of improvement. Expect U.S. GDP growth of about 3 per cent in 2014, said Peter Buchanan, senior economist at CIBC World Markets. “It’s hard to believe, but that will be the best performance in close to a decade.”
An economic recovery should serve to counteract the negative sentiment coming from both earnings pressure and the beginning of stimulus tapering by the U.S. Federal Reserve.
“There are concerns about a double negative,” said Greg Newman, senior wealth adviser at the Newman Group, a ScotiaMcLeod affiliate. This month, the Fed is scaling back its quantitative easing program, which has proven a potent stimulant for U.S. stocks since the financial crisis struck.
But equities will continue to benefit from Fed bond buying, which will still pump $75-billion (U.S.) a month into the financial system.
“It’s still a huge amount that has to be absorbed,” Mr. Newman said. “And the Fed is not going to let up … until you start to see a true hand off, until you see a sustainable private sector recovery.”
According to estimates compiled by Bloomberg, the S&P 500 will post an increase in 2014 of 5.5 per cent, hardly the rapturous stretch that 2013 proved to be, but still decent. And the outlook should improve if the broader economy picks up more than expected.
It could be a bumpy ride, though.
“The markets had such a strong run that people are looking for some kind of pullback. And when you’re looking for something hard enough, it might actually happen,” Mr. Telfser said.
“We believe it will be a short-term pullback.”