This bull market has room to run

As investors ponder where the S&P 500 will go in 2014, it helps to remember the two forces that drive stock prices. The first is what a company's earnings are expected to be; the second is how much investors are willing to pay for a slice of those earnings.

So far in 2013, both factors have worked in tandem to propel the U.S. equity benchmark to a 27 per cent gain. But those hoping for similarly spectacular returns in the year ahead are likely to be disappointed. The problem, oddly enough, is that there's currently more good news than bad.

Go back a year and the market faced many clear and present dangers, ranging from the European financial crisis to concerns over profit growth in the United States. As those risks faded away, investors jumped back into stocks, increasing the price they were willing to pay for corporate earnings.

Now, with 2013 drawing to a finish, there's growing reason for economic optimism, including the news on Friday that the U.S. economy grew at its fastest pace since 2011 in the third quarter. But as fear dwindles and moods brighten, there is correspondingly less potential for improvement in investors' outlooks to provide the fuel for additional stock gains.

Those hoping for big returns from U.S. stocks in 2014 will have to count on increases in corporate profits to drive the market. After years of worrying about huge macroeconomic themes, investors should keep their eyes trained on the nitty-gritty details of earnings announcements.

"The constant theme of the last few years is that people have been worrying about where the next crisis is going to come from and the enormous amount of political noise," says Vincent Delisle, an investment strategist at ScotiaBank. "They forgot to pay attention to what drives equity markets, and that's corporate profits."

To the surprise of many observers, profits have set records during this recovery even though revenue growth has been sluggish. Companies have benefited from rock-bottom interest costs and little to no growth in employee compensation – two trends that show no signs of reversing any time soon.

"I remember in 2010, people couldn't believe corporate profit margins would stay so lofty, and they believed they were about to fall and take the stock market down with it," says Paul Edelstein, director of financial economics at business-information firm IHS. "Three years later, [profit margins have] been maintained. They may have topped out, but there aren't really any signs they're going to fall. They could when the labour market heats up, but that could be another two years from now."

An improving U.S. economy could provide another boost to the market, by improving those lagging corporate revenues, the raw material for profits. Christine Short, the associate director of S&P Global Markets Intelligence, says the third quarter of 2013 appears to have been "an inflection point" for revenues, as the companies in the S&P 500 reported 4 per cent year-over-year growth after several quarters of weak or even negative numbers.

More than 50 per cent of S&P 500 companies beat analysts' expectations for sales, she says. "We're starting to see revenues that line up better with earnings … I have no doubt that as we go through 2014, we'll continue to see this trend of quarterly earnings-per-share records that will result in a calendar-year record."

That doesn't mean S&P 500 will stage a repeat of its glorious performance in 2013, however. Why? Because while earnings may set records, the price that investors will pay for those earnings may come under pressure.

On the first trading day of 2013, analysts expected the companies in the S&P 500 to produce a total of $105.08 in earnings per share over the next 12 months. The market placed a multiple of just under 14 on those earnings, yielding an S&P 500 mark of 1,462.

As the year progressed, and companies continued reporting solid earnings growth, analysts steadily increased their forward estimates. By mid-December, the forward estimate stood at $115.86, an increase of more than 10 per cent.

But the increase in earnings accounted for slightly less than half the market's 25 per cent gain. The greater portion of the advance was the result of investors' willingness to pay more for the earnings, as evidenced by a price-to-earnings ratio for the index that swelled to 15.4.

The question now is whether additional expansion in the P/E ratio is possible. "Getting P/E expansion is not something that lasts forever, and getting both P/E expansion and positive earnings revisions is rarely a combination that sticks," Mr. Delisle notes.

He cautions that rising interest rates – widely expected for 2014 – could bring down P/E ratios as bond yields begin to offer increasing competition for investors' attention.

Rate increases from the U.S. Federal Reserve or the Bank of Canada don't "seem like a first-half of 2014 event. But my sense is that 2014 will be a good year for profits, not as good a year in terms of P/E expansion," he says.

Mr. Edelstein of IHS says the improving economy could offset the negative effects of rising rates, meaning multiples could stick at current levels. "That means the stock market's 2014 gains will be incumbent on earnings growth – and we won't get the 20-odd per cent gains we saw this year."

But, he says, "There's still plenty of room for earnings growth, and that would drive the market."

Mr. Delisle has a target price of 1,950 for the S&P 500 for 2014, which implies a total return of 10 per cent, including dividends. Scotiabank also forecasts the Canadian dollar dropping below 90 cents; that currency benefit would push the S&P return for Canadians to 15 per cent to 16 per cent, he says.

"The key question is 'Are earnings getting better or worse?' And in our opinion, the earnings picture both in the U.S. and globally is getting better," he says.

Not everyone agrees. Ben Inker of the asset-management firm GMO LLC scoffs at the notion that earnings forecasts should be relied upon as a guide to market valuation.

"I personally hate looking at the P/E of the market on forecast earnings, because forecast earnings aren't particularly accurate, they're biased upwards, we don't have that long a history of them, and the bias hasn't been stable," he says.

His firm believes fair value for the S&P 500 is 1,100, about 40 per cent below its current level. GMO projects that the S&P 500 will lose an average of 1.3 per cent annually over the next seven years, after inflation.

Why? It goes back to those record profit margins.

"We think profit margins are very good and likely to come down, and our guess is that over the next seven years, profits will be lower in real terms than they are today. Margins will be lower, and given that sales … grow pretty slowly, it won't be enough to counteract the falling margins."

It's a danger that bullish investors should keep in mind. Mr. Inker, however, acknowledges that he cannot forecast what the market will do in any given year. Until there's clear evidence that corporate profit margins are deteriorating, U.S. stocks seem poised for more healthy gains in 2014.