Corporate Earnings Remain Healthy

OCEAN CITY — Investors are looking at another strong year of equity returns, with the S&P 500 up more than 28% at the end of November.
A key feature of this year’s equity market gains has been multiple expansion — the increase in the price/earnings ratio.
However, with the Federal Reserve likely to start tapering in early 2014, we believe the future path of equity prices will be increasingly dependent on corporate earnings rather than on valuation re-rating. To that extent, third-quarter earnings provide cause for optimism.
EPS of S&P 500 companies continued their positive trend in 3Q13, increasing 6.5% year-over-year (YOY) to $27.68 and generally exceeding analysts’ expectations.
This earnings season has offered solid signs of improving fundamentals. Growth in overall earnings and in sales ticked up 5.4% and 3.6% YOY, respectively. Both represent upturns from previous quarters. Encouragingly, these growth trends are being exhibited across a broad range of sectors. Nine out of 10 sectors grew their earnings over the prior year, with financials and consumer discretionary leading the pack. Critically, all 10 sectors posted revenue growth in the third quarter, with consumer discretionary and health care leading the way.
We find these developments encouraging for equities going into 2014. However, there are concerns as to whether earnings can continue to climb, particularly as interest rates do. In that context, we believe it might be helpful to break out the three components of EPS growth — revenue, margins and buybacks.
For the first time since 2010, Bank of America Merrill Lynch (BofAML) Global Research sees a coordinated acceleration in global economic growth for 2014, with nominal U.S. and global growth to be around 4% and 7%, respectively, which should stimulate capital spending. This leads us to believe that the sales growth we saw in the third quarter is sustainable.
A more contentious point for many investors is the direction of profit margins. Much of the growth in earnings following the 2007-2009 global financial crisis has been driven by the dramatic growth in corporate profit margins. The operational leverage gained from massive cost-cutting initiatives has allowed companies to maintain strong earnings even in the face of revenue growth that has often been modest.
A reversion to the mean from current levels would mean a potentially substantial knock to earnings. To what extent is this probable? While an improving labor market and rising rates could potentially pressure margins, we do not believe there will be an imminent collapse in profit margins barring a recession.
Part of this argument is that margins could be undergoing a structural shift. Over the past decade, an increasing share of S&P 500 company profits has come from overseas, where the effective tax rate is lower. We don’t believe companies’ share of foreign profits will drop substantially nor do we expect domestic corporate taxes to rise.
Finally, EPS growth can be supported by buybacks, which reduce the number of shares outstanding. BofAML Equity Strategy estimates such actions boosted EPS growth by 1% in 2013 and will have a similar impact in 2014.
Taken together, BofAML Global Research forecasts EPS to grow 7% in 2014, in line with the long-term growth trend, to $118 a share. The cyclical sectors — energy, technology and industrials — are expected to display the strongest earnings growth in the year ahead.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)