U.S. Equities Remain Solid Investment Options

U.S. Equities Remain Solid Investment Options
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OCEAN CITY — Recently analysts have been dialing back earnings expectations for U.S. companies, driven chiefly by declines in oil prices and a relentless rise in the value of the U.S. dollar. Despite this, we still see reasons to invest in U.S. equities.

We advise investors to be more selective within equities and to focus on higher quality, larger-cap stocks that may be insulated from a pickup in volatility.

A majority of the S&P 500 companies have reported fourth quarter earnings and the results have been mixed, with some posting outsized gains in profits and sales, and others disappointing even the most pessimistic projections. Although roughly 55% have beaten expectations, overall estimates for the fourth quarter had been revised downward by roughly 6% over the last three months to account for expected currency headwinds and lower oil prices.

Given the decline in earnings expectations, volatility has picked up significantly and equities have experienced several selloffs since September. Negative guidance from some companies’ quarterly announcements has led BofAML Global Research strategists to cut their estimate of 2015 S&P 500 earnings from $124 to $119.50, only slightly higher than where they stood at the end of 2014. However, stronger profit growth is expected to resume in 2016 given improving economic growth, and they maintain their S&P 500 price target of 2,200 for the end of 2015. It may take time for market participants to look past the rough few quarters ahead, and volatility may remain elevated for some time.

One of the main reasons earnings for the S&P 500 have been dragged down is cuts in the Energy sector, where analysts see profits falling by roughly 45% this year. Some companies in related industries such as Materials and Industrials have suffered as a direct result. Oil prices could remain low over the course of the year, further hurting the aggregate earnings for the S&P 500, but are a big positive for many companies and for the U.S. consumer.

Lower energy prices are beneficial for the overall economy, and a boon to several industries. In particular, rail companies, airlines and other transportation companies benefit from lower fuel prices, while autos and certain retailers should get a boost from consumers’ propensity to spend their savings from cheaper gasoline.

A rising dollar hurts corporate profits as companies convert sales in foreign countries back to the dollar for accounting purposes. Roughly a third of revenues of large cap companies in the U.S. are generated internationally, so this is no small issue.

The rise of the greenback boosts the broader economy in ways that may outweigh the translation effect and the impact on competitiveness. The dollar’s strength reflects expectations for better economic growth and stability than in most other developed countries.

A rise in the dollar has been associated with increasing equity valuation multiples. This may be a response to rising confidence in U.S. assets, either as safe havens or sources of comparatively strong returns. Valuations for U.S. equities remain high relative to the rest of the world, but we believe this premium is justified — the balance sheets of American mega-cap corporations outshine those of most of their international competitors.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)