Marcuard's Market update by GaveKal Dragonomics
As the second quarter US earnings season winds up, the dominant picture is of stronger sales and faster earnings growth. That’s handy. In the early stages of this five year bull market, it was central bank liquidity that pushed equity prices higher. Then over the last two years, multiple expansion took over. Now, with valuations back in line with fair value, top and bottom line growth are emerging as the market’s main driving force.
With more than 450 of the S&P 500’s companies now having reported, 2Q14 sales are up by 4.3% year-on-year, compared with an average of 2.2% over the preceding four quarters. Meanwhile, earnings have risen 9.9% YoY, compared with a 2Q13–1Q14 average of 5.4%. Profit margins remain elevated at 9.4%, defying the expectations of the market bears. This coincides with our view that profit margins should remain comfortably high. At this stage in the cycle any pressure on profit margins is most likely to be exerted by an acceleration in employee compensation. However, as we have argued before, the impact of rising wages is likely to be smaller than generally expected.
Looking forward, given the favourable household leverage situation and an improved labour market—supported by the second quarter’s strong growth in GDP—we are optimistic about growth prospects for the second half of the year. As a result, we fully expect to see even stronger sales and earnings growth over the coming months.
Barring negative surprises, that means the next phase of the recovery is likely to see a pick-up in capital spending by businesses. It shouldn’t take long to materialise. Usually US business capital spending lags sales growth by just one quarter. Encouragingly, the ISM manufacturing PMI—the principal leading indicator for business capital spending—rose to 57.1 in July, stronger than the expected 56. As rising sales begin to squeeze capacity, it will not take companies long to start shopping for new plant and equipment, or even to consider setting up new factories to meet the rising demand.
The obvious beneficiary of this expected recovery in US capital spending will be the industrial sector. The ISM manufacturing PMI tends to lead business capital spending by around eight months, and year-on-year growth in the S&P 500 industrial sector’s trailing 12-month sales per share by 14 months. This relationship makes sense, as it is industrial companies which produce the nuts and bolts needed for a broader capacity expansion.
A turn-around will not be before time. So far this year, the S&P 500 industrial sector index has underperformed grievously, declining -0.7%; the worst performance of any sector except consumer discretionary stocks. The flip-side of that underperformance is that valuations look reasonably attractive. The sector’s price to 12 month forward earnings ratio and price to book value ratio are both around their historical medians. With industrial companies’ sales and earnings set to improve as capital spending recovers, P/E ratios in the sector look likely to follow their historical pattern, rising relative to the ratio of the overall equity market as business capital spending picks up. In such an environment, the S&P 500 industrial sector index should outperform the broader index.
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