US Equity Valuations: Under Pressure in H2?

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Managing US Corporate Profit Expectations
These are certainly heady days for US equities, having recently flirted with new all-time highs. The general profile of US economic data during Q1 was supportive for risky assets: below-trend economic growth did not threaten the time horizon over which the Fed will change its policy rate. Bad weather contributed to below-potential GDP growth during the quarter. There have been indications that inclement conditions affected corporate performance, particularly for companies with an end-February fiscal quarter. Over 30% of the 21 companies who have reported Q1 EPS have cited bad weather as a factor affecting results.
S&P500 operating EPS is now expected to rise +1.1% during Q1 compared to the +6.5% growth envisaged at the start of the quarter. The incidence of negative guidance remains high: 93 out of 111 companies issuing guidance have indicated negative bias for Q1. This has not, however, proved detrimental to equity prices due to the Fed’s continued quantitative easing programme. Most commentators are expecting asset purchases to cease by the onset of Q4. Will the sensitivity of equity prices to changes in earnings expectations increase once quantitative easing has been concluded?
Size of Estimate Cuts Could be Crucial
The standard practice of guiding EPS estimates down as the quarter progresses remains intact. The average “bottom-up” EPS estimate cut during the reporting quarter has been -4.2% and -4.4% over the past 5 and 10 years, respectively. The current revision to Q1 EPS is -4.5%, slightly ahead of historical behaviour. This is not necessarily disastrous, as the experience of the past 14 quarters indicate: EPS estimates were trimmed by an average -3.1%, but the S&P500 enjoyed an ave...

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...verage hourly earnings has hit 4%. This suggests that 2015 will bring greater risks of wage inflation eroding corporate profitability.
A recovery in 2014 H2 S&P500 operating EPS is expected, but dividend growth is expected to slow this year and in 2015. Equity investors currently appear to be demanding less of a dividend safety buffer than in the earlier stages of the post-March 2009 bull market.
Expected corporate profits growth in the US in 2014 ranks lower compared to forecasts for the Eurozone and main emerging markets.
US equity returns in 2014 may be capped by earnings growth, but the velocity of circulation of money could be particularly important by adversely impacting bond yields. There are some similarities between the current environment and 1987, implying some risks of an equity market correction, but, in the interim, the S&P500 could move higher.
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