Will the global stock markets continue to higher? That is always the key question for investors. Given the interlocking nature of the global financial system, markets around the world have become increasingly correlated. Now that the United States is in its second week of earnings season where results up to March 31 are being released, reviewing the outlook of the US stock market through the S&P 500 can give a good idea into what investors should expect for the rest of the year. Year-to-date, the S&P is up 4.93 per cent. The consensus view at the beginning of the year was that the market would post returns similar to last year, that is, the low double digits. So far so good, as with just over three months gone, everything is well on course. The current price to earnings multiple of the S&P 500 is 15.4 times earnings. This equates to current earnings of around US$85 per share and one can argue that based on earnings and the price to earnings multiple the market is reasonably valued at this time. Appreciate that the stock market is a discounting mechanism so what happens next is based not so much on the current earnings announcements, but on how the market views the current outlook for earnings through to the rest of the year. The reality is that at this time the market seems to be a bit nervous. This nervousness was very apparent last week when the Internet giant Google released results. An earnings shortfall of US$13 million due to rising expenses resulted in a sell off that shaved around US$15 billion from the company's market value. That move came after Alcoa, usually the first company to report, also disappointed the market. Since entering April the S&P 500 has failed to break past 1,337 and closed last week at 1,319. With the index currently trading below its 100- and 200-day moving averages it reflects a market struggling for momentum as there is at present no definitive catalyst to push the market higher.
Setting the tone
This is why the current earnings season is so important as it will set the tone for the rest of the year. A strong earnings season will allow the market to continue to overlook the increasing number of headwinds that are popping up. Up to now, the good news have held sway as investors have shrugged off the triple whammy of an earthquake, tsunami and nuclear disaster in Japan, along with the ongoing unrest in the Middle East and North African region that has resulted in a premium on crude oil. The trading pattern from last week suggests that there is just a bit of a waver and so this week and next week will be crucial. Investors should be tuned not just to the actual results but to the outlook given by management. Last week, Goldman Sachs put out a note to investors that highlights the interconnectedness of markets as well as the number of factors that needs to be considered when making an investment decision. You will recall that the US markets took off towards the end of last year when out of the blue the Obama administration was able to strike a deal to extend the tax cuts that were due to expire. Since then, according to Goldman Sachs, the run-up in oil prices as a result of global tensions have resulted in gasoline prices rising to the point where it effectively offsets the benefit from the tax cut. This has prompted Goldman to reduce its estimate for gross domestic product (GDP) in the US for the end of the first quarter to an annualised rate of 1.75 per cent.
Appreciate since the announcement of the tax cuts this GDP estimate was originally as high as 3.5 per cent, but has since been revised downward to 2.5 per cent and now 1.75 per cent. It is clear that higher oil prices and inflationary pressures in general are beginning to have a negative effect on US economic growth. It should be obvious that there is a correlation between GDP growth and corporate profitability. In the current environment, that correlation may not be as pronounced as in the past since over 40 per cent of the revenues of S&P 500 companies comes from outside the US. Nonetheless, US GDP and global GDP remain important benchmarks for predicting stock market performance over the long-term. Since the end of World War II, corporate profits in the US have measured around 9.5 per cent of GDP. The most recent data suggests that corporate profitability stands at over 11 per cent of GDP. Such historically high rates of profitability relative to GDP are the result of overseas earnings (as already mentioned), and the strong boost to corporate margins as a result of labour cost reductions and productivity gains coming out of the restructuring following the financial crisis. This, to my reckoning, has run its course and coupled with higher input costs as a result of commodity price inflation it is likely that margins will be eroded in the coming quarters.
Critical headwinds
In order to remain on the same growth trajectory, corporations will have to sell more which means more consumption. Except for corporations that have strong operations in the emerging markets, this can prove to be a challenge. In Europe, budget cuts and austerity are the order of the day and this will have a negative impact on consumer spending. In the US, the debate on cutting expenditure is belatedly coming to the fore but the US consumer is still very much overleveraged. The Japanese economy is warded in critical condition and the only growth likely is in the niche reconstruction effort and even here questions remain as to how this will be paid for. If margin pressures come to the fore and consumption remains lackluster going forward, then look for companies to miss on either their earnings or revenue announcements or on both. Even for those that hit their numbers, look carefully at the guidance on offer. In the last couple years, it was fairly easy to undersell expectations and then over deliver, thus, prompting a rally in the stock price leading to an overall rally in the market. As the market has doubled from the March 2009 low and companies have beat expectations every quarter since then it becomes increasingly difficult to keep that pace going.
There are a number of macro issues that are also going to be of concern over the next few months. I have mentioned a couple times recently the issue of supply chain disruptions coming from the disasters in Japan. In the context of just in time inventory systems and a global supply chain, this is a serious issue for corporations to come to terms with. It could very well result in a permanent shift of elements of the supply chain away from Japan-the world's third largest economy. The economic impact on Japan and for that matter the global economy is as yet unknown. In Europe, I predicted long ago that a Greek default is inevitable and the current trading suggests that the market is now coming around to that view. There is the dilemma of the one size fits all approach based on the single currency: the euro. As inflationary pressures build in Germany, it becomes necessary to raise interest rates to cool things down. However, such moves will push Greece, Ireland, Portugal and Spain closer to the edge. It is a challenge that has no easy solution.
Over in the US, the end of the second round of quantitative easing (QE2) in June is almost at hand. The key question is whether the economy is strong enough to sustain itself without the monetary support that is currently on offer. From my vantage point, there is a bigger question and it relates to the purchase of US debt. Towards the end of last year, I pointed out that the US Federal Reserve (Central Bank) passed China as the largest holder of US debt. If the Fed now stops its purchases and there is no substitute, how will the US debt be funded? China has been steadily reducing its purchases of US debt and Japan can no longer be relied upon. Consistent with this view, one of the world's largest bond funds has exited treasuries and even seems to have gone short. Simply put, the environment over the next few months may prove to be quite tricky. The easy money made by simply playing the market is history. Going forward prudent stock selection is likely to be the best option for investors.
Ian Narine is a broker registered with the SEC