US equity bulls face tough earnings test

Staying bullish on US equities has become a lot harder lately.

Lofty valuations, a strengthening dollar and sharply lower oil prices pose a challenging backdrop for investors as companies unveil their latest quarterly results during the next few weeks.

At a time when the US Federal Reserve has served notice of finally tightening policy and ending years of easy money which has bolstered a massive run-up in equity prices since 2009, investors have turned away from US shares, opting for cheaper valuations and more supportive central bank policies in the eurozone and beyond.

In turn, the S&P 500 stands unchanged for the year, a performance reflecting uncertainty over corporate earnings and Fed policy. Now more than ever, analysts say US companies require a robust economy that results in higher revenues rather than continue boosting equity prices thanks to hefty cost cutting and using cheap financing for funding record amounts of share buy-backs and dividends.

"As the Fed considers raising interest rates, even if the process will be very slow, there will need to be 'real' growth in earnings and top-line revenue for equities to move higher from here," says Oliver Pursche, chief executive of Bruderman Brothers.

For the first quarter, though, estimates are going in the opposite direction thanks to falling oil prices and a higher US dollar, which has surged more than 21 per cent over the past 12 months.

For many US multinationals, the stronger dollar lowers their foreign-based revenues. On a per share basis, estimated earnings for the first quarter have fallen by 8.2 per cent since year end, the largest decline since the aftermath of the financial crisis during the first quarter of 2009, according to FactSet.

Earnings are expected to drop nearly 5 per cent year-over-year on a sales decline of 2.7 per cent. Excluding energy, earnings are seen rising 3.4 per cent and revenue increasing 3.1 per cent but that is still down from estimates of 8.9 per cent and 4.7 per cent growth, respectively, as of December 31.

The sharp reduction in estimates comes when the ageing bull market has produced a gain of 250 per cent for the S&P 500, including the reinvestment of dividends over the past six years.

Heading into a tough earnings season, stocks are not looking cheap, trading at about 17 times forward earnings. Further gains require the type of top growth that has remained elusive.

Against that backdrop, the S&P has eased from a record close over a month ago, with investors decamping to other markets.

Flows into European and Japanese equities have created something of a vacuum for US stocks. Investors pulled more than $11bn from exchange-traded funds invested in US stocks in the first quarter, a reversal from three consecutive quarters when the asset class recorded $138bn of inflows, according to data from Markit.

"ETF money flows go a long way to explaining why US large cap stocks barely budged from New Year's Day until March 31," says Nicholas Colas, chief market strategist at Convergex.

Data from EPFR and Jefferies, which include mutual fund flows, make the divergence between the US and other developed markets even more pronounced. The latest report showed $42.6bn of withdrawals from funds investing in North American equities in the year to March 25, compared to $61.3bn that has moved into Asia Pacific and Developed Europe equity funds over the same period.

Earnings for the S&P Europe 350, which includes companies such as Danone, Lafarge, ThyssenKrupp and L'Oreal, are expected to climb 14.1 per cent in 2015 from a year earlier, with double-digit gains forecast for each sector except energy, according to S&P Capital IQ.

With all of the negativity around the US, there is always that chance that the surprises are to the upside, which could push the broad market back into record territory.

"With this decline in estimates, we expect reported results to show modest upside as companies once again clear the lowered bar," says Adam Parker of Morgan Stanley. "Earnings for the group of companies reporting prior to Alcoa have been above estimates. The sample size is quite small, but beats included FedEx, Nike, and McKesson among others."

As investors await a slew of earnings and outlooks from companies, at the very least they should brace for volatility. Rising volatility across commodities, currencies and US Treasury yields in recent months has not been replicated by equities.

"The volatility of currencies is elevated, the volatility of commodities is elevated and the triple whammy is interest rates as well," says Paul Ebner, a portfolio manager at BlackRock. "We are right at an inflection point in Fed policy. Those are big inputs into what companies do. Naturally, that will translate into equity and earnings volatility."

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