Market Reflections - United Capital

October 14, 2015

Investment Management

EQUITY MARKET REFLECTIONS

WHAT MIGHT HAPPEN TO CORPORATE PROFITS? by Gene Balas, CFA

C

orporate profits are a primary ingredient in stock market valuations. With that in mind, let’s take a deeper look at the concept of earnings and ask three

questions. First, what are investors currently paying for those earnings? Second, how might the earnings season unfold as companies report their third quarter results? And lastly, and perhaps more importantly, what are longer-term the ramifications of profit growth on corporate actions? Data provider FactSet offers some clues. Sales for companies in the S&P 500 are projected to dip 3.4% in the third quarter from a year earlier, with profit margins at 10.1%, which compares to the record-high of 10.5% in the second quarter. As companies arguably have less excess to trim from their operations, the effects of declining sales are expected to take its toll on earnings. (Simply reverting back to historical levels of profit margins would itself argue for a drop in profits.) Indeed, FactSet reports that S&P 500 earnings are forecast to fall 5.1% in the third quarter from a year earlier. Low oil prices, a strong dollar and weak overseas growth (think


Equity Market Reflections October 14, 2015

China and other emerging markets) are partly to blame. If actual earnings match these estimates, this would be the first time since 2009 – when we were in recession – when earnings fell for two quarters in a row.

Ned Davis Research pointed out in a research note dated October 7, that, in order to return to what NDR determined is “fair value,” the S&P 500 would need to fall by 16.8%.

Standard and Poor’s Ratings Services’ rated universe of nearly 2,000 US nonfinancial companies held $1.82 trillion in cash and short- and long-term investments as of year-end 2014, an almost 5% increase from 2013.

Of course, earnings could come in better than expectations – or they might not. The backdrop is that, even after the correction, the S&P 500 recently traded with a price to earnings multiple of 17.9 times trailing twelve months earnings, also according to FactSet, compared to the 10 year average P/E multiple of 15.7. That means stocks may be priced for perfection – and could be vulnerable to a correction. In separate research, and using different valuation criteria, Ned Davis Research pointed out in a research note dated October 7, that, in order to return to what NDR determined is “fair value,” the S&P 500 would need to fall by 16.8%. And it’s always possible that markets could correct even further than simply arriving at fair value. Let’s now change gears entirely, shifting from how investors might react to any profit declines to what corporate chieftains might do. After all, one of their primary missions is to generate profits to return to shareholders. There are several different ways of boosting profits, but here, we’ll consider two: combining forces with complementary companies to eliminate redundancies and introducing new efficiencies to their workplaces to augment productivity. What we know is that cash on corporate balance sheets is at very high levels, and borrowing costs are at extremely low levels, especially for companies that carry investment-grade ratings. Indeed, Standard and Poor’s Ratings Services’ rated universe of nearly 2,000 US nonfinancial companies held $1.82 trillion in cash and short- and long-term investments as of year-end 2014, an almost 5% increase from 2013. Meanwhile, you’d have to go back 40 years to find AAA-rated corporate bond yields as low as they are now. So, not only do many corporations have enough cash to go on a shopping spree or invest in new equipment or technologies, they can borrow to do so. (Of course, the corporate cash balances are not evenly distributed among all companies; some have significantly more cash than others do.)

© 2015 United Capital Financial Advisers, LLC. All Rights Reserved www.unitedcp.com



What this means is that, in order to maintain high levels of profits, companies can buy other companies – the recently announced purchase of EMC by Dell Computers is a prime example – and/or they can also invest in labor-saving technologies to extract more output from their current workforces. Now that the unemployment rate is a low 5.1%, according to the Bureau of Labor Statistics, and posted job openings relative to the size of the labor force is at a record high, as seen in the nearby graph, companies may find they are having difficulty finding the exact workers they need without boosting pay significantly. Consequently, investing in new technology may make sense for some companies.




The upshot is that increased merger and acquisition activity could be beneficial to some investors in the acquisition targets. And increased investment in equipment and software can add to economic activity, both directly in the short term through increased spending on capital expenditures, and in the long term, through higher productivity gains, which are an important ingredient in allowing the economy to grow faster without inflationary pressures and giving workers a pay raise at the same time. So, as the saying goes, “Necessity is the mother of invention,” a modest squeeze on corporate profits need not necessarily be a bad thing – at least in the longer run. In the short term, it is an added risk consideration for investors weighing whether the market is properly valued relative to its fundamentals. If you have additional questions about how possible short- and long-term outcomes for the financial markets could impact your own short- and long-term goals, have a talk with your United Capital financial adviser. We offer a wide range of strategies to help clients align their financial goals with their life goals. We call it FinLife. At United Capital, we want to help you identify the financial choices that are right for you.

Disclosures United Capital Financial Advisers, LLC (“United Capital”) provides financial life management and makes recommendations based on the specific needs and circumstances of each client. For clients with managed accounts, United Capital has discretionary authority over investment decisions. Investing involves risk, including possible loss of principal, and clients should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances. The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. United Capital, Ned Davis Research, S&P Ratings, and FactSet are separate and unrelated entities.
