The US equity rally that began in mid-March has propelled the S&P 500 and the Nasdaq indices to leve...
The US equity rally that began in mid-March has propelled the S&P 500 and the Nasdaq indices to levels not seen in almost a year. A quick resolution to the Iraqi conflict and an earnings season with limited negative news have driven stocks higher, particularly the more volatile stocks that had been laggards earlier in the year. At current valuations, stocks appear to be priced for perfection.
The first quarter earnings season ended with the majority of companies achieving or surpassing analysts' expectations for quarterly profits. Widespread corporate restructurings and cost-cutting programmes have paid off in the form of preserving profitability in the face of a decidedly tough economic environment.
While decent earnings certainly appear to be positive news, a few important facts must not be overlooked.
First, the profitability targets so many companies handily achieved had been previously lowered, on average by 70% since last June, making them easy to meet or beat. Additionally, few companies were able to report any organic revenue growth ' medical device companies were a noteworthy exception. Fewer still increased their full-year earnings guidance, indicating CEOs have little visibility of future growth.
Finally, cashflow growth was anaemic at many companies, implying continued weak corporate capital expenditures in the near future.
One noteworthy trend has been the impact of a weaker dollar, which helped boost first quarter earnings from non US operations once translated back to greenbacks. Over the long term, a weaker currency should help US manufacturers grow revenues and profitability.
A weaker dollar not only makes US exports more competitively priced in overseas markets, it also reduces the threat of local deflation posed by cheap foreign imports. If the currency continues to markedly weaken in 2003 as the Treasury Secretary recently suggested, it would be a positive for US companies' earnings in the second half.
However, we view currency gains as low quality earnings and prefer to own companies that are growing revenue through increasing volumes or raising prices.
The outlook for strong consumer spending remains tenuous. If the lower mortgage rates available in recent weeks stay low, yet another wave of refinancing could free up more discretionary capital. But other signals point to a flagging consumer, who has been so important to the US economy in the past two years.
The slow economic recovery and fragile corporate earnings make equity valuations seem particularly stretched following the spring rally. Now earnings quality must continue to improve for stocks to grow into their current valuations.
Given that sentiment is ahead of fundamentals, the better investment opportunities will be in companies able to grow earnings by gaining market share, through either competitive cost advantages or pricing power earned by a proprietary product. Today, such opportunities can be found in parts of the healthcare sector and among select technology companies.
Weaker dollar boosted earnings.
Low interest rates at present.
Low inflation continues.
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