Watch your wallet, it's US earnings season again

And we're off! US reporting season is underway and there's a definite sense of unease about what might happen over the next few weeks. Despite jitters about Portuguese banks, both the Dow Jones and broader S&P 500 remain near record highs, and company valuations are in nose-bleed territory. So, with company earnings growth only modest at best, and with stocks priced for perfection, there can be no slip-ups. If the worst does happen, there will be serious repercussions for London, too.

First signs have been reassuring. Aluminium giant Alcoa, traditionally first out of the blocks, had a good second quarter, slightly exceeding market expectations. However, one swallow does not a summer make, and businesses facing far tougher tests than Alcoa will need some good excuses to assuage unforgiving Wall Street analysts.

And they had better be good. The S&P 500 is already trading on a forward price/earnings (P/E) ratio of 16, above its historical average and looking expensive to many. "As we enter the crucial second quarter earnings season, the major danger for stocks is that whilst global liquidity has created high equity valuations, we cannot stay at these levels unless there is a significant improvement in earnings to justify it," says Interactive Investor's head of investment, Rebecca O'Keeffe.

"Bad weather created a ready-made defence for many US companies who underperformed in quarter one, but with no excuses available this time around, they will have to step up in order to support their current lofty levels or risk a swift and severe market re-rating," she adds.

What's different this time?

Well, global stockmarkets themselves are different than before. Cheap money from the Federal Reserve has bankrolled much of a five-year rally in US equities during which time the Dow has doubled in value to over 17,000. Near-zero interest rates have also made other investments, including traditional income plays like bonds, unattractive.

American firms have rediscovered their love of share buy-backs, too. According to Factset, cash-rich companies purchased over $154 billion (£90 billion) of their own shares in the first three months of 2014. That's 50% more than the year before, and the third-largest splurge since 2005. Notably, Apple splashed out $18.6 billion and IBM $8.3 billion. The net effect is that the big reduction in the number of shares in issue flatters the earnings part of the earnings per share (EPS) equation. Underlying growth might not be so impressive.

Of course, companies will argue that repurchases have been the most efficient use of spare cash - a form of return to shareholders. But as Factset points out, with the surge in stock prices, the tactic is becoming less effective. Remember, when stockmarkets rise rapidly share repurchases become more expensive, and the buyback yield during the first quarter slumped to a miserly 3.3% compared with 4.9% when buybacks were at their previous peak in 2007.

Rising (heart) rates

And then there's the Fed. So-called tapering - the winding down of asset purchases - has had the market in a spin for months, and the central bank has just said the programme will end in October. The rate rise that will inevitably follow is the topic of much debate. Financial markets reckon rates will rise during the third quarter of 2015. Many analysts brought forward expectations after data revealed unemployment fell much faster than expected in June - down to 6.1% - and some now think rates could rise as early as next spring.

Schroders plumps for June next year and for a rise to 1.5% by the end of 2015. "Our view is that unemployment will fall faster and further than the authorities forecast as a result of healthy output growth and a continued decline in the participation rate," says Keith Wade, chief economist at the investment bank. He points out that "in the absence of a clear inflationary signal, the Federal Reserve kept policy too loose for too long with the effect of creating imbalances in financial markets. That led to the tech bubble of the 1990's and the housing bubble/banking crisis of the 2000s. "The chances of the same thing happening again are not insignificant."

Clearly, everything depends on the strength of the US economic recovery. At its June meeting, the Fed rate-setting committee cut its forecasts for GDP growth in 2014 from 2.9% to just 2.2% due to the harsh winter. The IMF thinks it will be even less - just 2%. But economic activity has "rebounded in recent months," the Fed says. And anyway, as Deutsche Bank points out, investors "are re-assured the monetary authorities will respond aggressively to any economic threats - not just to an international crisis, but even to a common domestic slowdown."

There's little doubt that the debate over where equity markets head next will rage on whatever the current reporting season throws up. But what is clear is that earnings growth for the three months just gone had better justify these lofty valuations. All good things come to an end, and this rally surely will. But, as always, the timing is impossible to predict. Those who get it right will dine off the story for ever, but it's almost irrelevant for the sensible folk who regularly drip-feed money into equity markets through thick and thin. They'll keep some powder dry and make merry when it eventually goes wrong.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.