The Big Picture: US earnings confirm "buy the dips" strategy

You can do circles trying to figure whether quantitative easing (QE) primed the real economy or mainly asset prices, and what international politics could spark next. But the strength of dividend income is the ultimate anchor for stockmarkets, weighted in firms' cash flows and revenues. This is why I have suggested in these macro pieces, the trend in company reporting is vital. 

The US continues to set the pace

Third-quarter results explain why October's circa 10% fall in the US stockmarket has virtually rebounded - which is very significant because everyone wondered, was this a necessary healthy correction or the ominous start of a crash? Technicians will be relieved the S&P 500 index is back above its 50-day moving average. 

Nearly 80% of S&P 500 companies have beaten third-quarter 2014 profit forecasts and over 60% for sales. Strength in sales is important because it scotches fears that post-recession profits recovery might peak given a limit to raising margins. It's no guarantee of prosperity ahead, but it affirms those who say the US economy is overall robust.

Some commentators have pinpointed weak figures from McDonald's as "the truth about US consumer expenditure." This is absurd. The reason McDonald's is in decline is because it's selling ridiculously expensive junk food people are turned off by, with high fixed costs from all its outlets that employ a great many staff. Talk about negative operational gearing and being a long-term short! 

Not to lapse into bullish complacency now the US has wound down an exceptional monetary stimulus. It will take a while for any underlying momentum effect to wear off; so company reporting possibly from the second quarter of 2015 will be the real test.

European company reporting also lends support

Despite recently gloomy macro data, continental European firms have also enjoyed a bullish third quarter 2014, 67% beating earnings forecasts and 59% ahead of sales. It remains to be seen what extent the weak economic numbers eventually manifest in company figures; but this latest reporting period will have encouraged global portfolio managers in search of returns. They see US QE as a resounding success (albeit "they would say that, wouldn't they" when asset markets have benefited most) so even its limited adoption by the European Central Bank (ECB) is likely to encourage them. Again, the true verdict is some way off.

A positive leading indicator is a fifth of eurozone banks more bullish about lending prospects - companies requesting more credit - this is especially so in France and Germany (quite ironically, versus GDP progress) while Italy remains downbeat.

Mixed picture starting to emerge in the UK?

Ernst & Young cite UK profit warnings at their highest summer level in six years, mainly due to competitive price pressures. In the third quarter there have been 69 profit warnings compared with 56 in the third quarter of 2013: retailers being high profile, but also affecting support services, software/computer services, construction/materials, and media. That the UK economy is largely service-oriented nowadays implies this can combine to affect GDP, and is a significant trait for considering what ratings are justified on the more cyclical shares. 

As I have noted in Stockwatch pieces before, the typical "quality cyclical" stock enjoyed a parabolic upswing in 2012 and especially 2013 (coinciding with the third round of US QE) then consolidated or dropped in 2014 as exuberance wore off and reality is sought. In some situations you see very attractive yields, but typically the earnings cover isn't good and the cash situation implies the extent of dividend is good for only another year maybe. So beware potential "value traps" if the best of the UK recovery is over.    

Not to over-react. In construction for example, older contracts have incurred margin pressure as costs rise in a recovering economy. Contractors priced aggressively during recessionary years as it made economic sense to deploy their assets, cover overheads and maintain capability for better times. So there is an aspect of cyclical adjustment that does not make for a downturn. Similarly, London property prices became over-cooked: falling prospects for estate agents there does not imply a UK housing slump.

These EY reports have a context of negativity e.g. a year ago "earnings expectations dipped in late summer...we're a long way from economic, financial or monetary normality and the road back won't be smooth." Regarding the first quarter of 2014, the report suggested "the recovery is picking up speed, but UK profit warnings have edged up again to reach their highest first quarter total for three years." It marks an interesting correlation with stock prices to make this particular report worth following; otherwise it is easy to be lulled by the majority of listed firms updating "in line with expectations". 

More positively as regards the private sector, company liquidations are down by 11.7% compared with July to September and the number of people filing for bankruptcy is down by 19%. The question is whether this is a lagging trend whereas profit warnings are a leading indicator.

Risks continue to brew in China

Perhaps the chief economic risk remains China where "crash" warnings look extreme in context of circa 7% GDP growth; yet economic history has no precedent of a country escaping recession after running up debt anywhere near 250% of GDP - as China has done. It is now the largest constituent of global GDP so a downturn would be very significant whatever happens in the US. Notably, Unilever and Nestle have cited a sharp slowdown in Chinese consumer demand just when the authorities want consumers to replace infrastructure spending as the economy's engine. Yet falling house prices make this harder and the financial system is heavily geared towards the property sector. It's a disturbing mix, and the authorities will be lucky to muddle through.

There's still no real alternative to stocks, for income

US equities continue to look pricey on price/earnings measures and the UK market is fully valued - true bargains very hard to find. Yet investors may well be tempted to incur the risks in a financial context of low interest rates and high cash balances looking for a return; it's quite a self-reinforcing situation. October's market behaviour affirms "buy the dips" and undermining the cult of equity would need a more serious breakdown in company results. Keep attuned to Stockwatch pieces!

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.