Equity markets are driven by earnings, not GDP growth. With US profitability at record levels, Jay Feeney is upbeat about the prospects for US equities.
Earlier on this year, the US economy was humming along nicely. But the situation has soured in the last couple of months. Macro data has disappointed, unemployment remains stubbornly above 8% and there’s no end in sight for the paralyzing political gridlock in Washington.
That’s not all. The “fiscal cliff”—the USD 500-600 billion of tax increases and spending cuts equal to 3-4% of GDP that are set to kick in automatically at the beginning of 2013—is looming ever closer. And the eurozone debt crisis continues to depress sentiment.
Ben Bernanke’s downbeat semi-annual testimony to Congress reflected this deteriorating backdrop. The Federal Reserve chairman observed that the US central bank was carefully examining the recent loss of momentum in the country’s economy to see if it was “enduring”. He added that reducing the unemployment rate “seems likely to be frustratingly slow”.
It is a situation that Jay Feeney, Robeco’s US CIO, acknowledges: “We are now approaching what we’d call stall speed,” he says. And yet he remains positive about the prospects for the US equities. How come?
Equity markets are driven by earnings, not economic growth
The crucial point for Feeney is that it is earnings that drive equity markets, not GDP growth. “Too many people waste their time trying to forecast an unknowable future versus looking at the analyzable present tense,” he says. “Using macroeconomic forecasting to predict the stock market is a waste of time at best and a huge distraction as worst.”
Look at chart 1 to see why. It shows there is little correlation between stock market performance and economic growth. Compare that with chart 2, which shows a long-term regression between earnings per share (EPS) on the S&P and the S&P itself. The stronger correlation is striking. “This is the variable you want to watch,” says Feeney.
Chart 1: Equity performance is not correlated with GDP growth
(Quarterly S&P returns vs QoQ GDP growth)
Source: Bloomberg, Robeco
Chart 2: Earnings are correlated with EPS
(S&P 500 vs EPS (1960-2011))
Source: Bloomberg, Robeco
“When I get distracted by what’s going on in Europe and the political gridlock in Washington, I’ll always come back to the most important factor driving the market, which is earnings,” he adds.
It shouldn’t come as too much of a surprise that his favorite statement on investing is from the legendary investor Peter Lynch: "Earnings drive the market." “That is what I think everybody should be focused on,” agrees Feeney.
Macro relevant at company level
This focus on earnings does not mean that Feeney views the macro picture as an irrelevance. True, he does not incorporate explicit macroeconomic views into his portfolio construction. But if they not used in a top-down way, they do play a role at the company level. After all, the earnings of an international consumer products group with 80% of sales outside the US would be affected by the strength or weakness of the US dollar.
As such, he sees a number of positives in the US economy that are feeding through to corporate earnings. He points to a recovering US housing sector, a manufacturing sector that is experiencing a renaissance, a relatively robust consumer and a financial system that is healing. Credit is expanding, oil & gas prices have moderated and inflation is contained. “I think the pieces are in place for the US to reach escape velocity,” he notes.
Corporate profits are at record highs
And what about those corporate earnings? In fact, US businesses are highly profitable and flush with cash. Corporate profits as a percentage of GDP are at levels not seen since the 1950s.
Moreover, Feeney suggests that the current high margins are largely sustainable. "Aside from the drastic cut-backs that management implemented during the crisis—they slashed and cut to the bone—most of the durable improvement in margins has come from globalization,” he observes.
This high level of profitability has wider implications. “Profitability is so high right now in the US that the amount of dry powder that companies have in terms of redeploying into share buy-backs, as well as new investment, is very considerable.” These hefty cash resources are one reason why Feeney is so optimistic on the outlook.
In fact, quality cash flow generation is one of three things Feeney looks for in an investment. “Three things will basically dictate your return,” he says: “How cheap are they? Fundamentally, do the companies generate a lot of cash flow? How does management deploy it?”
Valuation is attractive
So what about these two other fundamental factors he feels should underlie an investment decision? Valuation is positive. "The US equity market is exceedingly cheap, with a very high equity risk premium embedded into it," says Feeney, noting that the 8% equity risk premium currently priced in is more than double the long-term average. "The US market is inexpensive on an earnings basis.”
It is a slightly different story for business momentum. On an economy-wide basis, Feeney describes it as “a little bit messy right now”, thanks to the political gridlock, the situation in the eurozone and the fiscal cliff—something Feeney sees as a “very, very dangerous” situation, but which he believes is already priced into the market.
But elsewhere there are significant positives on this front: overall credit conditions are improving and quarterly EPS remain very strong. “The end of political gridlock should go some way to unleashing all that profitability,” he concludes.