Corporate earnings drive markets more than before

As most developed stock markets hit new highs, alarm bells have started ringing from all directions. Market commentators, politicians, some pundits and some respected portfolio managers and economist have recently joined the crowd. Whenever markets or stock prices hit new highs, there is always a concern. Using simple probability theory, the higher it goes the weaker the momentum becomes and the bigger the likelihood of small correction or may be consolidation. When these take place, sector rotation, asset reallocation are followed.

Obviously, there are lots of reasons why stock indices hitting new highs. Some are related to good market fundamentals such as attractive valuation, equity supply and demand, ample liquidity and corporate earnings. Others are related to the economic fundamentals and monetary policy. Since 2008 when most central banks in the developed economies lowered rates to near zero or negative in some places like the eurozone, mountain of liquidity were followed that have been supporting the world financial assets. Most of this liquidity did not go into production and economic activity but into the world financial markets.

Added to this ample liquidity has been corporate cash mountain that has been used for buy backs and increasing dividends for most big companies. At present, some of this liquidity might be reduced by increase in economic activity and business spending. Central banks have not drained money out of the system at some time in the future they will be starting some form of tighter money supply. Going forward equity investors should focus on company earnings if they want to achieve good performance. Ultimately, the performance of a stock price follow earnings and profitability and not just liquidity. Most stock market indices are expensive on historic basis but taking into account the level of interest rates, inflation and global liquidity and based on forward valuation, they still seem attractive. The key question for investors how the market will transit itself once those supporting factors reverse themselves.

Encouraging

There are some encouraging signs that companies are back on reporting profits again, although might not be very much but they have come out of the profit recession they have faced over the past few years. Good example of this is US corporates. According to Bloomberg, the US S&P 500 operating earnings per share rose over 8% in the third quarter from a year prior. This renewed profitability should provide support for equity markets going forward. Although rising wages that is caused by higher inflation and more rates rises might put profit margin at risk. If these new developments are accompanied by stronger global economic growth then it might be acceptable to see stronger revenues to offset any decline in margins and provide support for earnings.

Corporates and individuals tax reform in the US once passed will be great boost for corporate earnings and profitability. Depending on which sector, the cut in taxes should benefit most companies apart from those ones that already pay low tax rates. A low rate of tax of 10% should boost earnings by at least 12 percent. US stock markets are starting to discount the chances of tax cuts into some specific sectors and individual companies too. Current analyst estimates for US corporates earnings is to rise by 10 percent in 2018. This seems quite optimistic but it is possible as the economic cycle turns to be more growth orientated. I believe that earnings momentum will accelerate for some certain sectors, such as high technology, mining, retail, banking and industries. Equity investors should be more active in those sectors and position themselves to take advantage of these earnings trends next year. Technology sector is one of most attractive from fundamental valuation standpoint, as the sector has higher margins than any of the other major stock market sectors and revenue growth forecasts are quite strong.

Overall, I am quite encouraged by the signs and optimistic for the next couple of the years. Also, I believe that stock markets will successfully transition to an earnings-driven rather than led by ample liquidity that supplied by most central banks. A gradual rise in US interest rates might create a headwind for the US equity market, but investors should focus on the sectors that could benefit from the growth, inflation and interest rate environment that I expect to happen in the coming years. @Rasameel