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Home > Blogs > Anthony Harrington > Extraordinary times call for... caution?

Extraordinary times call for... caution?

Investments: extraordinary times call for... caution? Anthony Harrington

Take a lackluster, nay, flat to falling economy in Europe and under-performance in the US and match that with record highs for the Standard & Poor's, which hit a new all time high on 28 March and may well do so again before this blog appears in print, and you are not alone if you find yourself scratching your head and wondering what, exactly, is driving things? It can't just be all that new money being created, surely?

Then there is the euro. Germany, the power-house of the EU, is perilously close to recession, the Cyprus bail-out could still come unglued, European investors have just been put on notice that their bank balances are fair game if their country needs a bail out, and yet the euro rose from 1.28ish to touch 1.32 against the US dollar, a gain, in FX terms, of 4000 points. Of course, it hasn't stayed there, at the time of writing it was back down from the high 1.318s to 1.303, having briefly touched 1.300, which, had it been breached, might have seen the euro back at 1.28 in double time. Baffled? You should be. You can find big institutions betting that the euro is going to crash back to 1.20-something "soon", and others betting that it is going to pass 1.4 in a few months, a difference of 20,000 points - talk about a wide margin of error!

So let us look at fundamentals. An excellent article by Sheraz Mian, Director of Research at Zacks Investment Research, cited in full by John Mauldin in  his free "Out the Box" series, poses the simple question: Are earnings expectations (of US corporates) realistic? Mian starts by giving an accurate precise of the position in which we currently find ourselves:

"We all know that markets don't always reflect the health of the economy. It is not unusual to experience stellar market returns in an otherwise mediocre economic backdrop - something that investors are currently experiencing."

He goes on to warn that investors need to look ahead.

"Future success in this investing climate is a greater challenge", and much of that success depends on whether corporates can actually earn what analysts and the market currently think they can earn.

Otherwise, oh dear, we'll discover that we were all simply celebrating yet another false dawn and the resulting hangover will be unpleasant. We are just through the first earnings quarter of 2013 and we have had time to digest the fourth-quarter 2012 earnings position. The first thing to say is that the Q4 2012 earnings were only OK if you believe that no news is good news. They continued a trend of three quarters of dead flat earnings growth.

Right now the market, Mias says, appears to be betting that all this is coming to an end and growth is going to come roaring back in the second half of 2013 and continue strongly into 2014. The phrase, "dream on", comes to mind...

What Mias wants is for investors to get a grip and show a little caution. They could do far worse than taking another look at their portfolios to see how their current stance would fare if the market turned down for the best part of a year.

"I am by no means suggesting that an earnings train wreck is on the horizon. Nor am I making a call to exit the market altogether. What I am suggesting instead is that current earnings expectations are vulnerable to significant downward revision. An acceleration in that negative revisions process will most likely result in the market giving back some, if not all, of its recent gains."

Investors could learn a lot, he suggests, by contemplating what happened with Q4 2012 earnings. When the dust settled what people discovered was that Q4 was distinctly average. Total earnings for the S&P were up +2%, year over year, and 65.5% of companies beat earnings expectations, the median "surprise" being about 3% over analysts' expectations. However, if you strip out the financial sector, which enjoyed a rebound after being hammered into the ground, earnings were barely positive, Mian points out. If you lay those rather ordinary earnings figures alongside the leap forward by the markets to historic highs in the Dow and the S&P, you have to ask yourself what all the fuss was about.

For Mian, the reason is plain: "Simply, the reason (investors were quite happy with the Q4 numbers) is the extremely low levels to which expectations had fallen from October 2012 to January 2013 as the reporting season was getting underway in early January," he says.

Investors seem to be taking this satisfaction and projecting it forward as if they were again going to get a pleasant surprise. Mian doesn't think this will happen, not if investors are expecting a significant rise in earnings.

"Earnings increase through two ways: revenue growth and/or margin expansion (margins are basically earnings as a percentage of sales). The outlook on both fronts is problematic," he warns.

Further reading on growth:




Tags: bail out , Cyprus , euro , Germany , investments , John Mauldin , returns , S&P , Sheraz Mian , Stan , Standard & Poor's
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