Sweet and sour earnings back on the menu for U.S. investors

By Rodrigo Campos and Julia Edwards

NEW YORK (Reuters) - It is back to basics on Wall Street after several weeks of market obsession with political manoeuvring over a government shutdown and threatened debt default. But some of corporate America's numbers have been found wanting.

The U.S. stock market broadly celebrated an agreement in the U.S. Congress that ended a 16-day partial closure of federal agencies and budget impasse but was then socked by earnings from market bellwether IBM .

Big Blue, as it is commonly known, was joined by a pair of underwhelming results from fellow Dow members Goldman Sachs Group and UnitedHealth Group - and all three stocks dropped Thursday. That was balanced, however, by gains in other components such as American Express , Verizon and Coca-Cola , which have all reported better-than-expected results.

The mixed nature of the picture was underlined by disappointing results in the technology sector from eBay on Wednesday, which was more than offset late on Thursday when Google reported revenue and profit that exceeded Wall Street's expectations.

With the S&P 500 touching an all-time record Thursday after the congressional deal, some of the earnings reports send a cautionary message. Profit margins are declining, and part of the market's rally earlier in the year was based on expectations for strong second half results. That has not happened, making current valuations - at about four-year highs - questionable.

The market "is not at an expensive valuation compared to historic levels, but it's expensive relative to recent history," said Michael O'Rourke, chief market strategist at JonesTrading in Greenwich, Connecticut.

Overall earnings growth is expected to come in at just 1.9 percent for the third quarter, down from an estimated 4.5 percent at the beginning of October. Any impact from the government shutdown and related political uncertainty will likely only be felt in the fourth quarter.

The disarray in Washington has had a silver lining for investors as it has ensured the Federal Reserve's massive bond-buying program to stimulate the economy is unlikely to be reduced until next year. Money coursing through the financial system should remain plentiful and cheap for at least the next few months.

For the market to sustain its rally, however, investors will need to believe that stocks are still undervalued based on hopes for future earnings growth - whether that growth is due to Fed stimulus or more fundamental growth in the global economy.

The S&P's forward price-to-earnings ratio is around 14.5, about the highest in four years, and a shade under the long-term mean of 14.85. The P/E multiple has risen throughout the year as earnings growth has remained stagnant, and forecasts are likely to fall in coming months. Without improved growth, that P/E will start to look expensive.

"The stock market's expansion this year has been driven by multiple expansion rather than material improvement in underlying fundamentals. That's why people do take a lot from IBM," said Adrian Cronje, chief investment officer at Balentine in Atlanta.

IBM said profitability in its hardware business declined by $1 billion year-to-date, and it missed revenue expectations by about $1 billion as well. The company's margin on earnings excluding interest and taxes fell to 17.8 percent for the first nine months of 2013, compared with 19.2 percent for the first nine months of 2012.

That's emblematic of a continuing trend, Goldman Sachs highlighted in a research note Wednesday. Excluding financial stocks, the S&P's earnings margin before interest and taxes - an important way of measuring profitability - had dropped for seven consecutive quarters through the second quarter, with the tech sector's margins hitting a three-year low.

This underscores the continued squeeze as a result of weakening demand and cost-cutting.

"The question is, how many levers do these companies have left to pull to keep that earnings growth going?" asked JonesTrading's O'Rourke.

LOFTY FORECASTS

Part of what fuelled the rally this year - other than Fed policy - was expectations for a strong second half of the year.

In July, Credit Suisse noted that six of the 10 sectors in the Russell 2000 were forecast to earn more than their usual percentage of earnings in the second half, with technology garnering 55 percent of its 2013 earnings from the latter half of the year.

"Earnings estimates for this year were very back-end loaded and if Q3 earnings are missing, it should lead to a healthy reduction of Q4 estimates," O'Rourke said. "That's the point (at which) the market starts to reconnect with the economic data, earnings and the real economy."

Those estimates have been driven sharply lower. The 1.9 percent expected growth in the third quarter compares with an estimate of 8.5 percent at the beginning of July. But forecasts for the fourth quarter have not fallen as much, and 2014's estimates have stayed pretty steady in the 11 percent range for months.

Tobias Levkovich, chief U.S. equity strategist at Citigroup Global Markets, believes these lofty forecasts are going to decline in the next couple of months, and "hence, buying into the risk-on trade has its detriments."

Levkovich specifically sees cyclical sectors, including consumer discretionary, materials, and industrials as having already priced in the good news. Current 2014 growth estimates for discretionary and materials shares sit at 18.9 percent and 17.4 percent respectively, according to Thomson Reuters data.

For their part, Wall Street analysts do not expect many gains next year, seeing the S&P 500 ending 2014 at 1,845, which would represent a 6.7 percent increase from current levels.

Still, the fourth quarter did not start well with the shutdown and threat of debt default expected to cut about 0.6 percent from gross domestic product growth, further hurting corporate earnings.

The struggles in Congress and the Fed's easy money have kept investors focus away from earnings in recent weeks.

"Right now the market is not looking at the economic data and earnings," O'Rourke said. "But several disappointing numbers and I would expect lower revisions for the fourth quarter will eventually weigh on equity prices."

(Editing by David Gaffen, Martin Howell and Grant McCool)

Source: http://news.yahoo.com/sweet-sour-earnings-back-menu-u-investors-225751106--sector.html
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