With the successful fourth-quarter US earnings season in the rear-view mirror for investors, attention has turned to the results for European companies.
Unfortunately, the comparison is not flattering. Expectations were low for both regions after the pandemic lockdowns drove an historic collapse in GDP. Negative earnings growth would have surprised nobody.
Positive earnings growth would, and that is what S&P 500 companies have reported so far, with earnings rising by 4% from the fourth quarter of 2019, significantly higher than the predicted fall of 13% (396 companies have reported). By contrast, European earnings have fallen by 10%, only slightly less than the forecast 14% drop (199 companies have reported).
The greater fiscal stimulus in the US and less onerous lockdowns should already have been factored into analyst estimates, but companies were still able to significantly beat their expectations.
One reason is that the internet-leveraged pandemic beneficiaries such as e-commerce and home streaming services have continued to generate strong earnings.
The announcement of vaccines last November has yet to translate into an increase in away-from-home activity, either because some restrictions remain in place or because people are unwilling to go out to shop, relax or work until a greater share of the population has been vaccinated (see Exhibit 1).
Neither the delay in the resumption of economic activity nor the rise in US Treasury yields to nearly 1.3% for the 10-year bond has dismayed equity investors. US retail investors reportedly directed more than USD 58 billion in fresh cash to equity funds last week, the largest weekly inflow on record. Foreign investors meanwhile poured USD 78 billion into US equities in December, just slightly below the previous record inflow of USD 79 billion last May.
One might conclude that it is simply this wave of cash that is pushing equity markets higher, but some caveats are warranted.
While foreign inflows have indeed been significant since last spring, many domestic US investors have been selling to the foreign buyers. Cumulative retail equity fund flows have in fact been negative over the last few months, even allowing for last week’s historic inflow. The large dollar amount of the inflows also reflects the market’s greater value; as a percentage of market capitalisation, inflows have not been unusually high (see Exhibit 2).
Regardless of the cause of the market’s gains, valuations reflect an appreciation in prices that is outpacing the increase in earnings. Investors are anticipating the fiscal stimulus to come and are still counting on an end to the lockdowns to release pent-up demand. The crucial question is whether the price appreciation has moved too far ahead of earnings.
In some parts of the market, this may be true, particularly among the pandemic winners. The elevated price-to-earnings ratios (P/E) of these mega-cap stocks inevitably distorts the P/E of the index overall.
One way to assess the valuations of the full range of stocks in the index is to look at the median P/E as opposed to the market cap-weighted P/E. When one does this for the technology sector (including internet retail, interactive media and services, and movies and entertainment) separately from the rest of the market, a notable divergence becomes apparent.
While the median P/E of the tech sector is higher than it has been in 17 years, the median P/E for the rest of the market is in fact at its long-term average. Given that very low interest rates warrant a higher P/E across the market, and that earnings growth should still follow from the coming fiscal stimulus, merely ‘average’ valuations may be surprising (see Exhibit 3).
This suggests there are still reasonably priced opportunities in US equities, though some selectivity is in order.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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