The Return of Fundamentals

Quarterly earning season is upon us, and underneath the guise of downward-revised forecasts and the effects of write-downs, the story tells of U.S. corporate profits falling, not rising. These results caused The Economist to ask the question, “Are corporate profits at last running out of steam?” in its recent Buttonwood article, “Sound the Retreat.”

In 2013, multiple expansion was the primary driver of the U.S. Stock Market’s returns. Eventually, however, more robust earnings growth will be required for the stock market to continue rallying. As stated in “The Market Valuation Debate” in our 2014 Capital Markets Forecast, “sooner or later, the fundamentals have always, and will always, reassert themselves.

fundamentals

Sources: Thomson Reuters, MSCI and BlackRock Investment Institute

Adrian Cronje warned of this possible course of action in his quarterly investment letter to clients at the beginning of this year:

“We are not yet in the camp which sees stocks in outright “bubble” territory but are becoming increasingly cautious about valuation and growing signs of unusually bullish sentiment, especially in U.S. stocks. If there is anything that could lead climbers to fall and perish from overconfidence during the descent, it could be that margins peak and corporate profits begin to fall relative to expectations. Today corporate profits relative to wages and total compensation are at an all-time high. Share buybacks are an increasingly important way for companies to continue beating bottom line growth estimates. This is an unsustainable dynamic, and fundamentals must take over to drive equity returns from here.”

The sustainability of revenue growth, and with it earnings and dividends, remains crucial to justify current valuations. With this slowing trend brewing beneath the surface, the question becomes this: will the global economy pick up enough (without offsetting inflation) to enable profit growth to continue?

We think the question is still open and will continue to carefully watch this trend and look to capture opportunities that arise from it.

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