These two indicators are pointing to a year-end rally for global equities
Upbeat corporate earnings and improvement in economic indicators suggest further upside for global equities as winter approaches
In my pre-teenage years, I read voraciously; especially Captain W.E. Johns’ books about his hero (and mine) Biggles. These breathlessly related the adventures of ace pilot, James Bigglesworth, as he flew into unchartered territory without the slightest regard for personal safety. Hugh Lofting’s Dr. Doolittle books were another favourite too, for the good doctor was always finding unusual animals in the same unsurveyed territory.
The pushmi-pullyu for instance had two heads, one on each end of its body (don’t ask). Not only did it enable it to use one of its heads to talk and the other to eat (thus allowing it to speak with its mouth full, without being rude) but it also meant that the good doctor could speak to a camel through the pushmi-pullyu, knowing that they can speak a dialect of camel language.
In investment, pushmi-pullyu’s are somewhat less useful for, although we all like balance, recent years have seen a flip-flop between strong corporate earnings and a weak economy or vice versa. Both have shown signs of recovery but not necessarily at the same time, resulting in them pulling the market in different directions.
The third quarter corporate earnings reporting season has just begun with results pouring through on a daily basis. It gives us an insight on how companies are doing, as well as their underlying markets. It is the job of stock market analysts to forecast these profits, and they typically do so with such accuracy that the actual results when released often provide positive surprises or negative shocks.
The current earnings season has in general been reasonably positive (at this very early stage) with 76 per cent of reporting companies in the S&P 500 publishing earnings above the mean analyst’s estimates, and 62 per cent showing revenues above the mean. That has reduced the prospective share price to earnings ratio for the S&P 500 to 16.4, down from the 17-18 times of a month ago. In truth, absolute earnings are flat to slightly negative but in markets it is the unexpected that moves prices; not the actual figure which investors already know.
The big US bank sector has so far reported results above expectations and even habitual disappointers like IBM are showing signs of life. The US airlines (a cyclical business if ever there was one) United and Delta have performed better on lower fuel costs and buoyant demand, although our own Cathay Pacific has disappointed because of Asian competition and losses related to misguided fuel hedges.
A good earnings season is welcome because the last five quarters have been disappointing, partly because the previous few years had shown bumper profits as companies downsized. Most market participants are crossing their fingers for a reversal of that trend this quarter because earnings are very important for share prices. Higher earnings means more money to pay out in dividends and lower P/E valuations – and that makes shares more valuable.
The other side of the pushmi-pullyu has not been so buoyant in recent years and this is the expectation regarding economic performance. There is only so much improvement that companies can do themselves without the underlying economies improving. In recent years, sluggish growth in the economies has hindered the progress of share prices - so any improvement in economic indicators would be a good thing.
Michael Taylor’s Coldwater Economics keeps an eye on around 450 economic indicators from the world’s major economies every month and highlights any departure more than a standard deviation away from market consensus. Coldwater’s Global Index is now showing the highest proportion of economic indicator surprises over shocks since 2014. All the main global regions are positive and the sick man, Europe, is now as high as it has ever been. Global economies are still on the weak side - but they are a lot better off than they were.
So perhaps the pushmi-pullyu battle between earnings and the economy might actually be extinct – or at least endangered. If that is the case, it means that both corporate earnings growth and the positive direction of movement of economic indicators might be in the right constellation for the first time in a long time.
Improving earnings expectations are good for equities, while stronger underlying economies provide an impetus for corporate growth. This indicates that we might be in line for some perkier equity performance; something that a miniscule rise in US interest rates will not quash. As the quest for yield goes into the same unchartered territory as Biggles and Dr. Doolittle, perhaps investors might well find some comfort in equity market returns – at least for a while.
Richard Harris is chief executive of Port Shelter Investment Management.