U.S. equities: Building a case for a more constructive outlook

A man sitting outside reads a newspaper.

U.S. economic releases are increasingly positive, suggesting an end to the recession.

A number of factors have been aligning recently to lead us to become more positive about the U.S. stock market. The most immediate and obvious is the stellar earnings surprises of the second quarter of 2009.

Earnings are telling a good story

A whopping 76% of S&P 500 companies reporting earnings beat estimates, and 51% also beat revenue estimates. On average, companies are beating estimates by 10.4%.

A closer look at the Q2 earnings results reveals that the highest percentage of positive earnings surprises has been within cyclical sectors — technology (with 94% of companies surprising on the upside); consumer discretionary (with a 92% positive surprise ratio); materials (with a 92% positive surprise ratio), and industrials (with an 86% positive surprise ratio).

A common notion has been that the strength of this earnings report is due only to cost cutting. The data does not support this, as 51% of reporting companies also exceeded revenue expectations, with 29% reporting higher year-over-year revenues.

Furthermore, the natural progression of events heading out of a recession is first for earnings to recover through corporate cost rationalization and then through top-line growth. One step must precede the other. This is the normal course of events. Top-line growth will eventually come along in due time.

Overall, second-quarter earnings results exceeded expectations by a wide margin, and this could be very supportive of stock prices and valuations heading forward.

Valuations are supportive

Stock market valuations are another positive factor. Based on 2010 estimated operating earnings, the market is trading at only 13 times 2010. This is not excessive by any means, particularly as the economy is clearly at the turning point out of the recession. Applying 15 times to 2010 projected earnings, this would give us an S&P target of 1,110, or another 10% to 15% upside from current levels.

While potential downward earnings revisions to 2009 (and 2010) were a concern, the second-quarter 2009 earnings report provides cause for greater optimism. Given the fact that most key economic indicators suggest that we are about to turn the corner (or possibly have already turned the corner) on the worst recession in decades, current market valuations do not appear to be overly expensive.

A housing bottom?

An uptick in housing numbers has also been very encouraging. New home sales surged 11% in June, the highest pace of sales since November 2008, and the third consecutive monthly gain. Also, existing home sales rose 3.6% in June, the third straight monthly increase. These readings support a bottoming in U.S. housing. Similarly, other key economic data such as the Conference Board’s Leading Indicator Index has been steadily moving upwards over the last few months, suggesting that we are heading out of the recession.

Corporate credit spreads and lower market volatility send positive signals

Corporate spreads and the Volatility Index (VIX) peaked in the fourth quarter (2008) as the financial crisis hit its climax. Since then, both have declined significantly, indicating improving investor sentiment.

For a sustained rally in the equity markets, credit spreads are a key ingredient. Credit spreads are a leading indicator of macroeconomic business conditions, with a narrowing of spreads signaling improving investor sentiment and generally, business expansion. History has shown us that stock markets tend to trough on or about the time that credit spreads peak. Given current credit spreads, a trough appears to be in place for equity markets, although market pullbacks are still to be expected.

Market breadth improving

Market breadth is an important aspect of the equity markets as it captures whether the market is moving higher on the back of a few heavyweight stocks or whether it is a broad-based rally. Market breadth has been tracking the equity markets, and both have trended higher since the March lows. From a technical perspective, this is very encouraging.

In summary

As we head into the historically weak third quarter, the potential for near-term weakness must be kept in mind. However, longer term, a more constructive view of the U.S. stock market is developing. The confluence of data argues for this. Earnings data, while not recording year-over-year improvements, is heading in the right direction, with an increasing rate of upward revisions. Economic releases are increasingly positive, suggesting an end to the recession. Valuations, while not exceptionally cheap, leave room for upside, supported by fundamental improvements in the economy and corporate earnings. Finally, the technical picture also looks encouraging, with the S&P 500, Nasdaq and Dow 30 all breaking to new highs on strong breadth.