Earnings Strength Likely to Continue

by Bob Doll, Chief Equity Strategist, Fundamental Equities, BlackRock

Equity markets rose again last week, continuing the rally that has been in place since early September. The Dow Jones Industrial Average climbed 0.6% to end the week at 11,133, the S&P 500 Index advanced 0.6% to 1,183 and the Nasdaq Composite rose 0.4% to 2,479.

The impetus of the now month-and-a-half long market rally was the end of a consistent downgrading of economic growth prospects and the possibility (soon to be a reality) of additional action on the part of the world’s central banks to combat the still-present risks of deflation. On the economic front, recent data has been somewhat mixed, but is certainly stronger than it was over the summer. The Index of Leading Economic Indicators rose 0.3% in September, meeting expectations. Compared to one year ago, the index is up 6%. As the recovery has progressed, that growth rate has slowed significantly, which is consistent with our view that the pace of the economic recovery is slowing as well. The question, of course, is how significant that slowdown will be. Housing remains very weak and is acting as a drag on overall economic growth. The corporate sector, in contrast, is a source of strength, with capital expenditures remaining positive. The labor market remains the key to an improved economic environment since increased employment levels would result in higher levels of consumer spending and would also help put a floor under the fragile real estate market.

Regarding central bank asset purchases, we have already seen the Bank of Japan begin its new quantitative easing program and investors expect that the Federal Reserve will announce its program at its upcoming policy meeting in early November. There remains a great deal of debate surrounding whether the central bank will launch an open-ended monthly purchase plan or a total fixed-budget plan. Our guess is that it is likely to be closer to the former and that the Fed will want to adopt an incremental and flexible approach that still underlines its commitment to reflate the US economy. Additionally, we think it is important that central banks around the world work in a coordinated fashion to avoid the “beggar thy neighbor” policies of protectionism and currency wars.

In addition to the economic and quantitative easing factors that have helped markets move higher in recent weeks, third-quarter corporate earnings results have also been strong. At this point, approximately 30% of S&P 500 companies have reported results and upside surprises are exceeding downside misses by about a 6-to-1 ratio, an impressive figure that has been helped by noticeable improvements in revenue growth. Looking ahead, we expect that the pace of earnings growth is likely to slow somewhat in the quarters ahead and that year-over-year comparisons will become more difficult given recent strength. Nevertheless, we still expect to see a good environment for corporate earnings into 2011.

With deflationary threats still present in the United States, there is a growing concern that the United States will fall victim to the same sort of debt crisis that has been plaguing Europe in 2010. From our vantage point, this is unlikely to occur, at least for the next few years. As of now, the US dollar remains the world’s primary reserve currency and is still the favored safe haven in times of panic. Over the longer term, however, we agree that the United States will need to undergo a politically difficult fiscal adjustment. Near-term ongoing stimulus remains important since the economy is still in a fragile state, but the United States does need to address the longer-term issues of high deficits and structural imbalances. We expect to see some combination of higher tax rates, lower spending and entitlement reform that could include raising the retirement age means-testing in the future.

Although market conditions have improved in recent weeks, an air of uncertainty persists, with the future direction of the economy remaining cloudy. Equity markets continue to price in modest economic recovery, a scenario with which we would agree. In addition to uncertainty around how the macroeconomic environment will impact financial assets, one key issue for stocks in the year ahead will be whether corporate earnings are able to hold up in the face of low nominal growth. As we indicated earlier, we believe they will, which should allow stock prices to continue their grind higher. We would also point out that equity markets do not need to rise by much in order to outperform cash and Treasuries in the current environment. Additionally, we would note that in the current rally, correlations between sectors and individual stocks have been falling. In this sort of environment, selectivity has become more critical, a trend we expect will persist.