U.S. stock markets have hit record highs recently, but lacklustre earnings growth across corporate North America is providing a reality check for investors.
Both earnings and revenues are expanding at a low single-digit pace, indicating that economic growth, particularly in the United States, remains short of optimistic forecasts earlier this year.
Despite a few high profile surprises from companies such as Verizon and Microsoft, bright spots have been the exception rather than the rule so far this earnings season, suggesting that caution may be in order for investors.
"While valuations might still be appealing, they are no longer compelling," said Sam Stovall, chief equity strategist at S&P Capital IQ. "It makes me become less and less enthusiastic about pounding the table."
Based on the 213 of the S&P 500 companies that have reported so far in the third quarter, earnings are on track to grow 4.1 per cent, according to data from S&P Capital IQ. That is down from 4.9 per cent growth for the previous quarter and 5.2 per cent growth for the first three months of the year.
Revenues, which are less susceptible to accounting manipulation than earnings, are on track to grow at an annual pace of 3.8 per cent. That is heartening as it comes after a drop of 0.6 per cent in the second quarter and meagre 1.1-per-cent growth in the first quarter, but observers caution against reading too much into the sales gains.
"It's encouraging, but I'm going to still be a bit suspicious because last quarter's numbers were so weak," Mr. Stovall said.
The sector in the S&P 500 with the fastest growing earnings per share is telecom, which is expected to show a 27 per cent increase. However, part of that gain is the result of Sprint Nextel Corp. falling out of the index following its recent takeover by Japan's Softbank, which removes its losses from the calculation.
The energy sector is projected to be the biggest laggard, with earnings per share down 7.5 per cent.
Of the 213 companies that have reported, about two-thirds have beat analyst expectations, while 43 have missed and 29 have met, S&P Capital IQ said. Among 48 companies that have provided guidance for what investors can expect in the fourth quarter, 37 are negative, meaning that the new guidance is below previous expectations. Eight are positive and three are in line with previous forecasts.
"This produces a negative-to-positive ratio of 4.6, higher than the 15-year average," S&P Capital said in a report Thursday.
American companies such as Black & Decker Corp., EMC Corp. and Linear Technology Corp. have been quick to blame the recent 16-day U.S. government shutdown for lower earnings expectations for the last quarter of the year.
Another negative signal for investors came Thursday when the latest U.S. manufacturing data showed growth was at its slowest pace in a year this month, while factory output contracted for the first time since late 2009, according to Reuters.
Analysts say U.S. consumers and businesses are being cautious about spending, which is evident in the third-quarter revenue numbers.
Given that U.S. GDP is growing at an anemic rate of about 2 per cent, investors should expect more of the same low single-digit growth in earnings next year, says Paul Taylor, chief investment officer, fundamental equities, at BMO Asset Management Inc.
"What we've seen over the past 12 months is what we'll see over the next 12 months," Mr. Taylor said.
It's a similar story in Canada, where analyst are projecting earnings growth of 6 per cent, according to numbers crunched by CIBC economist Peter Buchanan.
Canada's earnings season is just getting started, but Mr. Buchanan expected growth among S&P/TSX Composite companies to be driven by the energy sector, unlike in the U.S., as well as health care, utilities and financials. Earnings will be weighed down by the mining sector, as it continues to struggle with rising costs and falling commodities.
While markets in both the United States and Canada appear reasonably valued in relation to profits, stocks are becoming expensive when compared to revenue.
John Hussman, manager of the Hussman Funds in Maryland, said in a note this week that the S&P 500 is valued at 1.6 times sales – about twice its norm before a 1990s bull market led by Internet stocks. A noted bear, Mr. Hussman predicts that the S&P will deliver a 2.6-per-cent average annual return for the next decade. That compares to a 22.5-per-cent return for the S&P 500 so far this year.