Analysts are predicting a 10.6% jump in profits, which seems too optimistic. Three sectors look promising: tech, materials, and financials.
Once again, consensus estimates seem overly optimistic.
Consensus bottom-up forecasts see earnings generated by companies in the Standard & Poor's 500 index expanding 10.6% in 2014 to a new record high of almost $120 per share. That would mark a big improvement over 2013, which is on track for a 4%-5% gain.
To be sure, investors have good reason to expect better profit growth next year. The U.S. economy is strengthening, and even Europe, long the scapegoat for weak earnings by U.S. multinationals, seems to be on the upswing.
Still, forecasts require tempering. Wall Street analysts often set the bar too high when predicting outcomes far in the future, and there is much to suggest that 10% bottom-line growth is unachievable. For starters, revenue growth looks to be anemic.
"There could be double-digit profit growth in 2014, but at this point, it looks like a bit of a stretch to get there," says Tobias Levkovich, chief U.S. equities strategist at Citigroup's CitiResearch.
The unofficial start of the fourth-quarter earnings season is Jan. 9, when Alcoa (ticker: AA) releases its financial results. Wall Street's (lowered) expectations call for the S&P 500 to close the books on the 2013 calendar year with earnings of nearly $109 a share, a 4.7% rise over 2012. A year ago, full-year estimates called for 10% profit growth by the S&P 500 in 2013.
The recent earnings trend has not been positive. Since Sept. 30, a record-high 94 members of the S&P 500, including Target (TGT), Starbucks (SBUX), Cisco Systems (CSCO), and Honeywell (HON) have unveiled fourth-quarter earnings forecasts that missed sell-side estimates. A record-low 13 firms have issued positive guidance, according to FactSet Research.
China's slowing economy, as well as dim prospects from retailers and the government shutdown in October are partly to blame.
Looking ahead, there are some positive developments. Europe's recession ended last year and a recovery is underway. The budget deal passed by Congress will loosen government purse strings a bit. Bulls expect a recent pickup in both hiring and capital spending by corporations to continue into next year. And rising stock prices and higher home prices have fueled spending by some consumers and boosted confidence that the U.S. economy will continue to improve.
Corporate America, however, has relied heavily on share buybacks and cost cuts, rather than revenue gains, to fuel profit growth. Profit margins are already at record highs, having edged up to 9.7% during the third quarter of 2013. Increased hiring and more capital spending aren't the stuff of expanding profitability.
Revenue growth, meanwhile, isn't going to save the day. At 4%, it's picking up steam compared to the 2% that 2013 is on track to deliver. But far faster revenue growth is needed for the S&P 500 to expand its bottom line at a 10% pace, says Howard Silverblatt, chief statistician at S&P Dow Jones Indices.
None of this stopped the U.S. equity gauges from ending 2013 at record highs. The S&P 500 posted its biggest annual advance since 1997, with a total return of 32.4%. It now trades at 15.4 times (rosy) 2014 earnings estimates.
Whether the market is cheap, expensive, or fairly valued is a topic of considerable debate. Market strategists—the top-down thinkers on Wall Street—surveyed by Barron's (see "Bullish on 2014," Dec. 14) expect far more muted gains for stocks this year, with targets that range from 1,900 to 2,100 for the S&P 500.
Meanwhile, strategists surveyed by FactSet Research expect roughly 8% profit growth next year, which would take the S&P's per-share earnings to $118.
"The margin expansion story is done, but I do see a better year ahead for the economy, which should translate into earnings growth" says David Rosenberg, chief economist and strategist at Gluskin, Sheff & Associates. "Earnings should do the heavy lifting for the market."
Among stock sectors, technology is favored by many investment pros.
Already pressured by falling demand for laptops and personal computers, profits for many companies were hit hard by China's slowing economy. But those earnings are expected to turnaround in 2014, climbing more than 9% compared to last year's 2% rise.
Granted, a slowing China remains a concern. Still, analysts see corporations spending more on information technology and expect PC sales to rebound in 2014, as Microsoft (MSFT) ends its official support of Windows XP, which could prod corporations to upgrade to machines running Windows 8.
Analysts have high hopes for the materials sector—the mean estimate is that earnings will climb 15% this year, according to FactSet. Telecom services could rise almost 13%, fueled in part by rising popularity of "cloud" technology, as more enterprises outsource some functions of their data centers to be run by Verizon (VZ) and other cloud-computing operators.
And in the financial sector, the Street sees profits rising roughly 11% this year, boosted by rising prospects for property and casualty insurance companies.
Opinions on consumer discretionary stocks remain mixed despite the Street's forecast for almost 16% growth this year. The sector delivered among the strongest returns last year, fueled by media companies, a rebounding housing market and automobile sales. But Citigroup's Levkovich says the stocks look expensive.
Or as Brian Belski, chief investment strategist at BMO Capital markets, puts it, "too many people who are too bullish and looking for too much."
Still, more than a few pundits argue that profit margins have room to edge a bit higher this year, perhaps to 10.4%. And share repurchase programs are expected to remain a tailwind for earnings this year, especially as activist shareholders increasingly flex their muscles, says S&P Dow Jones Indices Silverblatt.
Still, investors should not count on a rapid ramp up in earnings this year. "Slow and steady works pretty well," says Silverblatt. "It's boring, but it works."
