US equity investors ignore warning signs

As US equity investors bid adieu to the weakest first quarter in five years, few are dwelling on the lacklustre performance.

Indeed, many appear to be ignoring any warning signs about the economy's prospects: a disappointing 0.5 per cent gain on S&P 500 in the first three months, set against the strong performance of long-dated bonds since January. More than ever, with the equity market bull run in its sixth year, there is optimism that stocks will enjoy further gains.

The bull case for equities largely comes down to three factors. These are expectations of a stronger economy later this year, monetary policy remaining highly supportive; while the return of retail investors is only in its early stages.

Such thinking by investors means disappointing data and a sharp reduction in first-quarter earnings growth estimates for S&P 500 companies is being played down, while the recent turbulence seen in high-flying biotechnology and internet stocks is not seen as a sign of brewing trouble, rather a healthy correction.

Carmine Grigoli, chief investment strategist at Mizuho Securities, expects the S&P 500 will reach 2,075 by late summer on the back of stronger profit growth.

"The crucial issue for the stock market is whether we see the economy accelerate during the second half," he says.

For now, then, both bond and equity investors are in a state of suspense until May, when they can gauge whether the tone of data for April confirms a rebound in activity after the harsh US winter.

"The first quarter [for the economy] is clearly a write-off. We need to wait until we see April's data," says Andrew Milligan, head of global strategy at Standard Life Investments.

Before the widely expected spring rebound, there is the matter of the first-quarter earnings season in the coming weeks. Expectations are grim.

Analysts have cut sharply their expectations for S&P 500 earnings growth since January to minus 0.4 per cent from a year-on-year rise of 4.4 per cent, according to FactSet. Yet, they see first-quarter revenues expanding 2.5 per cent, so the contraction in earnings suggests companies are facing higher costs.

"Once first-quarter earnings start to come out, we are probably going to see pretty decent top line numbers, but also a compression on multiples," says Oliver Pursche, a portfolio manager at Gary Goldberg Financial Services.

Much, therefore, depends on companies delivering upbeat guidance for the coming quarters, given current valuations for stocks - the 12-month forward price to earnings ratio is 15.3 times, well above its 10-year average of 13.8 times.

"Most people remain hopeful about earnings performance in the second half of the year because the economic data are still supportive," says Mr Pursche.

Slides in forecast earnings for Amazon, Expedia, General Motors, Best Buy and Mattel have resulted in expected profits growth for the consumer discretionary sector falling to 4.4 per cent from a prior estimate of 12.8 per cent.

Investors' faith has helped the S&P 500 set a series of record highs since the start of the year, but the broad market's rise of just 1.3 per cent since January marks its weakest first-quarter performance since the opening three months of 2009, when stocks hit rock bottom during the financial crisis.

By contrast, long-term bonds have recorded a total return of 5.3 per cent this year, according to the Barclays US Aggregate index, with long-dated Treasuries up 7.7 per cent.

This has occurred in spite of the Fed reducing its purchases of long-term bonds, while the possibility of rate hikes arriving before mid-2015 should the economy gain speed in the coming quarters emerged after the central bank's policy meeting last month.

"There is still a bit of suspicion in the bond market that there is something more to the economy's slowdown than the cold weather," says Michael Fredericks, portfolio manager at BlackRock.

This has played out in the equity market, with economically sensitive sectors such as consumer and industrial stocks lagging behind, while bond-like proxies, notably utilities and real estate investment trusts, have rallied sharply.

The sharp drop in long-term bond yields since January has certainly emerged as a forceful counter to the Fed's forecast of higher growth and inflation this year and optimism among equity bulls.

"For long-term investors to be placing more and more assets in 30-year bonds as yields fall, the message is very clear that the expected combination of growth and inflation over the investment period has moved significantly lower in recent months," says Richard Gilhooly, strategist at TD Securities.

"This forecast, backed by real money and consistent flows, is a better indicator than forecasts based off spot economic data that have been notoriously wrong in recent years." As the calendar heads into spring, the economy is likely to assume even more importance.

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