The title of Blackstone Vice Chairman Byron Wien’s latest monthly investment commentary says it all: “
Worried About the Second Half.”
Wall Street’s consensus view is that the American economy, which has recorded lackluster growth for much of the past five years since the 2008 recession, will finally take off in the second half, giving stocks the impetus for a renewed move higher.
Wien is not so sure. The veteran investment strategist has written extensively about his view that profit margins are peaking.
In his commentary, Wien revisits this theme (emphasis added):
Although there is a palpable degree of optimism about corporate performance in the second half of this year, I wonder if it is justified. Companies have generally beaten analysts’ estimates more than two-thirds of the time so far this year, but I think that is mostly because management guided estimates lower so the results would compare favourably. That was certainly the case for Alcoa and Coca-Cola. United Parcel Service did not prepare the market for disappointment and the stock declined sharply. In the technology sector Microsoft, Intel and Google missed estimates. Second-quarter earnings are only expected to be up 2% over 2012 levels and full-year estimates are only projected to grow 4% — 6% over last year, with much of that improvement coming from stronger performance in the second half.
It is unlikely that we are going to see better earnings if sales don’t improve. Second-quarter sales are only expected to rise 1.25% over last year and full-year estimates are for a 2.75% increase. If there is some pressure on margins from modestly higher labour costs, depreciation and energy prices, that meager level of revenue improvement may not be enough to keep margins from eroding. It has been my view that profit margins are peaking and we should see if that observation is correct in the second half of 2013.
I still think the economy will grow at 2% this year, but I worry that final sales will not be enough to offset some margin deterioration. As a result I fear that earnings will be below estimates. I have been worried about economic growth and earnings all year and the Standard & Poor’s 500 has kept working its way higher. The liquidity being provided by the Fed is responsible for that. Valuations are still reasonable and if the easy money policy continues, I recognise that stocks can move up more from here. I think earnings will be below estimates, but investors may not care as long as the Fed’s bond buying program continues. Right now the S&P 500 is trading somewhat above 15 times consensus earnings and slightly more than 16 times the earnings level that reflects a reasonable degree of disappointment. This is not an extreme level of overvaluation, even considering the recent rise in interest rates. Investor sentiment is in optimistic territory, near the level that has signaled a likely decline in the past. Companies have considerable cash on their balance sheets, some of which will be used to buy back stock. That could increase earnings per share, offsetting earnings shortfalls.
“While a higher high may be ahead, at some point the Fed will slow its accommodation and investors will recognise the implications of slow economic growth and very modest earnings improvement,” Wien concludes. “That is why I believe a degree of caution is warranted.”
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