S&P 500 corporate earnings in 2013 likely grew about 6 percent. The S&P 500 price index, however, grew 29.6 percent. The difference between the growth in earnings and the growth in the price index amounts to P/E expansion.
What makes P/Es expand? Many things, including inflation, interest rates, tax rates, etc. However, in 2013, tax rates, inflation and interest rates remained little changed. What powered the 23 percent growth in the P/E that in turn powered the 30 percent growth in the market was growth in expectations for 2014.
The U.S. economy is widely expected to grow at better than a 3 percent rate in 2014 compared with a 2 percent rate in 2013. Corporate revenues within the S&P 500 should grow 3.8 percent in 2014 compared with 1.8 percent in 2013. Earnings should grow 10.8 percent compared with 5.7 percent in 2013. Therefore, dirty math derives that GDP should grow 50 percent faster, corporate revenues 111 percent faster and corporate earnings 90 percent faster than in 2013. Fasten your seat belts!
These hurdles are high. Real U.S. GDP has averaged less than 3 percent since the ’70s, and earnings historically grow less than 7 percent. However, with federal policies creating less of a drag and housing and employment rising, the case for an above average environment may rightly deserve an above average P/E.
Investment Returns = Reality Minus Expectations
Unfortunately, with expectations above average, the opportunity for reality to come in below average is above average as well. Recall that when reality exceeds expectations, markets typically rise. When expectations exceed reality, markets typically struggle.
So far, in 2014, the S&P 500 stands .50 percent lower on the year. Because expectations are high, earnings reports and conference calls are receiving high scrutiny. Accordingly, market analysis has shifted from macro to micro. Best Buy tells this week’s cautionary tale.
After rising 242 percent in 2013 on high hopes, the stock fell 30 percent after its earnings release failed to fulfill expectations. Conversely, SunTrust Bank reported numbers that well exceeded expectations, nudging the stock up 3 percent. In an environment of high expectations, positive surprises are met with smiles, while negative surprises are met with tantrums.
We think the first order of business for 2014 is to lower expectations overall. The economy may grow over 3 percent and revenues may rise, but earnings have headwinds. Low interest rates and tax bills have greatly expanded profit margins. Should interest rates and tax bills rise, profit margins will fall. Decreasing margins makes translating sales into profits more difficult.
Add to that the usual array of geopolitical risks, Chinese growth transitions and central bank policy uncertainties, and the risks to sub-optimal reality remain. The second order of business is to locate areas of low expectations within the markets where the reality hurdles are lower.
Bottom Line: In an environment of high expectations, you should expect more market volatility, lower stock correlations and better returns from your active money managers. The market will shift in 2014 from a market where everyone wins to one with both winners and losers.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.