After moving sideways for the past two years, U.S. corporate earnings may be poised for reacceleration in 2014. While the growth is likely to be modest, we believe investors may be overlooking the potential for improvement. There appears to be a general belief that earnings are entirely dependent on external factors such as the Federal Reserve stimulus, and that margins have peaked with nowhere to go but down. While there is a cyclical component to earnings, it seems unlikely that margins are peaking when U.S. hard-goods spending is well below trend and factory utilization also remains low.
If modest global economic growth continues, we believe margins can move higher from current levels, and thereby help to push up earnings. Earnings growth in the third quarter of 2013 was the highest we have seen since early 2012. Two issues that had been weighing on earnings — the double-dip recession in Europe and slowing growth in China — have abated. Revenue growth has also shown signs of improvement, and we believe high-single-digit earnings growth is possible in 2014.
When we consider the combination of valuation, fundamentals, and sentiment in today’s environment, we believe the U.S. equity market’s 2013 advance was rational. However, this performance was top quartile by historical measures, and our outlook is more tempered heading into 2014. Equity valuations are at the middle of their historical range. With stocks at average valuations, our expectation should be for average returns.