Stocks Still Have Upside Potential, Despite Correction Risk

We continue to think the outlook for US equities remains strong over a multi-quarter period. From a technical perspective, the monthly and quarterly charts of the S&P 500 are starting to look overbought, which previously corresponded with a cyclical top in stocks as was the case in 2000 and 2007. That being said, we are not too concerned at the moment as the price action can remain overbought for several quarters before any correction takes hold, and as we detail below, the fundamentals and valuations are not stretched either. In the event of a retracement, significant support exists at the 1,550 level, as well as trendline support at the 1,420 level should there be a more pronounced correction. These levels of support would provide good entry points for investors.

As alluded to above, although the technicals are starting to look slightly overbought, fundamentals and valuations continue to suggest further gains in US stocks over the coming quarters. In terms of the fundamentals, we highlight that earnings, profitability, leverage, monetary policy, opportunity costs and fund flows all remain supportive.

Earnings To Remain Positive Factor

US Equities Looking A Little Toppy
US - S&P 500 Equity Index & RSI (Below)

We continue to think the outlook for US equities remains strong over a multi-quarter period. From a technical perspective, the monthly and quarterly charts of the S&P 500 are starting to look overbought, which previously corresponded with a cyclical top in stocks as was the case in 2000 and 2007. That being said, we are not too concerned at the moment as the price action can remain overbought for several quarters before any correction takes hold, and as we detail below, the fundamentals and valuations are not stretched either. In the event of a retracement, significant support exists at the 1,550 level, as well as trendline support at the 1,420 level should there be a more pronounced correction. These levels of support would provide good entry points for investors.

US Equities Looking A Little Toppy
US - S&P 500 Equity Index & RSI (Below)

As alluded to above, although the technicals are starting to look slightly overbought, fundamentals and valuations continue to suggest further gains in US stocks over the coming quarters. In terms of the fundamentals, we highlight that earnings, profitability, leverage, monetary policy, opportunity costs and fund flows all remain supportive.

Earnings Beating Expectations
US - Q313 Earnings Surprises*

Earnings To Remain Positive Factor

First, from an earnings perspective, data from Yahoo Finance shows that since October 8, over 900 companies have announced earnings, which predominantly surprised analyst expectations. Indeed, 61% of companies exceeded estimates, 12% came in line, and 27% missed estimates. Moreover, a whole host of companies across different sectors reported that earnings were driven by some combination of improved pricing power, a recovery in Europe, still-strong US sales, cost cutting initiatives and a strengthening consumer. Going forward, we see several reasons to believe that earnings will continue to remain strong.

Earnings To Track PMI Higher?
US - S&P 500 Earnings Per Share (% chg y-o-y) & PMI

As the chart above illustrates, there is a strong correlation between US PMI numbers and earnings growth, and this suggests that earnings will continue to improve, particularly if upcoming PMI readings are not overly affected by the brinkmanship in Washington in recent weeks. Moreover, we highlight that profit margins for the S&P 500 remain strong at 8.7%, and we see little reason to anticipate a substantial deterioration. Typically, profit margins get hit by a combination of higher wages, rising commodity prices and higher interest payments. However, our macroeconomic and commodity forecasts suggest that none of these factors will come into play in the near future. This dynamic, combined with increased pricing power by companies and purchasing power by consumers suggests that profit margins, and hence profits should hold up.

Profit Margins Holding Up
US - S&P 500 Profit Margin (%)

Monetary Policy To Offer Fillip To Stocks

Second, monetary policy will remain supportive of stocks. US companies have deleveraged significantly since the crisis, with the ratio of debt-to-EBITDA for the S&P500 near 20 year lows at 3.6x, down from 5.7x in 2009. In addition, from a investor's standpoint, the earnings yield on the S&P 500 is 5.9%, whereas the 10-year treasury yields 2.5%, implying a spread of 3.4%, which is non-negligible for yield-seeking investors in a low interest environment. Moreover, the dividend yield on the S&P 500 currently stands at 2.0% and is in an uptrend.

Corporate Leverage Ahead?
US - Ratio of Debt to EBITDA (S&P 500) & Spread Between Earnings Yield & US Treasury (%, RHS)

Although tapering of QE is on the cards - likely early next year, either in March or April - the Fed continues to expand its balance sheet by US$85bn by month, and will only taper slowly, particularly given the budget and debt-ceiling showdown in Washington, which we believe will weigh slightly on Q4 growth. This means that the Fed's balance sheet will continue to grow over the next few quarters, which is positive for US stocks and risk assets in general.

Fed's Balance Sheet To Remain Supportive
US - Federal Reserve Balance Sheet, US$mn

Investor Sentiment Turning In Favour of Equities

Third, from an asset allocation point of view, we still expect a sustainable US economic recovery and rising bond yields to force investors out of the bond market and into the equity market. During the global financial crisis investors piled into safe-haven assets such as US Treasuries and reduced their exposure to equities. Data shows that the reversal of this trend is well under way, which provides support for stocks and risk assets. In the first eight months of 2013, flows into equities by mutual funds have rose by US$754bn, compared to outflows of US$196bn over the same period in 2012. Similarly, last year there were inflows of US$991bn into bonds in the first eight months of the year, but declined to US$366bn this year as investors started to re-allocate their capital.

Equities Back In Fashion
US - Annual Cumulative Mutual Flows Into Equities and Bonds, US$m

Valuations Are Not Expensive Enough To Signal A Cyclical Peak

Although valuations are not necessarily cheap anymore, they are not expensive either, which suggests potential for additional multiple expansion before equity markets run out of steam. The 12-month trailing Price-to-Earnings (P/E) ratio for the S&P 500 is currently 16.8x, just above its 10-year average of 16.4x, but below its 20-year average. Moreover, the Price-to-Book ratio (P/B) is at 2.6x, which is also just above the 10-year average, but well below the 20-year average. This suggests that equities could head higher still before becoming overbought. Lastly, we highlight that there is historical evidence to show that multiple expansion is correlated with rising real yields, which will occur as monetary policy starts normalising over the coming quarters.

Room For Multiple Expansion Ahead
US - Price-to-Earnings & Price-To-Book Ratios (RHS)

Risks To Outlook

Although we remain bullish US equities, we do highlight a number of downside risks. First, given that the S&P 500 is trading near the channel uptrend and is overbought according to several momentum indicators, there could be see a sizeable short-term correction before the index heads higher again. Second, earnings growth, which have in part been driven by cost cutting, could be hit by slower-than-expected revenue growth should US and global growth disappoint. Third, given that many US corporates have increased their exposure to emerging markets, a stronger US dollar over the coming months could weigh on repatriated earnings, hitting top line revenue figures.

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This article is tagged to:
Sector: Country Risk
Geography: United States
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