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Bold start to Q2 earnings season

by Community Manager

‎07-16-2014 02:17 PM

Market commentaryBy John Jares, assistant vice president of equity investments


We’re still early in earnings season for the second quarter, but if the yardstick of success is companies posting better-than-expected results, we’re off to a strong start.


Last week, aluminum producer Alcoa kicked off the season by reporting that profits on its continuing operations tripled compared to a year earlier, and the company increased its growth forecast for the year. Several of the largest U.S. financial, health care and technology companies followed Alcoa’s lead this week by also beating Wall Street’s expectations in both revenue and earnings, and some also raised their outlook for the rest of 2014.


We’ve only heard from a small sample of the Standard & Poor’s 500, but the fact that the positive revenue and earnings trend is being seen across a number of sectors could mean more good news is coming.


The results offer more support for the view that the U.S. economy is on decent footing and is positioned to strengthen further in the second half of the year. We’re seeing more jobs created, more consumer spending and more industrial activity, and at the same time, we’re not seeing much of an increase in inflation. Taken together, the data suggest that we are still in the expansionary stage of the business cycle, which is when equities have done well historically.


Of course, equities have been doing well for more than five years now, as the S&P 500 has gone up more than threefold since hitting bottom in March 2009. Fundamental valuation metrics, such as price-to-earnings and price-to-sales ratios, and profit margins are now above their long-term average, which invites some healthy skepticism regarding how much higher the market can climb. A good argument, however, could be made that we are still in the middle innings of the business cycle, and if that’s the case, there remains room for valuations and margins to further expand.


Late last week, as part of an article previewing second-quarter earnings, Barron’s aggregated the analyst expectations for earnings growth and revenue growth for each of the 10 sectors of the S&P 500. Revenue growth has been the missing component during the current bull market, with earnings growth instead being driven largely by cost cutting, corporate debt refinancing and share repurchases. Like other investors, we have been watching for signs of an upswing in revenue to provide additional support for equity valuations.


The analyst forecast is for second-quarter revenue to grow overall by 2.7 percent, less than the quarter’s expected GDP growth rate, but a number of the individual sectors — notably health care, technology and consumer discretionary — are predicted to see far stronger revenue growth compared to the second quarter of 2013.


Revenue in the health care sector is growing due to the aging baby boomer population and also the Affordable Care Act, which is adding more participants to the system. As volumes go up, care providers and pharmaceutical makers are able to improve operating margins as fixed costs are leveraged. In technology, the recent trend of businesses establishing and growing their online presence is being joined by sizable outlays to replace old equipment underlying that presence.


The analyst forecast in Barron’s calls for revenue growth in the consumer discretionary sector to be nearly twice the overall average. Granted, this growth would be from a relatively low comparable, but consumer spending represents, by far, the largest chunk of U.S. GDP, so faster growth could provide a meaningful lift to the broader economy. Some signs of growth already can be seen: Retail spending has been picking up after a bumpy start to the year, and we’re seeing more leisure travel, which has increased the pricing power of air carriers and hotel chains.


We currently have a slight underweight to U.S. large-cap equities compared to the benchmark, mostly due to valuation concerns and the prolonged weak trend in revenue growth. While the second quarter’s numbers will have the market’s attention for the next few weeks, our main interest as long-term investors is what those numbers may imply for the quarters ahead.


USAA Investments Managed Portfolio Outlook

Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. While signs point to continued recovery of U.S. economy, valuations are no longer cheap and profit margins are near record highs.


We are tactically underweight fixed income, primarily to fund a deployable cash position. Within fixed income, we prefer areas of the market that are more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate bonds and high-yield bonds. The USAA Intermediate Term Bond Fund and the USAA High Income Fund fit this profile.


We are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund provides potential protection against the risks of long-term inflation.


We are overweight non-U.S. developed markets and emerging markets based on relative valuations. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. Along with compelling valuations, they offer an interesting long-term prospect for growth. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.


As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for your individual goals, objectives, risk tolerance and time horizon.


This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.


Consider the investment objectives, risks, charges and expenses of the USAA mutual funds carefully before investing. Contact us at 1-800-531-8910 for a prospectus containing this and other information about the funds from USAA Investment Management Company, Distributor. Read it carefully before investing.


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Past performance is no guarantee of future results.


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The Russell 2000® Index is an unmanaged index which consists of the 2,000 smallest companies in the Russell 3,000 Index, and is a widely recognized small cap index.


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Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers.


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