Why I'm optimistic about earnings and the economy

By Banu Simmons

While the S&P 500 Index (SPX) had a rocky start in January 2014, the bull market returned in the second half of February. The outlook for the global economy remains favorable, despite some weak economic data from the US and the currency turmoil and capital outflows in some emerging countries.

In the United States, some of the disappointing economic data were attributed to unusually cold winter weather which disrupted economic activity in January and February of this year. Moreover, U.S. economic growth in the fourth quarter of 2013 turned out to be 2.4%, a slower rate than previous estimate of Bureau of Economic Analysis (3.2%).

The downward growth revision was attributed to smaller-than-previously estimated growth in personal consumption expenditures and downward revisions to business investment in inventories and exports, and government spending.

Furthermore, economic indicators such as the U.S. pending home sales came out weaker than expected in February. This, coupled with higher than expected initial jobless claims, raised concerns in financial markets with regard to the strength of the recovery.

I am less concerned about the health of the US economy and expect annual real GDP growth in excess of 2.7% in 2014, even though the cold weather might cause GDP to grow at a slower pace in the first quarter.

I believe that the government budget deficit has been a drag on the economy in the past year, whereas in 2014, recovery will not be curbed by such fiscal issues. Furthermore, despite the downward revision in February, consumer spending has been growing fastest since 2011, which increases our confidence with regard to improving economic fundamentals.

On the basis of the company earning-reports for the fourth quarter of the last year I remain fairly optimistic about future earnings, despite having some reservations with respect to the slow growth of capital spending.

By mid-February, most of the companies included in the S&P 500 had published their earnings results for 2013 Q4 and around 65% of them reported better revenue than expected and more than 75% reported better net income, i.e. bottom-line results than expected.

I continue to believe that any threats to the global recovery is likely to stem from emerging markets. Growing indebtedness of the Chinese economy raises questions about the sustainability of the 7.5% growth target in the long term. Furthermore, increasing political risks in certain parts of the world could potentially damage global economic recovery.

In the light of the growing crisis in Ukraine, the near term financial market volatility may increase as investors are generally more nervous about a market correction than they were last year. Although the size of the economy in Ukraine is too small to have a long-lasting impact on global economy, depending on the length of the trouble, a rally in precious metals might be expected.

In February, I made various changes to our portfolio. I sold Expo Nafta (EXPE), which according to our stock selection method, reached its fair value. I also sold the gas stock Southwestern Energy (SWN) after releasing its earnings which beat the market estimate.

Gas prices had a good run in the last two months owing to the cold weather in the US. I reduced our exposure to the energy sector, given that the manufacturing sector capacity utilization is not yet strong enough to justify further rallies in gas and oil in the near future.

I also made some additions to our portfolio in February. As a long-term thematic investment allocation, I bought 3D Systems (DDD) and Stratasys (SSYS) in the 3-D printing sector. In my opinion, these stocks have potential for medium- to long-term outperformance despite already having had a good run last year.

DDD posted record quarterly and annual revenue, up 52% and 45% year compared to 2012 Q4, respectively. The company's R&D expenditure increased 53%, which coupled with new product launches and joint development partnerships seem to indicate higher long-term growth potential in a rapidly expanding market.

Stratasys (SSYS) also beat the revenue estimates of the market. The company's subsidiary MakerBot made a significant contribution to fourth quarter revenue, owing to its affordable desktop 3D printers which shows very strong positive sales momentum.

While the purchases above were growth stocks with growing demand potential, we also made a purchase on valuation basis. I added Lockheed Martin (LMT) to our portfolio.

This stock stands out as a value stock with a high return on equity and high dividend rate, and it had lately a trend of positive earnings surprises. I believe that the US defense cuts are already priced in.

DISCLAIMER: The investments discussed are held in client accounts as of February 28, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
Banu Simmons

Banu Simmons

I have a decade of financial sector experience as an econometrician/quantitative analyst. Furthermore, I conduct academic research on equity analysis

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