Fedís underlying message a bad signal for US profit growth

Sep 24 2013, 10:37 IST
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SummaryThe euphoria with which investors in the US stock market greeted the Federal Reserve's decision to stick with its easy-money policy has begun to evaporate, as the message the Fed was sending about a less-than-stellar economy sinks in.

The euphoria with which investors in the US stock market greeted the Federal Reserve's decision to stick with its easy-money policy has begun to evaporate, as the message the Fed was sending about a less-than-stellar economy sinks in.

An economy still in need of a safety net may be too weak to produce robust earnings growth, meaning that the Standard & Poor's 500 valuation, now at its most expensive on a price-to-earnings basis since 2010, becomes harder to justify.

The Standard & Poor's 500 is up 20% so far this year and hit new highs last week, boosting the index's forward price-to-earnings ratio to 14.94, its highest since early 2010. At that time, though, company earnings were improving more rapidly than now as business activity rebounded from the depths of the recession and financial crisis in 2007-09.

Profit growth for 2013 is expected at about 6%, a far cry from the 31% achieved in 2010. That undermines the case for further gains in stock prices and has led some investors to consider reducing their earnings forecasts.

"The Fed's no-confidence vote in the economy really causes us to revisit our profit estimates for the rest of this year and next," said Leo Grohowski, chief investment officer at BNY Mellon Wealth Management in New York. "I would not be surprised to see consensus numbers get adjusted." Investors are more likely to be prepared to pay higher prices for shares if they think earnings are expected to rise, so if current profit expectations fail to materialise, valuations could be stretched.

Markets had expected the Fed last Wednesday to cut back on its $85-billion-a-month in bond purchases, which have been behind its efforts to spur economic growth, and have injected money into the financial system. Instead, the Fed kept its stimulus in place and cut its projections for economic growth in 2013 and 2014.

Despite the weaker forecast, stocks jumped, but on Thursday and Friday the markets largely gave back the gains, partly amid fears of a government shutdown or debt default because of political gridlock in Washington but also because of concerns that prices had got overextended.

Now, investors' focus in the next few weeks is going to be on both Congress and third-quarter results, both of which will help show whether the Fed's prudence was warranted.

If stocks hold up it may be because of a rally in the bond market since the Fed announcement makes Treasuries less attractive. The

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