What’s in Store for U.S. Equities?

Equity returns this quarter have been a mixed bag, although across most sectors, business fundamentals look reassuring.

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Returns from U.S. equities are moderating, and stock market volatility is on the rise. We can hardly complain. Equity market performance over the past few years has been nothing short of spectacular, and since 2011 volatility has been very subdued as well.

The three drivers behind these excellent returns are low valuations, strong profits and low interest rates, and the first is now clearly in the past, with the S&P 500 trading at around 17 times our forecast of normalized profits.

For the most part, companies are still performing well, with upside ahead as the domestic economy continues to grow and financial sector conditions normalize. We have lowered our own earnings expectations and expect aggregate earnings per share this year to be more modest; however, excluding the energy sector, we expect EPS growth to be similar to 2014. We at J.P. Morgan Asset Management see only 2 percent growth in revenue, as lower oil prices and a strong U.S. dollar weigh on results.

The macroeconomic backdrop for the stock market is mixed. Most companies report improving business conditions in the U.S., although economists have again been revising downward their GDP forecasts. There are also increasing concerns about weakness in several emerging markets, including Brazil, Russia and China.

The weakness in earnings is concentrated in the energy and commodity sectors, where profits will drop by at least 50 percent this year, and in the big overseas earners, with the trade-weighted dollar index more than 20 percent higher than a year ago.

The market is still only in the middle stages of the business cycle, and the underlying business fundamentals in most industries continue to look very good. Gains may well continue to power on from here. Meanwhile, dividends are rising faster than profits, and share repurchases are at a record high. With cash flows and balance sheets strong, investment spending subdued and a growing cadre of activist investors putting more management teams under pressure, we expect the return of capital to shareholders to remain a key feature of this business cycle.

Mergers and acquisitions are on the rise, and so far most deals seem sensible; with no return on cash available, they are typically accretive to earnings as well. So we see the strength of the corporate sector as supporting stock prices, even as headline earnings will be pretty much flat this year.

Interest rates are of course still incredibly low. We could see an increase of more than 1 percentage point in long-term bond yields before the valuation of equities is called into question.

The financial sector is a place where we still find plenty of appealing stocks, particularly from a core and value equities standpoint. Higher interest rates and lower legal costs should add to existing trends toward strong credit quality and better loan growth, and there is room for at least cyclical improvement in investment banking profits as well. We also find many attractive names in the consumer cyclical industries.

Conversely, the high prices and limited growth opportunities of many utility, telecom, real estate and consumer staple stocks hold little appeal. From a growth investing perspective, we see plenty of opportunity in the long-standing favorite sectors of biotechnology and social media, and we have also been adding to semiconductor investments and good-quality companies that stand to benefit from a potentially long-lived recovery in the housing market.

Paul Quinsee is chief investment officer of U.S. equities at J.P. Morgan Asset Management in New York.

See J.P. Morgan’s disclaimer.

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