S&P 500 earnings are predicted to rise 7% in the December quarter. Three months ago the forecast was 15%. Over the same time the economics community raised its outlook for GDP growth and employment. Part of the shortfall stems from weaker than expected bank earnings. The main culprit, though, is declining productivity. The number of units is going up, bolstered mainly by a pick-up in consumer spending. But unit costs are increasing, too. Since early 2009 profit margins had been expanding, driving up profits faster than sales. That trend has now reversed, at least temporarily. Analysts predict that S&P 500 earnings will grow 4% in Q1 and another 4% in Q2. Then they see things accelerating in the second half of the year, which is a customary way of looking at things on Wall Street.
It's a complicated situation with plenty of cross currents. It's possible the conventional view will prove correct. The U.S. Dollar has appreciated in value by 10% against the euro over the last two months, though. That alone could throw today's predictions off the mark. Foreign profits will be translated at less favorable rates going forward, if the new scenario holds. Plus U.S. exports will be placed at a competitive disadvantage to European producers. The tailwind exports are providing to U.S. business could slow in upcoming periods. Slower growth around the world could amplify the impact. We'll see how that goes but with every country in the world except the United States driving its currency down to protect its industry, American earnings might take it on the chin a little harder than most people expect.
The situation in China is another wild card. That country probably will perform well over the long haul. But most countries in early stages of development experience a variety of booms and busts. And it looks like China could be in for at least a modest pullback. The realization might be postponed for a year as the old government exits the scene in October, ideally on a positive note. But significant adjustments appear to be in the cards. All that might not have a material effect on U.S. corporate profits. But it isn't likely to have a favorable one, either.
If earnings stall it's hard to see U.S. stock prices advancing sharply across the board. They might, if it's just a brief slowdown in growth, not a reversal. Still, our advice is to focus on high potential growth companies that are capable of producing superior results even if the overall economy flattens out. P/E multiples are a little on the high side now, fueled by the Federal Reserve's easy money policy. Worthwhile gains remain possible, nonetheless. And the companies we focus on here are likely to reinforce their competitive advantages in today's uncertain business climate, laying the foundation for even larger gains ahead.