Geneva, 5/02/2013 – Investors were relieved that the US Congress was able to come to a decision, albeit an acrimonious one, on the fiscal cliff.  The lengthily discussions over the fiscal cliff and super storm Sandy caused a drag on economic activity during the fourth quarter.  The initial fourth quarter GDP report revealed that the US economy contracted by 0.1% from a 3.1% expansion in the third quarter.  A 1.1% rise was expected by the market for the quarter.   Without robust economic activity the equity market is likely to be in a tug-of-war between earnings and valuation. 

From the nadir of 2009 profit margin expansion has been key to the recovery in the equity market.   Much of the profit margin expansion came from cost reductions as top line growth was minimal.  Without further margin improvements earnings growth is limited.  A sensitivity analysis of earnings suggests that a 50 basis point shift in average annual GDP growth translates into roughly $2.00 of earnings per share for the S&P 500.  However, the same 50 basis point shift in margins equates to nearly a $5.00 per share in earnings.

Data from the housing sector remains resilient, but unemployment continues to hover just under 8%.  In order to see the US equity market push significantly higher over the coming months, there needs to be a positive trend in earnings and margin expectations.  With the Institute for Supply Management’s index remaining above 50, the economy is still in an expansionary phase.  Thus there is the chance that positive trends on earnings could lay ahead, of course, barring no major collapse in other geographic areas.

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