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John Manley

That corporate magic is not dead yet

AdvantageVoice® Blog—5-13-13
John Manley, CFA, Chief Equity Strategist

“That old black magic has me in its spell. That old black magic that you weave so well.” —Johnny Mercer

“I am not dead yet.” —Queen Mary (spoken during her final illness)

The story is that the grand and redoubtable consort of King George V remonstrated her physician for turning his back on her as he left her sick room. He had assumed that she had passed on and believed that the honor was no longer necessary. When corrected, he turned, apologized, and bowed deeply.

I think that the cadre of experts who have persistently predicted a significant decline in S&P 500 Index earnings and the consequent death of the equity market might want to do the same.

Another quarter has come and gone, and corporate profits have yet to disappoint. While first-quarter revenue results were less than spectacular, earnings per share exceeded consensus expectations for 70% of the 80% of the companies that have already reported. Given the weakness in Europe and the uncertainty surrounding the budget issues in the U.S., it may seem like magic to the skeptical observers, but in my opinion, that is not the case.

It is neither deception nor sleight of hand. It is not the presentation of something that does not exist in reality. However, like any good magic trick, it is the result of deliberate planning and deft execution. Corporations are using low interest rates, share repurchases, and greater efficiencies to produce better earnings per share. Like anything else in this world, it can’t go on forever. On the other hand, I see no reason why it has to stop, either today or in the next quarter or even in the next year.

Critics are completely accurate when they say that, by any measure, current profitability levels are at or near 100-year highs. They are completely accurate when they demonstrate that those other periods of record-high profitability coincided with significant stock market peaks and immediately preceded major stock market declines. However, they are less than truthful when they neglect to point out that those prior peaks followed major economic expansions. They were moments of high employment, high capacity utilization, and strong pricing power. They were usually followed by a significant tightening of monetary policy as the Federal Reserve moved to restrain what appeared to have become a runaway economy.

Although there may be improvements in spots, I don’t think that any of the world’s economies are running away from us today. The forces that have driven corporate profits and profitability to current levels may, indeed, seem magical when compared with the prosaic economic forces at work in the past. However, they are no less real. In fact, they may prove far less ephemeral than the overheated economies that were the prior drivers. In addition, those other drivers may yet appear to exert their upward pressure on earnings.

Corporate earnings have used a new vehicle to ascend to lofty levels. That does not mean that they can’t use the old one to climb further still. I think that would be a pleasant surprise.

The views expressed are as of 5-13-13 and are those of Chief Equity Strategist John Manley, CFA, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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