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A more robust U.S. economy could lift 2014 profits and boost corporate spending, giving some comfort to investors worried about bloated stock prices.
Faster economic growth should translate into better sales growth for the Standard & Poor's 500 index, and that has investors watching the coming fourth-quarter earnings reports to see if chief executives sound more optimistic—and if they plan on spending the gigantic pile of cash they are hoarding.
Fourth-quarter growth looks like it is going to be mediocre, but an unusually high level of profit warnings for the quarter could set the stage for companies to beat expectations that have been lowered dramatically.
For the S&P 500, fourth-quarter profit growth is expected to have increased 7.7 percent from a year ago, while revenue is expected to have risen just 0.4 percent, Thomson Reuters data showed.
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But it is the outlook for the rest of the year that investors will watch closely. An improved pace of hiring—December's weak, weather-affected jobs report notwithstanding—along with increased domestic energy production, appreciating housing and asset prices and less fiscal drag from Washington could help push 2014's growth toward a more robust 3 percent.
If that occurs, sales growth will rise as well. Analysts at Mizuho Securities noted this week that rising GDP is a good predictor of profit growth.
"I think there's a good chance you'll see expectations generally rising as the year progresses," said Carmine Grigoli, chief investment strategist at Mizuho Securities in New York.
Expected revenue growth for 2014 is currently 3.8 percent, according to Thomson Reuters data, after an estimate of just 1.8 percent in 2013, but some see it better than that. Goldman Sachs, for example, expects 5.1 percent growth thanks to economic improvement.
The historical relationship between the economy and profit growth suggests the expected economic pick-up could add between 3 to 5 percentage points to S&P profit growth, Grigoli said in a research note this week.
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That could also mean more growth could be coming from sales than in recent quarters, so companies will have to rely less on cost cutting to boost margins.
Analysts forecast companies to start signaling that they're ready to spend more on capital expenditures after years of caution on that front and an increase in deal activity and share buybacks.
"We would expect they would start to loosen their purse strings," said Karyn Cavanaugh, market strategist at ING US Investment Management. "We've had the fiscal cliff, the sequestration and the Washington shutdown, and the world hasn't fallen apart."
Buybacks and deals
Goldman Sachs analysts note that corporate balance sheets currently hold about $1.3 trillion in cash (excluding the financial companies). They expect big increases in buybacks and deal activity, but also see capital expenditures rising 9 percent in 2014, compared with a meager 2 percent rise in 2013.
The better outlook for profits should ease concerns that valuations have become stretched following last year's nearly 30-percent rally in the Standard & Poor's 500 index. The forward four-quarter price-to-earnings ratio for the S&P 500 is at the highest since the fourth quarter of 2008.
Some of the optimism has been factored into profit forecasts, with double-digit growth expected in both the third and fourth quarters of 2014, Thomson Reuters data showed. S&P 500 earnings growth for 2014 is seen at 10.8 percent, compared with 5.7 percent growth for 2013.
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Conservative outlooks by U.S. companies have meant reduced analyst forecasts for much of the past two years, even as the majority of companies have then exceeded weaker estimates.
In fact, the ratio of profit warnings to positive outlooks for the fourth quarter is the worst since at least 1996, based on Thomson Reuters data. There were 9.8 negative outlooks for every one positive one.
Expectations for robust growth may be premature as well.
Friday's U.S. payrolls reports, for instance, showed that U.S. employers hired the fewest workers in almost three years in December, though some economists saw the setback as temporary.
If the economy keeps pace with current projections, it could mean analysts have underestimated profit growth for the year.
"The market increasingly will be looking at top line revenue growth, and it wants to see expansion in the top line," said Quincy Krosby, market strategist for Prudential Financial, which is based in Newark, N.J.
Investors have been worried about how companies will be able to maintain profit margins. Net margins have been easing since 2011, according to Thomson Reuters data. They were at 9.73 percent in the third quarter of 2013, compared with 10.61 percent in the third quarter of 2011.