US equities aren't as bleak as they appear Dark clouds appear to be gathering over Wall Street. The third-quarter corporate earnings season kicked off this week, and analysts are increasingly gloomy about the outlook. According to FactSet, a data provider, the estimated rate of growth in earnings per share (EPS) for the S&P 500 index in the third quarter is -2.7 per cent, following 11 successive quarters of growth. As a result, there are deepening fears that the mighty bull market in US stocks since early 2009 is in imminent danger. Projections of earnings such as these are watched and interpreted almost obsessively by financial reporters and investors alike. However, negative EPS forecasts may not be the harbinger of doom for equity returns that one might presume. True, lower earnings estimates for the S&P in 1990 and 2001 gave way to poor returns on stocks. But they were followed in 1991 and 1998 by more than respectable gains in the index. Miles Standish of Fisher Investments UK thinks investors are paying too much attention to data such as headline gross domestic product growth and earnings forecasts, and ignoring the data that really matters. He points to the fact that the US economy is growing faster in the right places, namely the private sector. Real business has been expanding nicely, a fact that often gets lost in top-line data that include the far less productive government sector. Corporate revenues have therefore been increasing much faster than GDP. Partly due to these factors, Standish and his colleagues at Fisher - a firm that has been notably optimistic on the outlook for some time now - reckon that the bull market in developed world equities "has a lot of room to run." Despite the overlooked positives for America's economy, US equities are not cheap, especially using longer-term valuation methods. The S&P trades on around 22 times of its average earnings for the last ten years (the "cyclically adjusted price earnings (p/e) ratio" calculated by Yale professor Robert Shiller). Only on five occasions in the past 130 years or so has it gone much higher than this, and deep bear markets ensued every time. Admittedly, the US market looks rather cheaper based on the forecast earnings mentioned earlier. Today's forward p/e of 13.1 times is below the average since 1985 of 15.1 times. The bad news, however, is that forward p/e multiples have little predictive power. Only a tenth of the variation in annual returns over time can be explained by reference to this ubiquitous metric. The current rating is also almost identical to that in the first quarter of 2008, after which the S&P suffered a 39 per cent meltdown. I do not envisage another such catastrophe any time soon, however. Aside from better-than-appreciated corporate fundamentals, the Fed's ongoing money-printing initiatives could play a decisive role. The third instalment of quantitative easing - nicknamed QE3 - may do little to help the real economy, but is likely to boost stocks and other risky assets. That is the clear lesson from the experience of QE1 and QE2, and from the European Central Bank's liquidity operations. The bears argue that there is one vital difference this time round. The first two phases of QE occurred while earnings and certain leading indicators of economic activity were in much better shape. But the gushing of the Fed's newly minted cash now faces a powerful counter-current. For what it's worth, though, my guess is that the influence of printed money will predominate in the near term. Yes, I know: a recommendation to keep faith with an overvalued stock market in the face of deteriorating fundamentals, and on the strength of monetary manipulation is not the most inspiring of rallying cries. I readily admit there is better value elsewhere, not least of all in our own FTSE 100 index. And even deeper discounts to intrinsic value are available in Europe and the emerging world. Still, while US equities may be somewhat expensive, they surely offer tremendous value compared to the main alternative. The 10-year Treasury note currently yields a pitiful 1.69 per cent. The last time long-term government bonds were this expensive was in the mid-1940s, just as a highly-indebted Federal government embarked upon the long process of inflating away its obligations. The parallel with today could hardly be clearer. The American public does not seem to share this view, however, at least judging by their allocations to mutual funds. The ratio of assets held in equity mutual funds compared to bond mutual funds is at its lowest level since the mid-1990s. After that, the S&P recorded several years of blistering gains, before peaking once the public had switched heavily into equities. Today's widespread bond fetishism therefore makes for another good reason to prefer equities. Dominic Picarda CFA is associate editor of Investors Chronicle. Watch his interview with Miles Standish on the IC website at bit.ly/Wjk2Ta