The US earnings season has begun. Analyst expectations are low, with stocks forecast to post their fifth consecutive quarter of lower year-over-year profits. Nevertheless, last week the S&P 500 broke out of a lengthy trading range to hit fresh all-time highs. Is the current market advance unsustainable?
The link between earnings and stock market returns is more tenuous than one might think. Markets look forward rather than backwards, so it’s not uncommon for stocks to gain when earnings are stagnating or to decline during periods of strong earnings growth.
Still, many investors did not anticipate that indices would break out of the trading range that has constrained stocks over the past 18 months until tangible signs of a profits upturn emerged.
Last month, fund giant Fidelity said that for stocks to break out of their “bull market purgatory” – the S&P 500 had been rebuffed on numerous occasions since last posting a new high in May 2015 – one of two things would need to happen: for corporate profits to jump or for valuation multiples to expand higher.
The latter was deemed unlikely, given that stocks already looked pricey – the S&P 500 trades on 16.6 times earnings, according to FactSet, well above its five-year (14.6) and 10-year (14.3) averages.
However, the Brexit shock has resulted in a dialling back in expectations for US interest rate hikes, and global government bond yields have moved even lower.
"There's really no hope for yield in the fixed income market," says high-profile finance professor and market bull Jeremy Siegel. That will drive investors into stocks; Siegel thinks stocks could gain 10-15 per cent over the next six months.
The concern is that the Tina trade – There Is No Alternative to stocks in a low-yielding world – is driving already heady valuations to unsustainable levels. The S&P 500’s cyclically-adjusted price-earnings (Cape) ratio is now 26, its highest level since 2007.
Similarly, FactSet commentators are not the only ones to have noted that one-year price-earnings ratios are elevated. Last month, the Federal Reserve cautioned it had “increased to a level well above their median of the past three decades”.
Goldman Sachs, too, is concerned, warning the “more intense search for yield” is making pricey indices increasingly vulnerable to any sudden market shock.
Accordingly, an earnings rebound is needed to assuage valuation doubts and “really get the stock market going”, as Siegel puts it.
Wall Street game
Earnings are forecast to decline by 5.4 per cent, but the true figures are not likely to be that bad. About two-thirds of companies usually beat estimates due to the old Wall Street game of under-promise and over-deliver.
So, assuming current analyst expectations are too low, corporate profits could "feasibly get back into positive territory" in the current quarter, says Liz Ann Sonders, chief investment strategist at Charles Schwab.
Additionally, analysts are much more optimistic regarding the second half of the year. They envisage earnings to grow by 4.2 per cent over the following six months and by as much as 7.2 per cent in the final quarter of 2016.
Still, while companies usually beat earnings estimates, it tends to be by a modest margin. Over the past five years, companies have beaten estimates by an average of 2.7 percentage points, according to FactSet. The 5.4 per cent profits contraction envisaged by analysts may be too severe, but history suggests that profits will still shrink for the fifth consecutive quarter.
As for the second half of the year, analysts are typically too optimistic about medium-term profits. They only reduce their estimates in the weeks and months leading up to earnings reports; over the past five years, they have overestimated actual earnings growth for the second half of the year by 4.7 per centage points.
If this usual pattern is played out, then earnings will actually fall, not rise, in the second half of the year.
Can corporate America defy the doubters? Unlikely, says Goldman Sachs, which predicts that second-quarter sales will disappoint due to continued dollar strength that is “not fully reflected in consensus estimates”.
Technology companies, in particular, may be the bearer of bad news. Two-thirds of the growth in profit margins over the 2009-15 period came from the technology sector, according to Goldman, with a quarter of that expansion coming from a solitary company – Apple. However, Goldman expects Apple’s second-quarter profit margins to shrink.
Additionally, Goldman expects companies’ forward guidance to be “overwhelmingly negative amid Brexit uncertainty”.
The cautious tone adopted by management in post-earnings conference calls will lead to forward earnings estimates being reduced while global political uncertainty will also be a “key theme” that will dampen investor sentiment.
Bank of America Merrill Lynch is similarly wary, warning that Brexit-related uncertainty will result in dampened company guidance.
Earnings improvements
Nevertheless, bulls can point to some encouraging data indicating that the earnings recession is ending. The number of companies pre-announcing upwardly revised earnings is at its highest level in five years, while the number of downside pre-announcements is at its lowest level since 2011.
Earnings appeared to trough in the first quarter; indeed, estimates for the current quarter have been cut by just 2.8 per cent. (Over the past 10 years, notes FactSet, average downward revisions were almost twice as high.)
Cuts in third-quarter estimates have been lower again.
At Trinity Asset Management, Brian Gilmartin’s Fundamentalis blog closely details the changing earnings picture. He says investors have endured a Godot-like wait for an earnings upturn, but he believes profit growth is finally “poised to accelerate”.
Analyst revisions are typically negative until the quarter starts, argues Gilmartin, only to become uniformly positive when firms subsequently beat the same lowballed estimates.
Things are different this time around: analysts have been issuing upward revisions for many sectors since the start of April.
Furthermore, revenues for the energy and basic material sectors bottomed some time ago. Last year’s collapse in commodity prices saw both sectors’ profits tumble, driving down overall S&P 500 earnings. So their relative recovery will boost earnings figures.
The most bullish take, perhaps, comes from veteran strategist Richard Bernstein. In a recent note, he analyses how stocks typically perform in the year following a profits recession trough. Typically, indices gained about 13 to 15 per cent. This was not because valuation multiples expanded higher. (In fact, multiples typically contracted.) Rather, "earnings-driven bull markets seem to be the norm" in such environments, Bernstein says.
A similarly substantial earnings rebound is possible during the remainder of 2016 and into 2017, he adds, assuming that 2015’s “extreme events” – specifically, the US dollar’s 25 per cent appreciation from mid-2014 to late-2015, which crimped US corporate earnings – do not repeat.
There is always the possibility of “extreme events”, of course, and various strategists say that the dollar strength seen in the wake of Brexit could further hit US earnings.
Embrace caution
Nevertheless, Bernstein cautions against automatically embracing the thesis that overvaluation invariably leads to poor long-term returns. That often happens, he says, but not always. There have “been many periods in stock market history” when earnings growth improves and drives continued bull market gains.
With earnings season now under way, it should become clearer in the coming weeks if Bernstein’s thesis has merit.
If earnings disappoint, the sustainability of recent market gains would be rightly questioned; after all, the so-called Tina trade might well explain the recent ascent to all-time highs, but it would not justify it in the absence of fundamental improvements.
If a cyclical rebound in earnings is near, however, then the recent all-time highs may represent the start of the next leg higher, rather than the exhausted last breadth of a dying bull market.
