Corporate earnings season is almost over in the US and what companies have said about how much money they’ve made shines a light on the direction of the market, because corporate profitability is the main driver of stock prices.
And so far, helped by a favourable business environment and no signs of a recession, the direction of corporate earnings growth is reflected (albeit somewhat giddily in the price of some) in stock prices and its across a broad number of sectors.
Runaway tech sector is an example, Google and Amazon both traded at over a $1,000 per share in June and July 2017 respectively.
Stocks are currently expensive by any barometer of measure. Not just in the US, in Europe corporate earnings growth was seen as "running neck and neck with the healthy clip seen in the US" according to Reuters.
As in the US, Europe’s corporate earnings growth is against an improving economic backdrop. Confidence in future growth of European equities was underpinned by 25% profit growth for first quarter 2017 according to the FT.
Global scene looks good for corporate earnings
There are a number of theories for why the stock markets are hitting such highs. Thus far, in the context of economic and profit growth experts see justification in those prices and further, going forward there is an expectation of improving and accelerated earnings growth.
In October 2015, the Harvard Business Review described the exceptional favourable economic environment for the largest North American and European multinational corporations.
It claimed they had enjoyed "their longest and strongest run of rising profitability in the post-war era, thanks to an environment that has supported robust revenue growth and cost efficiencies."
According to HBR, since the 1980s corporate profits had surged to increase their share of GDP by 30%. In 1980, corporate profits grew from $2.0bn and 7% of GDP to $7.2bn and 9.8% of GDP.
Underscoring the health of corporate earnings, this season has seen the third consecutive quarter of earnings growth in the US. Brighter forecasts across the world for India, China for example, means that multinationals like McDonalds and Boeing are benefitting from a falling dollar
Up but only for so long
In Europe, it is hoped that second-quarter earnings will boost European equities which is seen as a laggard to the US.
Jonathan Stubbs, a strategist at Citigroup said recently in the FT in, "if second-quarter European earnings do deliver the double-digit profit growth that analysts forecast, it will keep the region’s companies on course for the first full year of earnings expansion for six years."
US corporates are in a sublime moment, which commentators call the “Goldilocks” environment. Goldman Sachs described the current climate as "Steady growth and a patient Fed represent a Goldilocks scenario for US equities.
Growth data has not been too cold, supporting S&P 500 EPS growth of 14% in 1Q and consensus expectations for 11% in 2017.
“Nor have conditions run too hot, causing a rise in bond yields that we expected would constrain equity valuations this year. The economic environment has proven just right..."
Investors look for ways to pierce their bubble
Of the more than 90% of S&P 500 companies already reported for the Q2 2017 season FactSet found that: "Of these companies, 73% have reported actual EPS above the mean EPS estimate, which is above the five-year average of 68%.
In aggregate, earnings have exceeded expectations by 6.1%, which is also above the five-year average of 4.1%. Due to these upside surprises, the earnings growth rate for the S&P 500 has improved to 10.2% today from 6.4% on June 30."
It would be natural to think that companies producing such an upside surprise would expect to be rewarded by a similarly upward trajectory in share price. But investors as the WSJ points out “are raising the bar for what’s enough to propel stocks higher.”
Companies in the S&P 500 that reported positive earnings surprises for the quarter actually saw a decrease in share price of -0.3% from an average two days prior to reporting actual results through two days following according to FactSet.
This is a difference from other FactSet research which showed for the past five years companies in the S&P 500 reporting positive earnings surprises witnessed an average +1.4% increase in price during the same four-day window.
All good things…
Equally in the headlines are warnings that the corporate earnings growth bubble is going to deflate in the near future.
A Bank of America Merrill Lynch fund manager survey showed a decline in the number of fund managers expecting global profits to improve over the next 12 months with only 30% believing this to be the case compared to 55% at the beginning of the year.
Resilient though the bull market has been forecasts are for it to be subdued going in to third quarter as analysts historically lower their expectations in the immediate run up to the reporting period.
Goldman Sachs says there are signals pointing to slowing growth and “the outperformance of strong balance sheet stocks in a 10%+ market rally is rare, happening only 5% of the time during the last 30 years, including in 2000 at the tech bubble peak.”
Optimism and pessimism two sides of one coin
S&P 500 level certainly speaks of optimism, as indexes continue to climb and hit record highs . However, there are signals coming to the surface to suggest equity investors believe the pace of economic growth and therefore corporate earnings may be slowing.
A record number of investors (44%) in the BoA Merrill Lynch survey considered equities overvalued. And more than half surveyed said internet stocks were expensive, 18% of investors thought they were bubble-like.
Over 80% of respondents thought the US is the most overvalued region for equities while only 18% thought European equities undervalued.
“Market vulnerability to profit weakness is very high,” said Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, “with investors’ perception of excess valuation coinciding with high global profit expectations.”
Ronan Carr, European equity strategist, added that, “With the allocation to Eurozone equities still near historical highs the pause in performance may last a while longer.”
Where does that leave corporate earnings barometer?
Historical trends are only guides to what will happen in the stock market. No one has yet invented a working crystal ball. So far, while the economic story still plays well for corporate earnings, the perfect scenario may come undone at the edges.
In January this year, 62% of investors expected global growth and that figure has dropped in June to just 39% suggesting that momentum has peaked.
Goldman Sachs says the Federal Reserve risks the possibility that wage pressures build and weigh on corporate profit margins.
If the above-trend economic growth continues Goldman Sachs says it will eventually push inflation higher which could prompt an accelerated pace of Fed tightening. Consequently, leading to higher bond yields that will reduce equity valuations.
So, while US equity prices will continue to rise, price gains will be slower than the pace of earnings growth as monetary policy and valuation multiples each normalise.
Strong earnings continue despite the failure of Washington, DC with its health law bill, and what looks likely to be drawn-out drama for the White House to push through stimulus measures such as corporate tax cuts and increased spending on infrastructure.
James Dimon, chief executive officer of J.P. Morgan Chase & Co. responds to a question during the Q2 earnings call and is more succinct: “We’ve been growing at 1.5% to 2% in spite of stupidity and political gridlock because the American business sector is powerful and strong and is going to grow regardless.”