It’s All About Earnings

As I write, stocks are rebounding from a couple rough days late last week. The S&P 500 lost close to 2% on Thursday and Friday, which put the index at its lowest point since July 11th. I know what you’re thinking, and I agree. A 2% drop hardly qualifies as a sell-off. Yet given the lack of volatility we’ve enjoyed for most of this year, some people are getting nervous that last week’s action may be the beginning of the first correction (decline of 10% or more) in over a year and a half. The fears are being compounded by rising geopolitical risks, such as the situation in North Korea, intensifying trade rhetoric with China, and the terrorist attacks in Spain. At the same time, many investors have become fearful that President Trump is becoming increasingly isolated, which could imperil his chances of passing key pro-business initiatives such as tax cuts and infrastructure spending.

Yet once again, in a familiar pattern, investors are setting aside the extraneous risks and using the minor bout of weakness to add to positions. Sure, there was some encouraging news on the tax front this morning. Politico is reporting that Congressional Republicans appear to be reaching a consensus on key provisions of an impending tax reform proposal. While undoubtedly a good sign, it is still highly uncertain whether any forthcoming bill will get through both the House and Senate. The more likely reason that each and every minor dip is met with an army of eager buyers is corporate earnings. In the table below we show that earnings and revenue growth have been coming in strong over the past few quarters. Once it’s all said and done, earnings for the S&P 500 are likely to grow over 10% in the second quarter. Even more importantly, though, revenue growth looks set to grow at over 5% for the third consecutive quarter. Not too shabby, even if these results are heavily impacted by very easy comparisons in the Energy sector. And the consensus expectation is that S&P 500 earnings will grow in the double digits again in 2018.


Source: Standard & Poor’s

If current estimates for 2018 are to be realized (up 11% YOY to $145.59 per FactSet), the S&P 500 isn’t trading that far off historical averages at 16.8x.  But the big question is are 2018 earnings estimates realistic?  The biggest cost for most companies, labor, has been held very low for many years as a result of the huge slack in the labor market.  Now that the unemployment rate is down to 4.5%, most economists believe that labor costs are set to accelerate.  While this would be a good thing as it relates to the problem of economic inequality, it will also could be a rude awakening for companies accustomed to cheap and abundant labor.  But it is also true that the economy and corporations would could benefit from higher wages as the middle class gains more spending power.  In addition, a dramatic reduction in the corporate tax rate could more than offset an increase in labor costs.
So is the money correct in buying every dip?  It’s correct if the prices go higher.  Period.  Share prices have gone up with very few interruptions since March 9, 2009.  That’s a pretty long run.  When analysts try to determine if the earnings and balance sheets are properly valued, the consensus says share prices are fully valued but aren’t in bubble territory.  Price-to-earnings ratios for the S&P 500, a measure of relative value, are up almost 50% since the economic recovery began.  The economy is in pretty good shape, and the Federal Reserve seems to be moving cautiously.  Other than markets making new all-time highs, there are very few alarm bells ringing.  As such, we remain fully invested but defensive.  The question marks are many, but the risks increasingly appear skewed to the downside.