Personal Wealth Management / Economics

People Don’t Like Q2 Earnings, but Stocks Do

Earnings beat expectations, which is good enough for stocks.

Q2 earnings season is nearly over, and things are looking up! With 451 S&P 500 firms reporting as of 10:24 AM PST on Tuesday August 9, 71.6% have beaten expectations. Total earnings growth is negative for the fifth straight quarter at -3.5% y/y, but that's better than Q1's -6.7% y/y. Excluding the long-beleaguered Energy sector and its -82.1% y/y drop, profits in the other nine sectors are up 1.5%, rebounding from Q1's drop.[i] This is all good news. All of it. Really. Yet most observers don't see it that way. We're told earnings beat only because analysts ratcheted down their expectations too much. Or that companies are deliberately setting guidance lower so their pitiful results can look shinier by comparison. Or that we shouldn't get excited over Q2 since analysts now expect a Q3 drop. (Have fun squaring that with the first yah-but.) Newsflash: None of this is bad for stocks, which move on the gap between reality and expectations. All these negative interpretations are bullish, not bearish.

The naysayers' observations are fair enough. Companies do have a long history of dialing down their earnings guidance so they have a low bar to clear. Analysts have spent most of this bull market reducing their estimates as earnings season approached, and they indeed did so again during Q2. On March 31, analysts thought earnings would fall just -3.2% y/y. Fast forward to June 30, and they expected a -5.6% y/y drop. Now they're doing it again. On March 31, analysts pegged S&P 500 earnings growth at 3.2% y/y for Q3 and 1.3% for the year. Now, they see a -2% y/y Q3 drop and -0.3% y/y for the year.[ii] We wouldn't be shocked if those estimates fell further.

But this is all good for stocks, not bad. Seriously. Stocks don't move one-to-one with earnings. There is no preset relationship. Rising earnings aren't automatically bullish, and falling earnings aren't automatically bearish. What matters is whether the results-positive or negative-are a happyish surprise or a disappointment. If everyone expected earnings to soar, and they rose only a little, stocks would probably be unhappy. They would have pre-priced those lofty expectations, and unless they had every rational reason to believe gangbusters growth was truly around the corner, they would probably have to reset. Conversely, if everyone expects earnings to stink up the joint, and in reality they carry only a faint odor, stocks are generally relieved and happy. They priced in the overly dour expectations already, and less-bad-than-feared is a positive surprise. Positive surprises are bull markets' favorite underpinnings.

Not to pin market movement on any one thing, but since the first S&P 500 company reported Q2 results on June 28, the S&P 500 is up 9.3%.[iii] Obviously there was other stuff going on, like the post-Brexit bounce, but it also seems safe to say that if Q2 earnings were well and truly awful, stocks probably would not have topped 9% during earnings season. Negative surprises would have knocked them back. But Q2 earnings were a happy surprise. Analysts expected a big drop. In the end, they got a small one, which is fine. Earnings have fallen during prior bull markets, and the party has continued. It happened in the late 1990s, which were a marvelous time for markets. Stocks are resilient, forward-looking and efficient. Q2 earnings tally up commerce that happened between 1.3 and 4.3 months ago. To stocks, that is an eternity ago. They lived it and moved on. We don't mean to sound dismissive-it's just how markets work. Stocks today care about what's likeliest to happen over the next 12 to 18 months or so. Q2 is a footnote.[iv]

As for what's to come, we're mostly inclined to send thank-you notes to all the analysts who've cut their Q3 and 2016 forecasts. They're helping expectations stay low, making it even easier for "just ok" results to be a positive surprise for stocks. If they were raising the bar and stocks couldn't clear it, that would be bad. Their lowering the bar is a gift to the rest of us. It keeps sentiment in check, preventing markets from getting too far out over their skis. This is what you want in a healthy bull market.

Some pundits warn that without broad earnings growth, valuations like P/E ratios are getting stretched or (insert scary adjective here). We'd chalk this up as fear of heights, normal in maturing bull markets. Also normal in maturing bull markets: expanding valuations. It's a sign of investors' rising confidence, not bubbly sentiment. As bull markets progress, the scars of the prior bear market fade, and investors become comfortable paying more for future earnings.

The S&P 500's forward P/E is currently 17.09.[v] That's near its high for this bull market, set in early 2015. But it's also in line with late 2004, when there were nearly three more years of bull market left. And it's well below forward P/Es for much of the late 1990s. No level of P/E is inherently good or bad, as valuations aren't predictive, but P/Es do measure sentiment. When they have basically drifted sideways for 18 months, it seems hard to argue sentiment is suddenly now too hot.

Bull markets always have naysayers. If they didn't, we'd have another cliché besides "stocks climb a wall of worry." Clichés are born for a reason: Often, they're just true. So don't let this latest round of naysaying get to you. Embrace it for the bullish indicator it is.

[i] This and all preceding data are from FactSet's Earnings Scorecard, as of 8/9/2016.

[ii] Ibid.

[iii] FactSet, as of 8/9/2016. S&P 500 Total Return Index, 6/27/2016 - 8/8/2016.

[iv] We would have footnoted this, but we wanted to make sure you read it.

[v] FactSet, as of 8/9/2016.

If you would like to contact the editors responsible for this article, please message MarketMinder directly.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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