Fruitful Fundamentals

Now that the (probably long) wind down of the Fed’s bond buying program has begun, will this bull unwind with it? Many believe quantitative easing (QE) has been propping up markets—but we see little evidence. As we’ve discussed manytimes before, very few of QE’s new reserves have entered the real economy, never mind stock markets (which are an auction anyway—you don’t need new money for prices to rise!). Yet this bull marches on, suggesting something else must be propelling markets’ gains. Like a growing economy and private sector, led by strong corporations—which aren’t slowing down.

For the last four and a half years, the US has grown decently, though not robustly, and a key source of strength is Corporate America. Stocks represent a share of ownership in this—the earnings of publicly traded companies, which grew again in Q3. As of December 13, aggregate S&P 500 Q3 earnings per share rose +3.5% y/y, with 73% of firms beating expectations. While the headline number seems slow, as usual, it doesn’t tell the full story—growth rates varied from sector to sector. Consumer Discretionary led the charge, clocking in at +9.9% y/y. Technology and Industrials also came in strong at 8.1% and 6.6%, respectively. Only Energy was down, -8.2%. Financials were flat, but that number was skewed by a big one-off loss at one big US bank—not a sign of sector-wide weakness. Q3 revenue growth tells a similar story of varied growth. Aggregate S&P 500 Q3 revenue per share rose +2.9% y/y, slightly higher than Q2. Health Care and Consumer Discretionary led at 5.7% and 5.3%, and Financials revenues grew 2.4%.

While some might find these results a bit muted, in our view, they’re bullish. Earnings growth was never going to stay at double-digits for the whole bull—the longer this lasts, the harder y/y comparisons become to beat. But Q3 results confirm firms are still overall profitable and growing, and revenue growth defies all those who assume earnings are only growing due to cost cutting—an oft-heard objection from today’s skeptics.

Forward-looking economic indicators suggest growth should continue in the US and globally—even accelerate—supporting continued revenue (and earnings) growth from here.

In November, the US Leading Economic Index (LEI) rose +0.8%, its fourth consecutive monthly rise. LEI, comprised of 10 mostly forward-looking variables, is a very reliable predictor of economic trends in the near future. That it has steadily risen for a while bodes well—no recession in 50 years has started during a rising LEI trend. Its components paint an even brighter picture. A big contributor, once again, was the widening interest rate spread—an almost universally accepted bullish feature. A wider gap between short and long-term rates means banks’ lending margins are bigger, which encourages faster loan growth and more economic activity. More firms can access more money for growth-oriented spending, and the money they spend circulates throughout the real economy—boosting sales further up and down the supply chain. Though we don’t expect much in the near term, QE’s eventual end likely widens the rate spread more, driving even faster growth in the end.

Corporate America, the backbone of the US economy, is growing at a nice clip, and LEI tells us to expect more of the same. Yet very few expect this outcome—creating room for good fundamentals and fine earnings growth to positively surprise investors down the road. Indeed, analysts’ expectations for Q4’s earnings and revenue growth have dropped some since the beginning of the quarter.

In short, skepticism lingers, but it isn’t supported by past data or forward-looking indicators. It does, however, suggest we’re still near this bull market’s midpoint, giving stocks plenty of room to run before sentiment shifts to full-on optimism and eventually reaches its euphoric heights. Investors even just now recognizing the US private sector’s strength should have plenty of time to capitalize on future gains.