Searching for Meaning in Missing Earnings Love

With just over half of S&P 500 firms reporting, Q1 2018 truly has been a banner quarter. Earnings are up 23.2% y/y as of last Friday, according to FactSet estimates, the fastest growth since Q2 2010. All 11 equity sectors have posted positive growth. Yet stocks have moved sideways, leading many to conclude the thrill is gone. Worse yet, some argue, earnings growth may have peaked, leading to worries over where we go from here. But here is the thing: This isn’t that unusual, and in our view, it isn’t cause for concern. Worries over the lack of a rise during earnings season seem like searching for meaning in sideways times—and a sign of weak sentiment, lowering the bar reality needs to clear to positively surprise investors.

One thing pundits worried over earnings’ lack of impact get right: Last year’s tax cut plays a role, both in elevating the growth rate and, likely, in the lack of reaction. According to an analysis in The Wall Street Journal citing Thomson Reuters data, almost half of earnings growth is due to Corporate America’s reduced tax burden. This was, of course, widely known—and unlikely to move markets now. That is exactly what we argued last winter in our Headlines section, when the common media narrative held that some portion of tax cuts’ allegedly bullish impact was yet to hit markets.

That said, tax cuts are at best only a fraction of the reason earnings are up. Even at half of Q1’s rates, earnings growth would still be fairly strong. Moreover, revenue growth—totally unaffected by taxes—is up 8.4% y/y in Q1, based on firms’ reporting through last Friday. This is the fastest since Q3 2011! Additionally, 79% of firms reporting earnings and 74% reporting revenues have beaten analysts’ estimates—far ahead of long-run averages.

So given this bullish backdrop, why haven’t markets moved higher? In our view, like the tax cut, it is because mostly rational markets pre-price widely held expectations. In this case, few if any analysts expected a “bad” Q1. So, starting some months ago, stocks began moving on those expectations. Today, stocks are more likely reflecting events somewhere over the next 3 – 30 months, with the greatest emphasis on the next 12 – 18.

But consider one important word we typed above: Markets are mostly rational—not perfectly so. In the short term, markets can sway on a wide variety of factors, including mass sentiment detached from reality. As Ben Graham famously put it, “In the short run, the market is a voting machine but in the long run it is a weighing machine.” It is a mistake to overthink short-term sentiment wiggles—which is exactly what we think recent sideways volatility is.

As to whether this is the best earnings growth markets should expect, that is irrelevant. As noted above, this quarter was the fastest since Q2 2010. In the interim, we have seen far slower—even negative—headline earnings growth. Yet the bull market persisted. Fluctuations are normal. A broad-based, lasting profit downturn could be troubling, especially if no one sees it coming. Gyrations in growth rates aren’t.

Ultimately, in our view, this all amounts to overthinking a lack of uppiness while firms report strong fundamental earnings growth. Ironically, this was all preceded by years’ worth of worries over high valuations. The 12-month forward S&P 500 price-to-earnings ratio, based on rising earnings and stocks’ back-and-forth start to 2018, is down from 18.5 in January to just over 16 now, in line with five-year averages.^[i] Look, we don’t put much stock in price-to-earnings ratios’ predictive power, but the fact the solution to high valuations is now widely seen as a problem tells you something about sentiment.