The Profit Prophets Were Too Dour (Again!) in Q2

While most investors and financial reporters seem fixated on summer White House theatrics, Q2 earnings season is quietly wrapping up-and it was a doozy. With 472 S&P 500 companies reporting as of yesterday, Q2 earnings jumped another 10.3% y/y, confounding the many who expected a big slowdown from Q1's 13.7%.ⁱ Now pundits again warn the party is temporary, and that's just fine by us-it means expectations remain low and probably easy to beat. As Corporate America continues racking up profits and surprising the naysayers, we believe investors have plenty of reasons to become increasingly optimistic and bid up stocks.

When Q1 earnings soared, the popular narrative held that booming Energy earnings were the biggest driver and only temporary, so investors had better get ready for profits to come back to earth. So when Q2 ended, analysts expected earnings to rise just 6.4% y/y.ⁱⁱ Yet with most results in, 73% of S&P 500 companies have beaten expectations, greater than the average of 68% over the last five years. They've also beaten by more than usual-6.1 percentage points versus the 4.1 ppt five-year average.ⁱⁱⁱ Needless to say, this isn't an Energy-only story. Every sector except Telecom reported growth.

Earnings have long been healthier than advertised. It was just difficult to see because Energy's extreme moves skewed the headline number-first down, then up. When S&P 500 earnings fell for a year and a half in 2015 and 2016, Energy was the culprit. Only once in those six quarters did earnings outside of Energy fall. That broad strength is simply more visible now that Energy is in the plus column.

Or not. Surveys now indicate a majority of money managers expect an earnings slowdown and see it as an ominous sign for stocks. According to FactSet, analysts have slashed their Q3 earnings forecast from 7.0% y/y on June 30 to just 5.2% as of August 11. While some see this as prophetic, we see it more as a sign Corporate America's health remains widely underappreciated. Profit margins are generally improving, with 60% of S&P 500 firms reporting wider margins. Firms are increasingly efficient and better able to capitalize on sales growth.

Which is also robust. S&P 500 revenues grew a strong 5.2% y/y in Q2 (4.0% ex. Energy).^iv Analysts currently expect another 4.5% y/y in Q3.^v Revenues also massively beat expectations. Over the last five years, only 53% of S&P 500 firms beat sales expectations on average. In Q2, 69% beat. Hence, earnings growth isn't some temporary figment of cost-cutting. It is sales-driven organic growth, which usually powers earnings in maturing bull markets. When this happens, it can last quite a while. That few seem to see what's happening is a sign the future should have plenty of room to beat expectations.

This isn't the first time earnings have slowed or fallen and then rebounded well into a healthy ongoing bull market. Earnings contracted five straight quarters from Q1 1998 through Q1 1999 before storming back. The S&P 500 rose 21.0% that year.^vi Earlier in this bull market, earnings growth slowed to near zero in 2012 before powering back in mid-2013, a year the S&P 500 gained 23.9%.^vii

Such earnings rebounds drive improved sentiment as investors awaken to a reality better than they previously expected. Positivity becomes infectious when sentiment improves and animal spirits take hold. This time, the overly dour sentiment driven by Energy distortions suggests to us this bull market probably has much more life left than most appreciate.

[i] Source: FactSet, as of 8/11/2017.

[ii] Source: FactSet, as of 8/18/2017.

[iii] Ibid.

[iv] Source: FactSet as of 8/18/2017.

[v] Ibid.

[vi] Source: FactSet as of 8/17/ 2017. S&P 500 Total Return Index, 12/31/1998 - 12/31/1999.

[vii] Source: FactSet as of 8/17/ 2017. S&P 500 Total Return Index, 12/31/2012 - 12/31/2013.