Don't expect the first-quarter earnings party to carry over into the second.
After a number of disappointing periods, bottom lines took off in the first three months of the year, up 14 percent on average for companies in the S&P 500. That was the biggest jump since the first quarter of 2011. That led a number of strategists to say the market run that started after Donald Trump was elected president was on solid ground -- justified by bottom lines and not just inflated by the hope of deregulation or tax reform.
That argument is going to get harder to make.
While second-quarter earnings will be up, they aren't likely to rise nearly as much as bottom lines in the first three months of the year. The result will be fundamentals that are less able to justify the market's current height at a time when Trump's pro-market policy agency seems more and more stalled. It's a bad combination.
Analysts estimate that profits from April to June rose 6.4 percent for the companies in the S&P 500 compared with those a year ago, according to FactSet. That would be less than half of the increase just three months ago. What's more, it includes an absolutely stratospheric 370 percent increase in second-quarter profits from energy companies, which were in a deep earnings slump a year ago. Exclude the energy sector and S&P profit growth drops to 3.7 percent. Analysts expect the slower earnings growth to continue in the third quarter, up just less than 5 percent, again excluding energy. They do expect double-digit growth again in the last three months of the year. But analysts' estimates are notoriously unreliable out more than a quarter or two. What's more, it's likely that some of that growth optimism for the end of 2017 still incorporates a tax cut or Trump policy move or better overall economic growth, none of which may materialize.
For investors, what matters most is whether the market is priced to reflect actual profit growth. If they assume overall profit growth sustains its first-quarter pace, then investors can continue to rejoice in a market that is trading at 19 times profits. A recent Goldman Sachs Group Inc. report showed that the market over the past decade has traded at about two times growth. Instead, if they assume the true earnings growth of the S&P 500 is more like 9 percent, which excludes the huge jump from energy, then the market's 19 P/E is less attractive. At the extreme, if profits grow at only 6 percent, which is slightly more than the 10-year average, and investors begin to focus on the fact that the S&P 500 is trading at 26 times its 10-year average profits, then the market party can end real fast.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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