The Stock Market's Reaction to Earnings Is All Wrong
None of the excuses to explain the malaise in equities amid strong profits hold water.
It has become shockingly common this earnings season for companies to report better-than-expected profits only to see their share prices fall. There are many explanations but none make much sense, nor do they acknowledge the bright outlook for equities.
First-quarter earnings on average were forecast to rise by an exceptionally high 17 percent, so it might seem reasonable for investors to be disappointed with anything short of perfection. However, earnings are coming in close to a gain of 22 percent, so that theory doesn’t hold water. One might then reasonably infer from the share price declines that future earnings projections are being revised lower. Although Caterpillar Inc. did suggest the first quarter might be the peak for its margins, results were sufficiently strong that analysts revised up their estimates for the balance of 2018 and even 2019. There goes another theory out the window.
So to explain the market’s behavior, some analysts are suggesting the problem is that so much of the rise in earnings due to the decline in tax rates, which is nonrecurring, so it should be discounted somehow. This explanation is both wrong and incompetent. Unlike other periods when a company might see a temporary reduction in tax rates that artificially boosts results in one quarter that might be entirely reversed the very next quarter, this time the reduced tax rate is recurring. Moreover, every stock analyst understands this and has built a lower tax rate into their earnings forecasts for 2018, 2019 and beyond. In fact, that’s precisely why earnings were expected to rise about 20 percent this year, an extremely large gain at this late stage of the business cycle. Yet an incremental gain of 10 percent already expected for next year.
Another explanation suggests that stocks declined because the growth rate of profits will decelerate in 2019, which is another incompetent view. The 2018 tax reform resets the tax rate lower and resets the profit level higher. Another 20 percent gain on top of this year’s 20 percent increase was never in any analyst’s projections. Instead, it is impressive that analysts expect an incremental 10 percent rise in corporate profits in 2019 this late in the business cycle on top of the 20 percent jump gain projected for 2018.
Another widely expressed view is that stocks are historically expensive, so any retreat just represents more reasonable valuations. It has been repeated so often that it must be true, right? The data show the exact opposite.
The S&P 500 Index closed at about 2,663 on Friday. According to FactSet, projected earnings are $158.78 for 2018 and $174.89 in 2019. These numbers may be revised higher rather than lower after analysts recalibrate following the better-than-expected first-quarter earnings season in which 79 percent of firms so far beat estimates. The estimates indicate the market is trading at 16.8 times projected 2018 earnings and 15.2 times projected 2019 earnings. Those compare with the market’s average multiple of 16.7 over the past 50 years.
That average multiple was calculated over periods of both low inflation and low interest rates and high inflation and high interest rates. Since prevailing interest rates remain exceptionally low historically, a better comparison would be those periods when inflation was comparable to today’s rate of about 2 percent. In those periods, the P/E multiple for the market averaged around 19.5 times. On this basis alone, one should infer stocks are actually about 14 percent cheap and even cheaper based on 2019 earnings estimates.
Stocks react to multiple influences at any given time, and it is difficult, bordering on impossible, to assign blame for a sell-off to just one factor. The geopolitical situation remains highly uncertain. We hear about who’s sleeping with whom, or who’s lied to the FBI, or who’s paid off which political (or non-political) figure on the news every evening. That’s distressing. After a superb 2017, some increase in volatility and retrenchment seemed inevitable.
But much of this is just noise to the economics of business. The economy is healthy and growing, profits are rising nicely, and stock valuations are actually fair or below appropriate levels. Interest rates are rising, so some stock volatility should be expected and, of course, stocks have never been known to be stable. So the best explanation might be that’s it mostly noise. Market psychology can greatly affect stocks in the short run. Nonetheless, the values are there, and it’s reasonable to expect another leg up for the bull market.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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