The corporate earnings recession is officially over, but Wall Street’s celebration may be a bit premature. Although earnings are better than a year ago, they are likely not strong enough to support the stock market’s recent gains.
With nearly 99% of the S&P 500 companies reporting results for the fourth quarter, overall earnings per share are on track to rise 4.8% from the same period a year ago, on the heels of 2.9% growth in the third-quarter, according to FactSet. The estimate as of the start of the fourth quarter was 5.0% growth.
The two straight quarters of EPS growth effectively end a recession that started in the third quarter of 2015, after back-to-back quarterly EPS declines. Read more about the earnings recession.
The earnings recovery, coupled with hopes that President Donald Trump will fulfill his promises of tax cuts, a big boost in infrastructure spending and trade policies aimed at promoting domestic jobs, has helped propel a breakout rally in the S&P 500 index
to record highs. The S&P 500 has run up 11% since the election, and has produced 21 record closes since then.
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But unless Trump’s policy promises are fulfilled soon, the earnings recovery alone isn’t enough to hold the stock market at current levels, much less propel it to new heights.
Good, but not good enough
Earnings for the fourth quarter beat expectations, but by a lower margin than investors are accustomed to. Of the companies that have reported fourth-quarter results, 65% beat the FactSet EPS consensus, which is well below the one-year average of 71%, and shy of the five-year average of 67%.
Reported EPS are above expectations by an average of 2.0%, but that is well below the average beat of about 4.9% over the previous 11 quarters, according to data provided by RBC Capital.
And actual bottom-line results, based on generally-accepted accounting principles (GAAP), have trailed EPS based on non-GAAP measures, which companies often use to exclude certain expenses and losses, by the widest margin since the Great Recession, according to RBC Capital data.
Read more: Buffett, a longtime critic of nonstandard accounting metrics, called out by SEC for using them himself
Despite the lackluster performance, the S&P 500’s current bull market is on track to turn eight years old on Thursday, which would make it the second oldest bull market since World War II. But earnings have failed to keep up, making it the second-most expensive bull market in the past 70 years, according to Sam Stovall, chief investment strategist at CFRA Research.
On a trailing 12-month basis, using 2016 EPS based on GAAP, the S&P 500’s price is 25-times earnings, behind only the 30-times multiple recorded when the technology bubble burst at the end of the 1990s bull market, Stovall said.
What may be more concerning than current valuations, however, is how optimistic investors are that earnings will be great again this year.
“Investors remain encouraged…by a projected 11% increase in 2017 operating EPS, thus tracing out a ‘V-shaped’ recovery from the recent EPS recession,” Stovall wrote in a recent note to clients. “Plus, investors believe that this projected growth in EPS could end up being twice as high as current forecasts, should the Trump Administration be successful in cutting taxes and increasing infrastructure spending.”
See also: Investors may be banking too much on Trump lifting earnings
In addition, the negative-to-positive guidance ratio for the current first quarter is 2.0, meaning there have been two companies that provided EPS outlooks that were below consensus for every one company that provided an outlook that was above forecasts.
“However, that is less negative than we have seen since [the fourth quarter of 2011], and slightly below the average of recent years,” Morgan Stanley equity strategist Brian Hayes wrote in a recent note.
Should investors be buying Trump’s promises now?
One driver of the market’s rally is the expectation that President Donald Trump’s pledge to cut corporate and personal income taxes, resume and increase military spending and create jobs by repairing ailing infrastructure will spur economic growth and benefit stocks. Those hopes were boosted by his recent address to Congress, in which he promised to spend $1 trillion on infrastructure projects.
However, “as per usual, these speeches offer little in the way of specifics,” said Steve Reitmeister, executive vice president at Zacks Investment Research. “And indeed the devil will be in the details. So it is possible that when the government actually gets to work on these policies that it takes far too long and becomes far too compromised by special interests, that they lose much of their positive effect in the end.” Read more about what the lack of specifics means for stocks.
Analysts at CFRA agreed, noting that the infrastructure spending alone is expected to be rolled out over 10 years. The industrials sector, which enjoyed strong gains immediately after the November election, has underperformed the broader S&P 500 since the start of the year, as investors rotated into those sectors that were left behind in the period after the election to year-end. The S&P 500 industrials subsector
has gained 5.9% in the year so far, currently placing it fifth among all 11 sectors in the index.
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“What may be putting a cap on the industrials sector’s performance is the lack of clarity about how such a large spending program will be funded,” they wrote in a note.
Meanwhile, New York-based brokerage Convergex said an investor sentiment survey on the president found respondents taking a realistic view on how long it might take to enact corporate tax reform—not before end 2017 or 2018—and a wide spread of views on where the stock market will be by year-end. The average response was for the Dow to be at about 20,740, which is lower than today.
“Bottom line: the market may prove more patient than many market observers think possible, although our respondents also think volatility will remain muted,” said Nicholas Colas, chief market strategist at Convergex. “If they are wrong on that last point, all bets are off.”
Colas said the rally in stocks since the election and accompanying selloff in Treasurys “is a function of an especially complicated market dialogue.”
Trump’s challenge: Uniting GOP to back his agenda
President Donald Trump has laid out an agenda to overhaul health care, taxes and infrastructure, but internal disputes within the Republican Party could slow down or possibly derail his plans. Photo: Evan Vucci/Associated Press
The policy promises are weighing against the uncertainty about the timing and magnitude of any measures as well as what Colas gently describes as Trump’s “atypical” style of governing. The survey found 32% of respondents concerned about the potential for trade or currency wars and 31% worried that Congress will be unable to push through key legislation.
The three sectors respondents expected to benefit most from a Trump administration were financials, energy and industrials. Health care is expected to be most “challenged” by policy changes.
But the retail sector is already flashing signs of stress and is expected to replace oil-and-gas this year as most distressed sector, according to ratings agencies. Fitch Ratings said recently it expects the default rate for retail to jump to 9% this year from 1% in the last 12 months.
And Moody’s said the number of retailers ranked at the most-distressed level of the credit-rating spectrum has more than tripled since the Great Recession of 2008-2009 and is heading toward record levels in the next five years.
On Tuesday, HhGregg became the latest retailer to file for bankruptcy protection, dragged down by slowing traffic and competition from online sellers, including giant Amazon.com Inc.
. Amazon shares have gained 52% in the last 12 months. The S&P 500 has gained 20% and the Dow Jones Industrial Average
has gained 23%.
See: Number of distressed U.S. retailers at highest level since Great Recession