Something very unusual has happened this year. We're not talking about the increased volatility, though that is unusual. Rather, we are talking about the dichotomy between the stock market and earnings growth estimates.
As one prominent economic adviser likes to say, "profits are the mother's milk of the stock market." We agree with that statement, yet the stock market to this point has acted as if it is lactose intolerant.
According to FactSet, the first quarter earnings growth estimate for the S&P 500 has increased from 11.4% on December 31 to 17.3% today. That's huge growth and a positive revision trend that should be good for the stock market, but thus far, the S&P 500 is down 0.8% for the year.
Granted the S&P 500 had risen as much as 7.5% at its record-high on January 26, yet that gain got washed away in a hurry amid a flood of concerns about rising interest rates and an unexpected spike in volatility.
By February 9, the S&P 500 was down 5.3% for the year. It has recouped a decent portion of that loss, yet it's fair to say the strong earnings growth estimates for the first quarter and 2018 have not been a cure-all.
The reason being is that market participants have been bothered by a sense that earnings growth is at, or very near, a peak as wage pressures build with the tightening labor market, protectionist trade policies are floated, and the Federal Reserve continues to raise interest rates.
Basically, investors have become less willing to pay up for every dollar of earnings than years past when they could rely on the Federal Reserve not to take away the punch bowl; hence, there have been multiple compressions even as earnings growth estimates have increased.
Too Much to Ask?
When the year began, the S&P 500 was trading at 18.3x forward twelve-month earnings, which was a 14% premium to its five-year average. Today, at 16.1x forward twelve-month earnings, it trades in-line with its five-year average.
Remarkably, the multiple compression has occurred in spite of the understanding that first quarter earnings growth, at 17.3%, is expected to be the strongest earnings growth in seven years.
What's more is that the projected growth rates for the second quarter (+19.1%) and the third quarter (+20.9%) are even stronger. For the full year, analysts are expecting S&P 500 earnings growth to be 18.5%.
Every sector is expected to report earnings growth in the first quarter.
The energy sector is going to set the pace with a forecast growth rate of 80.4%. The increase in oil prices and easy comparisons are behind the robust growth rate, yet seven out of 11 sectors are anticipated to deliver double-digit growth. It's eight if you round up for the health care sector (+9.7%).
Revenue growth will be strong, too, with a forecast growth rate of 7.3%.
The open question today is, have growth estimates increased too much?
Typically, one sees earnings growth estimates come down during a quarter, making it somewhat easier for companies to surpass earnings expectations. The final earnings growth rate for the S&P 500 is often two to three percentage points higher than the expected growth rate just before the reporting period begins.
In this instance, though, growth estimates have gone up -- way up -- before the start of the reporting period. That could make it more difficult for companies to surpass expectations when they report.
A "disappointment" could create an unfair impression that a company had a weak report when in fact it had a solid report that didn't live up to some unduly high growth expectations.
What It All Means
There is no mistaking that the healthy earnings growth projections have been overshadowed by the trade war talk and rumblings that the likes of Facebook (FB), Alphabet (GOOG), and Amazon.com (AMZN) could be subject to stronger government oversight.
Aside from that, widening corporate spreads, fading copper prices, a flattening Treasury yield curve, and a soft patch of economic data have added to the market's consternation about future earnings growth living up to the high expectations.
There will be great interest, then, in the first quarter reporting period. The real interest, though, will revolve around how the stock market trades during what is expected universally to be a good reporting period.
Does the good earnings news restore a more bullish-minded market outlook or does the market continue to be preoccupied with worries about rising interest rates and trade battles impeding growth?
That is the question, or, rather, this is: "Got Milk?"