Earlier this week, Fed Chair Powell delivered exactly what the stock market wanted him to deliver: an overt hint that the Fed is on course to cut the target range for the fed funds rate by at least 25 basis points at its July 30-31 FOMC meeting.
The Dow Jones Industrial Average, Nasdaq Composite, and S&P 500 all ran to new record highs following that hint, showing yet again how the stock market relishes the idea of easy monetary policy and the persistence of low interest rates.
Little else seemed to matter, but something else should soon matter: second quarter earnings results and guidance.
A Mini Recession
There have been a handful of reporters already, but starting next week, the stock market is going to have its hands full for several weeks digesting a steady stream of earnings news for the June quarter.
The first busy week of reporting will be dominated by financial, transportation, and manufacturing companies, as well as a handful of high-profile stocks like IBM (IBM), Netflix (NFLX), and Microsoft (MSFT).
Expectations are low going into the reporting period. According to FactSet, second quarter earnings are projected to decline 3.0% yr/yr. That is down from a projection of -0.5% seen on March 31.
The unmistakable irony is that the S&P 500 is at a record high despite the cut in earnings estimates and the threat of experiencing an "earnings recession" with a second straight decline in yr/yr earnings. It would only be a mini-recession, though, considering first quarter earnings declined by just 0.3%.
Nevertheless, earnings growth for the S&P 500 in the first half of the year has been elusive, partly because of tough comparisons, partly because of higher operating expenses, partly because of trade uncertainty curtailing business investment, and partly because of weakening global demand.
There are a lot of moving parts to the earnings picture; and it's fair to say that the stock market hasn't been moved so much by the first half earnings outlook as it has been by the second half earnings outlook.
The direct driver of the stock market, however, has been the persistence of low interest rates and the friendly reminder from the Federal Reserve that it stands ready to use its tools to keep the longest economic expansion on record going.
That friendly reminder has enabled the stock market to steer through the lack of earnings growth in the first half of the year, because there has been an assumption that the low interest rates, and dovish policy approach, will invite a stronger growth environment in the second half of the year and beyond.
If current estimates stay where they are, it's really the "beyond" where the meat of expectations lay. To wit, FactSet reports the consensus earnings growth estimate for third quarter earnings is -0.8% but then gives way to a hockey-stick ramp in the fourth quarter (+6.0%), first quarter of 2020 (+9.8%), and second quarter of 2020 (+13.5%).
Those estimates are not going to remain static, and if history is any guide, there is a greater probability that they will be revised lower rather than higher.
That will assuredly be the case if the trade deal standoff with China persists and/or new tariff actions are implemented. Conversely, a trade agreement could succeed in driving a more positive earnings growth outlook.
Q2 in View
Turning back to the second quarter, there have been a lot of warnings that have contributed to the downward consensus estimate revision. FactSet informs us that 88 S&P 500 companies have issued negative guidance, which is the highest number of companies since the first quarter of 2006.
The revisions have hit far and wide. The only sector that has not seen a downward revision to its second quarter earnings growth estimate since the end of the first quarter has been the energy sector. Hold your applause, however.
The energy sector is still projected to report a 5.2% yr/yr decline in earnings.
The sector sporting the highest estimated second quarter growth rate is the health care sector. Again, hold your applause.
The health sector is projected to report a modest 2.1% yr/yr increase in earnings.
The information technology sector will be one of the weakest areas, as second quarter earnings are expected to decline 11.9% yr/yr, according to FactSet. Hold your boos, though.
The information technology sector has gained 9.4% since the end of the first quarter while the health care sector has gained just 0.4% versus a 6.1% gain for the S&P 500.
Fortunately, things look better for the top-line growth outlook. Second quarter revenues for the S&P 500 are expected to be up 3.7%. While that is down from a 4.5% growth rate forecast on March 31, it is underpinned by expected growth in all but three sectors.
Strikingly, information technology (-1.1%) is one of those three sectors, which is the most influential drag there is. Energy (-1.1%) and materials (-15.0%) are the other two sectors.
What jumps out is that second quarter revenues are expected to increase, yet second quarter earnings for the S&P 500 are expected to decline. That is the crossroad to margin pressures.
What It All Means
This has been some year so far for the S&P 500. It is up 19.9% year-to-date and trading at a record high without any apologies -- or earnings growth to speak of in the first half of the year.
Falling (and low) interest rates have been the catalyst for multiple expansion. Currently, the S&P 500 trades at 17.1x forward twelve-month estimates, which is a premium to the 5-year average of 16.5x and the 10-yr average of 14.8x, as determined by FactSet.
We saw a footer in a CNBC segment recently that asked the question, "Can Q2 earnings justify the rally?" The answer is no, but the real question is, can the guidance justify the rally?
There is a lot of hope in the afterlife following the first half of the year. It's understandable, because hope springs eternal in a stock market that fears no evil with a Federal Reserve standing by its side.
However, if global economic growth isn't resurrected with rate cuts, and earnings estimates in the "beyond" don't measure up, the stock market would have to atone for some first-half excesses.