The first quarter earnings reporting period is going to come into focus in the coming week with earnings reports on Thursday from Citigroup (C), JPMorgan Chase (JPM), and Wells Fargo (WFC).
Those are some important companies, but when it comes to earnings, every company is important. Why? Because earnings drive stock prices.
The latter is a key fundamental tenet, which is why we quipped in a market view update last December that the stock market must have been riding in an autonomous vehicle in 2016. To wit, S&P 500 earnings growth was just 0.5% in 2016, yet the S&P 500 Price Index increased 8.5% in 2016.
In other words, earnings had little to do with the gains registered in 2016, which were a function predominately of faith in the Fed put for most of the year and faith in the Trump put late in the year.
That's why we smirk at the suggestion these days that earnings are going to dictate where this market goes in the near term. That strikes us as being only half right.
The fullness of market-driving expectations is currently rooted in political considerations. What's happening on the political front will dictate how the earnings reports and guidance from the first quarter earnings reporting period will be received by the stock market.
We feel blasphemous even suggesting that earnings aren't the most important driver of the stock market. Every now and then, though, the market puts its blinders on and runs on sentiment more so than earnings.
The most recent case in point was noted above, yet it bears reminding that the S&P 500 increased in price from the third quarter of 2015 through the second quarter of 2016. The distinguishing characteristic of that particular period is that S&P 500 earnings declined year-over-year in each of those four quarters.
The stock market's ability to trade up through declining earnings stemmed from the Federal Reserve's inclination to hold the fed funds rate at, or near, the zero bound and to provide an ongoing reassurance that it stood ready to provide added accommodation if necessary.
That inclination has changed somewhat in more recent months. Today, the Federal Reserve is talking more about tightening policy than easing policy, and it is doing so in the face of a strengthening labor market and rising inflation.
The stock market has reacted well so far to the change in the policy narrative because it recognizes policy rates are going up for the right reasons and expects the U.S. economy to strengthen further. The Treasury market, as we have noted before, hasn't traded with the same sense of assurance.
In any event, we can't dismiss the reality that the stock market has also drawn some comfort from the understanding that the earnings recession has ended and that analysts' average earnings estimate calls for some reassuring growth in 2017.
Down, but Up
According to FactSet, S&P 500 earnings are projected to increase 9.8% this year. It would be remiss not to mention that the average growth estimate was 11.5% on December 31. A similar downward revision has been made for the first quarter, which is projected to deliver 8.9% growth versus an estimated growth rate of 12.5% on December 31.
The S&P 500, as of this writing, is up 5.5% year-to-date, so it has effectively been increasing in the face of decreasing earnings growth estimates.
Its ability to do so has been helped in no small part by the market's faith in the prospect of tax reform being enacted this year, although it is only fair to concede the point that there is some enthusiasm for the understanding that the projected 9.8% earnings growth rate for 2017 doesn't include any allowance for the benefit of a cut in the corporate tax rate.
The continued belief that tax reform will happen has helped the market steer through the downward earnings revisions, yet as we alluded to in our previous column for The Big Picture, there have been some interesting divergences in the stock market suggesting market participants aren't feeling as assured as they once did in the inviolable nature of the Trump put.
The latter is a psychological backstop for the stock market resting on the notion that the Trump Administration will see through tax reform, deregulation, and an infrastructure stimulus plan, and by doing so, it will invite stronger economic growth and stronger earnings growth.
The flattening yield curve, however, and the underperformance of the financial sector, the domestically-oriented Russell 2000, and the transports, has been a marker for some that speaks to a diminishing sense of faith in the pro-growth trade.
The inability of the House GOP to bring the health care reform bill to a vote was regarded as a setback since it exposed the understanding that comprehensive tax reform is unlikely to be achieved quickly or easily. Be that as it may, the S&P 500 is up modestly since that vote was canceled on March 24, which goes to show there is still an abiding hope in the tax reform effort, which has been the major driver of the post-election rally.
There are some geopolitical jitters in the mix, namely North Korea and Syria, that have created some anxiety for the stock market, mostly because they pose a risk to focusing on the tax reform effort, which brings us back to the first quarter reporting period.
What It All Means
In every earnings preview we provide, we always point out that the final growth rate tends to be two to three percentage points higher than the estimated growth rate in front of the reporting period. The fourth quarter was no exception. When we published our preview of that period on January 12, the projected earnings growth rate was 2.6%. The final earnings growth rate was 5.0%, according to FactSet.
Accordingly, with a current projection that first quarter earnings will be up 8.9% year-over-year, there is room for comfort for the market in the assumption that the final growth rate will be in the double digits and room for confidence in the understanding that 8.9% growth would be the highest year-over-year growth since the fourth quarter of 2013.
For good measure, first quarter revenue growth is expected to be up 7.1%, which FactSet informs us would be the highest year-over-year growth since the fourth quarter of 2011.
The main point of consternation for the first quarter reporting period is the guidance that comes out of it. Based on FactSet's computations, second quarter earnings and revenue growth are expected to be 8.8% and 5.3%, respectively, with the energy sector setting the growth pace on both fronts.
With the market's valuation on the high side of things, it will be important for corporate America to sound an upbeat note for its earnings prospects, but it won't be paramount so long as the political narrative has a positive hue to it.
Coincidentally, Congress has a two-week recess starting April 10.
If corporate America expresses a general sense of caution about the outlook, which would be contradictory to elevated business confidence readings, it would provide some grounds for selling interest, but so long as there isn't any political upset, pullbacks related to earnings concerns are apt to be touted as a buying opportunity based on the narrative that better days lay ahead with a cut in the corporate tax rate.
Conversely, if the guidance is upbeat, it will help mitigate some of the valuation concerns based on the narrative that corporate America is faring just fine despite the stronger dollar and without any help from fiscal stimulus, which would just be the cherry on top should it come to pass as many market participants have envisioned since the election.
We cannot leave readers with the impression that earnings don't matter. They most certainly do. At certain times, they matter less, or more, based on outside factors that have a more powerful hold on market sentiment.
This stock market is gripped by politics right now and the tax reform process specifically. Because it is, expect the spin on the first quarter reporting period to be spun more by the political narrative and less by the earnings themselves.