The Big Picture

Briefing.com Summary:

*Strong earnings growth has fueled the bull market, but rising interest rates and narrowing market breadth present growing challenges.

*Sustained earnings growth is essential to offset higher interest rates and support valuations, particularly as earnings expectations remain elevated.

*Companies with strong balance sheets, healthy cash flow, and pricing power should outperform more interest-rate-sensitive businesses.

"This bull market should have more room to run if earnings continue to meet and exceed high expectations. If not, then the bull market may just be put out to pasture for a bit."

That was the conclusion to the Market View update we published in early July, which was just before the start of the Q2 earnings reporting period. Going into that reporting season, the blended earnings growth rate for the S&P 500 was 23.7%. At the conclusion of the reporting period, the earnings growth rate was 53.4%.

Not long ago, the S&P 500 and Nasdaq Composite hit new record highs.

It seems as simple as that: strong earnings drive a strong stock market. In some respects, it has been simple, but the move to record highs hasn't necessarily been easy. It has been an arduous affair, with rising oil prices and rising interest rates creating some doubt about the ability to sustain such strong earnings growth.

Those doubts have shown up more in the broader market than they have in the market cap-weighted S&P 500, which is dominated by its mega-cap components and has been enraptured by the AI trade. To wit: 53% of stocks in the S&P 500 are below their 200-day moving average. In early July, 65% of stocks in the S&P 500 were above their 200-day moving average.

This is a bull market, alright. It just isn't a market being overrun by the bulls.

A Rising Problem

The problem for many of the bulls out there is that interest rates have been rising. That is true for the policy rate and market rates. 

Stubbornly high inflation compelled the FOMC to raise the target range for the fed funds rate by 25 basis points to 3.75-4.00% on September 16. It was a unanimous vote, and the impression one has been left with is that the FOMC is not done raising its policy rate.

The fed funds futures market shows an 83.0% probability of at least a 25-basis point increase to 4.00-4.25% at the December FOMC meeting.

An axiom in the market is that you "don't fight the Fed." The inference is that the Fed's policy tinkering has a way of creating inflection points that, in time, end up being bad (raising rates) or good (lowering rates) for the economy and earnings growth.

Current economic data paint a generally good picture for the U.S. economy. The unemployment rate is a low 4.2%; initial jobless claims are below 200,000; consumer spending in aggregate is solid; and business investment has been turbocharged by the AI buildout.

The concern for some is that the best of times are over now that the Fed is raising rates; moreover, market rates have been responsive to the sustained inflation pressure, the rush of debt issuance to fund AI buildout plans, and the unrelenting increase in the national debt due to ongoing deficit spending.

To be fair, market rates have also gone up because the economy has been strong. No matter how one slices it, though, interest rates are higher. That raises the cost of financing, which can be a retardant for growth, and it raises the level of competition for stocks from risk-free Treasuries.

That understanding helps explain the multiple compression. Investors have become more discerning about how much they are willing to pay for future earnings, particularly when higher interest rates threaten to make those earnings harder to achieve. 

When the year began, the S&P 500 was trading at 22.2x forward 12-month earnings. Today it trades at 19.4x forward 12-month earnings, which is slightly below the five-year average of 19.8x and slightly above the ten-year average of 19.1x.

All Else Isn't Equal

This multiple compression is the result of earnings estimates going up faster than prices. The forward 12-month EPS estimate of $404.51 is up 31.1% since the end of last year versus a 13.3% gain for the S&P 500.

The estimate strength has been powered by the information technology, energy, and communication services sectors, with large contributions from semiconductor, integrated oil, oil refining, and social media companies.

More modest earnings growth, if any, has been seen elsewhere, which is why the specter of rising rates has, more recently, been weighing on the broader market. Higher rates, though, do not affect all companies equally. Neither does earnings growth.

Companies with strong balance sheets, healthy free cash flow, and pricing power should be better positioned to withstand a higher-rate environment. That favors select mega-cap technology companies, semiconductor manufacturers, energy producers, and industrial companies benefiting from infrastructure and power generation investment.

Conversely, homebuilders, real estate companies, smaller businesses with significant financing needs, and consumer discretionary companies dependent on credit-sensitive spending could face greater challenges. The distinction isn't simply between growth and value stocks. It is between companies that can sustain earnings growth in a higher-rate environment and those that cannot.

A stabilization or reduction in market rates, accompanied by continued earnings estimate increases, would be a welcome development. It could provide the foundation for a broadening of market participation, particularly among smaller companies and more economically sensitive sectors that have struggled to keep pace with the mega-cap leaders.

A sustained decline in rates driven by moderating inflation and resilient economic activity would be even more encouraging. That could invite some multiple expansion and provide relief to interest-rate-sensitive industries.

A decline in rates driven by rapidly deteriorating economic conditions, on the other hand, would be an entirely different matter. Lower interest rates would offer little comfort if earnings estimates were falling faster.

Similarly, another meaningful increase in rates, particularly one driven by inflation concerns, would likely put further pressure on valuations and raise questions about the durability of earnings growth.

In other words, lower rates aren't necessarily bullish, and higher rates aren't necessarily bearish. The economic and earnings backdrop matters.

Briefing.com Analyst Insight

Our market view is not that the bull market is destined to end because interest rates have gone up. It is that the bull market has become more dependent on earnings growth remaining strong enough to offset the headwind from higher rates.

That has been the winning formula thus far.

The S&P 500 has advanced even as its forward P/E multiple has contracted. Earnings estimates have done the heavy lifting, and the market has been rewarded for it.

The challenge now is that the earnings bar is substantially higher, market participation has narrowed, and interest rates have become more restrictive.

We expect that combination to produce a more selective market, with investors placing a premium on earnings visibility, balance sheet strength, and the ability to generate free cash flow.

That doesn't preclude further gains for the major indices. It does suggest that those gains could be harder to come by and that the performance gap between companies delivering on earnings expectations and those falling short could widen.

There is still room for this bull market to run. The economy is growing, employment conditions remain generally favorable, and earnings estimates are moving in the right direction.

Still, the market's margin for error has narrowed. Higher interest rates have raised the stakes for earnings growth, and investors are becoming more selective about where they place their bets. The bulls don't necessarily need interest rates to fall. They need earnings growth to hold up while interest rates are high. If that doesn't happen, there just might be a herd of bulls running to pasture.

--Patrick J. O'Hare, Briefing.com