How Corporate Earnings Power the Stock Market

How Corporate Earnings Power the Stock Market

  • 07.02.18
  • Markets & Investing
  • Article

Andrew Adams, CFA, CMT, Senior Research Associate, examines the current headwinds and tailwinds facing U.S. equities in the wake of high earnings growth.

To read the full article, see the full Investment Strategy Quarterly publication linked below.

Typically, when a company’s earnings rise above the market’s expectations over time, its share price follows a similar path higher. And when this kind of better-than-expected earnings growth occurs across the majority of publicly traded companies, a bull market is often the result. A similar environment has been in place since the end of the 2008 financial crisis, with notable improvements in both the pace and quality of earnings growth occurring over the past two years.

An Earnings-Driven Bull Market

This positive backdrop for busi­nesses has been consistent with one of our major themes since 2016: An improving economy should transition the interest-rate and stimulus-dependent market to an earnings-driven secular bull market. Data confirm that both the U.S. economy and corporate earnings improved over this time period, which produced one of the best years on record for the stock market in 2017. The positive trend in profits does not appear to be slowing down. Twelve-month S&P 500 operating earnings growth hit its highest level since 2011 in the first quarter of this year and is projected to be even better over the next two quarters, according to consensus analyst estimates from Stan­dard & Poor’s (as of June 1). On the surface, this rosy outlook bodes well for the future, but sky high expectations have led many pundits to wonder just how much better things can get.

A Pause in the Ascent

Investors mostly scoffed at the impressive growth during the first quarter earnings season, a possible sign that optimistic sentiment had already priced in better profits. However, to be fair, after such a remarkable price ascent over the previous two years, including a 7.5% gain for the S&P 500 in the first few weeks of January, some sort of meaningful pause in the market was likely in order.

There has also been no shortage of headlines regarding global trade, rising input costs, ten­sion with North Korea, and potential political landmines both in the U.S. and Europe to further discourage investors from committing capital to stocks, despite the healthy earnings landscape. However, the resulting uncertainty could go a long way toward lowering investor expectations for the market in the months to come, setting the stage for upside surprise potential if things do not deteriorate the way many fear they will.

To be sure, the pace of earnings growth should slow down in future quarters. However, we believe the market understands this and does not expect 20% earnings growth to continue indefinitely. There is also a big difference between the pace of growth slowing and negative earnings growth. Even if S&P 500 operating earnings ‘only’ grow at 10% (the rate currently esti­mated for the end of 2019) instead of the more impressive pace seen in the first quarter of this year, it is still a very healthy growth rate that we believe can sustain the secular bull market. In fact, S&P 500 12-month operating earnings have grown at an average of 7.7% since 1990, so growth at a 10% clip would still be better than the recent historical average.

Future Growth Drivers

So, what can help keep the economic and earnings expansion going? Economic growth is generally defined as an increase in the real value of products and services produced over time. In simplest terms, this growth occurs because more workers become employed and/or existing workers become more pro­ductive. Since the end of the financial crisis, economic growth in the U.S. has largely been attributed to additions in the labor market, as the unemployment rate has steadily decreased since 2008. However, productivity growth has not been nearly as impressive and will become more of an issue now that the labor pool has shrunk. It is unlikely that the U.S. will continue to add workers at the same pace of the past few years, which means companies will instead have to focus on productivity growth to keep the wheels turning.

Tax Reform as a Wild Card

Last year, Washington bet heavily that lowering taxes, particularly on corporations, would lead to more business investment, higher wages, and, in turn, better productivity and higher consumer spending. Perhaps, more than anything else, what companies decide to do with their tax bill-boosted cash balances will determine how the U.S. economy performs in the years ahead. If companies invest wisely in proj­ects and M&A activities that will grow their businesses, and if wage increases translate into more consumer spending, the economy has the potential not only to keep growing, but maybe even grow at a faster pace.

Many critics of the tax bill, however, have voiced concern that any tax savings may be merely passed on to shareholders in the form of share buybacks and increased dividends, and we do expect these options to remain popular among companies. Buybacks, in particular, draw the wrath of many individuals. It is true that a disproportionate amount of tax savings going toward share buy­backs will not generate the long-term economic growth that investments in capital can. Still, keep in mind that buying back shares does help increase earnings per share and can be an attractive alternative for companies that do not feel they can generate high returns on internal or external investments.

Will the Trend Continue?

Investors are still gathering evidence of what companies are doing with their excess cash, but preliminary signs show some pickup in both business investment and wages. However, it is too early to tell if these trends are likely to continue, especially with respect to cap­ital expenditures since many companies may have simply put off making investments until the new year in order to take advantage of the tax incentives that were included in the bill.

Early evidence is promising, but we will need to watch these metrics closely in the coming months to see if companies are investing in the future and making productivity improvements a priority. If so, it will increase the chances of continued eco­nomic expansion while helping the stock market combat rising input costs and the higher expectations of today’s investors.

Read the full July 2018 Investment Strategy Quarterly
Read the full July 2018 Investment Strategy Quarterly

All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risk including the possible loss of capital. International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. The S&P 500 is an unmanaged index of 500 widely held stocks. It is not possible to invest directly in an index Changes in tax laws or regulations may occur at any time and could substantially impact your situation. You should discuss any tax or legal matters with the appropriate Past performance may not be indicative of future results.