• Although 1Q 2018 reported earnings growth has widely exceeded expectations, equity market returns have been subdued, at least until most recently.
• A technical breakout from the market malaise is appearing, potentially signaling a delayed earnings rally.
• Inflation prospects have diminished, indicating lower odds that the Fed will aggressively raise interest rates this year.
While 1Q earnings have been exceptionally strong, many market participants have been frustrated by the lack of gains that are normally associated with strong earnings growth. According to Credit Suisse, companies that have topped analysts’ forecasts on both earnings and revenues have outperformed by only an average of 0.70% from the time earnings were reported through May 11. Historically, companies that have beaten estimates have seen a stock price boost of about 2%. Simply put, earnings growth has been strong but market reaction has been muted.
Through May 10, 454 companies within the S&P 500 have reported first quarter results, with 76% surpassing analysts’ earnings forecasts by an average of 7.4%.This compares to three-year averages of 68% and 4.7% respectively. Overall, first quarter earnings per share (EPS) growth is on track to climb by 22.9%, which is more than the initial 16.7% forecast before the start of the earnings season.
Importantly, Credit Suisse notes that the recent tax law change is effectively adding 7.6% to
corporate bottom line results. Excluding the reduction in taxes, earnings growth would have been on pace for 15.4%. Looking at each sector, all 11 major sectors are projected to post double-digit EPS growth. As illustrated in the chart below, EPS growth is expected to top 20% for Energy, Financials, Industrials and Technology. Energy companies are contributing far more than usual to U.S. earnings this quarter, now that oil has topped $70 a barrel for the first time since 2014.
Another positive factor is that more corporations are planning to spend more on plant and equipment infrastructure, as company executives nearly doubled their announced investment spending plans during 1Q earnings conference calls. Analysts are increasing their so-called capex spending forecasts and note that technology and healthcare companies are showing the largest increases in planned expenditures.
While earnings have been strong, but largely unrewarded, equities have recently rallied. The rally was fueled by new evidence that inflation is not as rampant as many feared earlier this year. On May 10, the Bureau of Labor Statistics (BLS) reported that the Consumer Price Index (CPI) rose less than expected in April. The muted CPI increase, especially a tepid rise in core prices, indicates that the surge in underlying inflation during the first few months of the year has largely moderated. In turn, tame consumer inflation data suggests the Federal Reserve will likely not need to increase the pace of interest rate hikes.
Upon this more bullish backdrop, we also note that on May 10, the index closed above 2,700 for the first time in three weeks and in the process, crossed above its 50- and 100-day moving averages. This is considered a positive for equity markets. Moreover, in the chart below you can see that the S&P 500 has broken through the technical-based downward-sloping trendline that began after reaching its all-time high on January 26.
While we are perhaps in the later stages of the economic cycle, the economy remains on solid fundamental footing. Equity markets have seemingly not yet reacted as strongly to the better-than-expected earnings announcements, but this may be due to valuations being near 15-year highs going into the reporting season.
Looking on the positive side, while equity markets have not rallied as much as investors may have hoped, valuations (such as price-to-earnings ratios) have come down with earnings rising more than the price of stocks. This perhaps reduces some of risk in equity markets posed by higher valuations. While markets digest the multitude of global developments on economic and geopolitical issues, we once more stress the importance of working with your financial advisor to help navigate through heightened volatility and the ebbs
and flows of the various market cycles.
This report is created by Cetera Investment Management LLC
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