Yes, Virginia, Earnings Do Still Matter

By the last week of April 2017, approximately two-thirds of the S&P 500 Index will have reported first quarter earnings.1 This earnings season will likely be highly scrutinized and dissected for the simple reason that it is the first reporting period within the new Trump administration. Not that the first 100 days of a new presidential administration could have any remote impact on the operating performance of any of the companies reporting this season, but that has never stopped pundits from putting together a good, salacious news story.

The story line for Q1 2017 will likely be focused squarely on whether the recent strength in the equity market can be justified by the earnings fundamentals underlying reported earnings performance. Admittedly, the equity market may have some performance to give back if actual earnings performance fails to exceed expectations, based primarily on the performance generated over the past 12 months characterized by the S&P 500 Index advancing just over 14% through March 31, 2017 (Figure #1).

Fig. #1
S&P 500 Index Price Performance (excluding dividends)
Trailing 12 Months through March 31, 2017

 

 

Source: S&P Dow Jones Indices LLC, S&P 500© [SP500], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SP500,
May 1, 2017.

One of the more striking data points in Figure 1 is that the S&P 500 Index had all but flat lined for the first seven months of the measurement period, only to experience a post-election inflection point on November 7, 2016, and advance nearly 11% through the end of March 2017. So, whether good or bad, the new administration will pretty much “own” the first quarter earnings performance.

Earnings Performance Supporting Market Values…For Now
Much of the attention in price returns for the S&P 500 Index over the past six months has focused on macroeconomic events, all as a result of a surprising change in power within the executive branch of U.S. government; pro-growth policies being proposed from the new administration; and seemingly pro-business majorities in both the U.S. House and Senate. Admittedly, some of the more anticipated proposals have either stalled during debate, such as health care reform, or have yet to be fully vetted, such as the recently proposed tax reform measures. Yet, both campaign promises remain highly anticipated by the market, so the market seemingly continues to discount the positive value attached to these pending proposals.

In response, equity valuation levels, as characterized by the S&P 500 Index, have exceeded multi-year highs. The price-to-earnings (PE) ratio on forward 12 months earnings reached 17.6 times as of February 17, well above the averages for trailing five-year (15.2X), 10-year (14.4X), 15-year (15.2X), and 20-year (17.2X) averages, and represented the highest 12-month forward price-to-earnings valuation since 2004.2 As Chris Gaffney illustrated last week, having price-to-earnings valuations at these levels seems to indicate that the market is clearly pricing in “earnings perfection” for the foreseeable future.

And, indeed, the earnings fundamentals underlying the market have, in many respects, been outperforming most expectations. Since year-over-year earnings growth in the S&P 500 Index bottomed during the first quarter of 2016, the market has shown consecutive improvements in year-over-year earnings growth that has helped provide a positive underpinning for equity market valuations (Figure #2).

Moreover, the equity market has exceeded earnings expectations in each quarter over the past two years. Nevertheless, the real trick for the equity market moving forward could be contingent upon continued underlying earnings performance.

Fig. #2
S&P 500 Index Price Performance (excluding dividends)
Trailing 12 Months through March 31, 2017

 

 

Source: FactSet. (https://insight.factset.com/earningsinsight_04.07.17),
May 1, 2017.

Watch For Marginal Improvements
It is reasonable for investors to become concerned with recent equity levels, as referenced above, and particularly so at these valuation levels. However, performance in the equity market is typically based more on the rate-of-change, or the second derivative in earnings growth, versus absolute values. In other words, it is the marginal rate of change or acceleration in earnings that investors should be focused on, rather than simply the absolute level of earnings growth.

Maintaining equity valuations at present levels will likely require a continuation of both year-over-year and quarterly sequential earnings growth for the first quarter 2017 reporting season. Based on initial first quarter 2017 S&P 500 earnings estimates, equity research analysts were predicting year-over-year earnings growth of 8.7%. Earnings at this level were taking into account the easy year-over-year earnings comparisons within the Energy sector, as crude oil was then trading below $30 per barrel for the first time in 13 years.3 Excluding the energy sector, first quarter 2017 earnings are anticipated to increase 5.1%, roughly in line with fourth quarter 2016 earnings growth. Needless to say, actual first quarter earnings performance will likely need to exceed expectations in order avoid an earnings-driven market correction.

At this point, earnings performance appears to be well on its way to exceeding market expectations. As of April 28, 2017, FactSet analysts predicted that the blended Q1 2017 earnings growth rate (which combines actual results for companies already reporting with estimated earnings growth for companies yet to report) would increase by about 12.5%,4 well ahead of initial earnings expectations that exclude the easy energy sector comparisons. Assuming final results match the current blended forecast, quarterly earning growth at this level would mark the highest year-over-year earnings growth since the third quarter of 2011.5

The acceleration in year-over-year earnings growth relative to expectations since March 31, 2017, can be attributed primarily to earnings improvements in five major sectors: Industrials, Financials, Consumer Discretionary, Information Technology, and Health Care groups.6 Importantly, four of the five sectors providing upside (all but Health Care) are considered early- to mid-cycle industries, or sectors that tend to outperform during periods of an improving economy. The fact that earnings performance is being confirmed by performance within some of the more economically sensitive sectors is yet one more positive data point that may help support market valuations.

Identifying a topping in equity market valuations tends to be more of a process versus the surpassing of any absolute level or valuation point, and investor concerns regarding lofty equity markets should at least ease somewhat assuming positive first quarter reported earnings continue to support higher relative valuations. That said, equity investors would be prudent to consider reviewing any portfolio allocation balances with higher equity levels to help identify positions that may have appreciated above positional threshold levels or risk allocations.

How much of a role do earnings reports play in your decision to buy or sell a stock in your portfolio? Let us know by posting your thoughts in the Comments section of our blog.

Until the next Daily Pfennig® edition…

Sincerely,
Tim Smith
Vice President
EverBank World Markets, a division of EverBank
1.855.813.8484
everbank.com