Why Super Earnings Won't Save The Stock Market

With stocks in retreat, many investors are hoping that a strong first quarter earnings season will restore confidence and reverse the decline. Indeed, analysts are projecting 17.3% year-over-year earnings growth for the first quarter, which would the biggest increase since the first quarter of 2011, according to data compiled by FactSet Research Systems, as reported by Barron's. Moreover, analysts  have sharply boosted those estimates from 11.4% at the start of the year, per both sources.

But fantastic earnings may not be enough to significantly lift stocks.

'Falling Valuations on Good Earnings'

 As Jim Paulsen, chief investment strategist at institutional research firm The Leuthold Group, told Barron's: "Last year was all about rising valuation on no earnings, and this year is all about falling valuations on good earnings. The market used up its excess valuation. We had 2% treasuries, 2% real growth and no inflation."

Despite rising forecasts of corporate earnings, all three major U.S. stock indices were down for the year-to-date through the close on April 2: S&P 500 Index (SPX), -3.4%, Dow Jones Industrial Average (DJIA), -4.3%, and Nasdaq 100 Index (NDX), -0.1%. All three reached YTD highs at the close on January 26. Their declines from that point are -10.1%, -11.2%, and -9.0%, respectively.

'Gangbuster Expectations'

Paulsen believes that those rosy earnings projections already are baked into stock prices. As a result, he finds a continued market decline much more likely than a rebound. "Just coming in as good as expected isn't going to do much," he told Barron's, adding: "Wall Street's got gangbuster expectations. It's a record-setting earnings year and a record-setting expectations year. If anything forces you to revise those expectations--even if the net result is a great earnings year but a little less healthy--it could be a really bad thing."

Peter Boockvar, chief investment officer at the Bleakley Advisory Group, shared similar opinions with Barron's. He said that earnings are merely catching up with expectations that drove price-earnings (P/E) ratios upward during the past five years, particularly in 2017. Ian Winer, co-head of equities at Wedbush Securities, hedged in his comments to Bloomberg: "We might see a positive surprise which will give the reason for a further rally, but what if the earnings disappoint? We'll have a problem here."

Looming Threats

Barron's indicates that investors are more worried now about rising inflation and interest rates than they are excited about earnings growth. The Consumer Price Index (CPI) registered a 2.2% annualized increase in February, and Paulsen predicts that it will hit 3.0% by the end of 2018, per Barron's. He also is concerned about the prospect of stagflation, high inflation despite economic stagnation, which may reduce corporate profit margins.

Not mentioned by Paulsen or Barron's is the growing threat of trade wars that may curtail economic growth while increasing prices to consumers and businesses alike. While investors appear to be factoring in this set of risks, it is unclear to what extent, if any, analysts and strategists are. Nobel Laureate economist Robert Shiller is among those who warn that the uncertainties being created are enough to spark a recession. (For more, see also: Why a Trade War Risks Economic 'Chaos': Shiller.)

The Bullish Case

Don Selkin, chief market strategist at Newbridge Securities Corp., remains cautiously bullish. As he told Bloomberg, "Yes, you have trade war issues, you have uncertainty around the tech sector, but if things stay where they are and stocks and the first-quarter earnings show solid growth, stocks will have a good reason to rise." Meanwhile, a survey of investors conducted by RBC Capital Markets in late March found that 45% are still bullish or very bullish about U.S. stocks, though a roughly equal percentage indicated that they have become less bullish since the start of the year, Bloomberg adds.

Another cause for bullishness is the expectation that corporations will increase their share repurchase programs significantly once they are permitted to resume them, CNBC reports. As noted in another Bloomberg story, corporate stock buybacks have been a major driver of share price increases during the bull market. Moreover, regulations force these programs to be suspended during the five weeks leading up to earnings announcements, and for 48 hours thereafter. (For more, see also: Stocks Poised for Bull Run in April Despite Monday Sell-Off.)

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