Despite 4 consecutive quarters of falling corporate earnings, U.S. stock markets finally set new highs after 15 months of trading in a narrow range. What will it take to keep the rally going? Most believe that earnings will need to at least level off and show signs of improving in the not too distant future to support continued stock market strength.
It’s still too early to tell how earnings will turn out this quarter, however, there have been slightly more positive than negative reports. This could signal that overall earnings are set to stabilize and possibly return to higher levels in coming quarters.
Walgreens and Pepsi opened the earnings season with slight beats on earnings, with Walgreens narrowly missing revenue projections, but Pepsi beating. Walgreens benefited from cost reductions driven by its merger with Alliance Boots, however, saw slower same-store sales growth lower than expected at only 2.4%. Pepsi befitted from higher margins likely the result of a productivity program, as well as, improving international growth.
Metals giant Alcoa and railroad CSX Corporation both beat on earnings and revenues. This is important as both companies are seen as harbingers of industrial activity. Alcoa’s metal production segment outperformed as it got support from aerospace contracts, indicating activity in that space. CSX’s earnings actually fell, but less than expected, as falling coal shipments (down 30% year-over-year) and flat oil shipments were offset by stronger than expected shipments of other goods.
Financial stocks are expected to be mostly neutral as low interest rates continue to weigh on the financial sector. JP Morgan did beat earnings and revenue estimates, however, as trading operations supported surged and loan growth grew by 10%. The loan growth is generally seen as positive, but it also could indicate that easy money is finding its way into higher risk loans. BlackRock met expectations as assets under management grew 4% to $4.9 trillion. Larry Fink however commented that clients “are facing unprecedented challenges as they attempt to navigate the current investment environment.”
Despite not finding any overtly terrible news so far, Goldman Sachs is warning to sell into the current market rally as they do not expect marked improvements in earnings soon. JP Morgan and others however disagree and are touting a large earnings rebound in 2017.
The key concern with those who are bearish on equities in the short-term is that equity price to earnings (P/E) ratios continue to climb as earnings fall faster than the number of shares in the market shrink due to corporate buybacks. Earnings and buybacks are linked in that corporations have a harder time buying back there shares if earnings are not strong.
What we can see by this dshort chart is that trailing price to earnings is not terrible. It's not good, but it's not terrible. If earnings do rise, the ratio could normalize. If earnings fall, we'll need to be even more careful.
According to Yardeni Research, the combination of buybacks plus dividends now exceeds corporate earnings. The result is that many corporations have borrowed to pay dividends and buyback stock this year. That is clearly an equation that cannot last. The last time that happened was 2007. Already corporate buybacks are forecast to fall significantly in the second half of the year.
If buybacks fall and earnings do not rebound, and the stock market continues to rise, then we would also see a continued expansion of P/E multiples. U.S. stocks are already richly valued at a current P/E of about 23. Despite being higher than average, we are not near 2000 or 2007 levels however.