Over the past five quarters, corporate profits have been shrinking, but the stock market remains near all-time highs. This divergence can’t persist forever, and will eventually break one way or the other. The question is, which way will things go?
At the moment, it appears that earnings could be reversing course, which would provide a very helpful tailwind for equity prices.
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Before we get into the current earnings picture, it’s important to understand just how bad earnings growth has been over the last five quarters. We can see this in the chart below, courtesy of FactSet.
In this chart, S&P 500 earnings growth is shown in blue, with S&P 500 earnings excluding the energy sector displayed in yellow. Notice that from Q2 2015 – Q2 2016, overall earnings growth (blue bars) have been negative, but that the decline peaked in the first quarter of 2016.
That quarter seems to have marked the trough in this cycle, with declining earnings growth subsequently slowing, although still negative.
More importantly, if we look at earnings excluding the energy sector (which only represents 37 companies in the S&P 500), earnings growth only went negative for one-quarter – Q1 2016. The second quarter of 2016 already saw a rebound back to positive earnings growth.
So, where does that leave us now?
Coming into the Q3 earnings season, profits were expected to fall just over 2%. However, as noted in a previous article, actual earnings historically come in 2.8% above estimates. This meant there was a chance we could see earnings turn positive this quarter, and so far, that could still play out.
As of Friday, roughly a quarter of the S&P 500 companies have reported earnings, with the majority coming in above estimates. This pushed the blended earnings estimate for the overall S&P 500 up to -0.3%. A few more positive surprises could easily turn that figure positive.
And of course, if we exclude the energy sector, earnings growth is almost surely going to be positive and accelerating from last quarter. Right now, estimates for earnings growth excluding energy sit at 3.3%.
In this context, it makes a little more sense why equity prices have not fallen further during this “earnings recession.” The fact is, it’s been an energy earnings recession more than anything else.
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The good news is that now that the price of oil has been low for so long, and has stabilized, comparisons to prior year figures are starting to look more attractive. This means that very soon (possibly this quarter) energy could cease being a drag on earnings growth, and begin to contribute positively.
If that’s the case it would buoy the trend of accelerating earnings growth that we’re seeing across the other sectors, leading to solid gains in the quarters ahead. There are few things the market would like to see more than a resumption of strong earnings growth.
But we’re not out of the woods just yet.
If you recall, this plague in corporate profits had its roots not only in the collapsing price of oil but also in the strength of the dollar.
The massive dollar rally that began in mid-2014 took a little while to affect multinational corporate profits, but it’s been taking its toll. Subsequent dollar stability helped ease the situation, but recently we’ve seen another strong move higher in the greenback.
This chart shows the dollar rising sharply above its 50 and 200-day moving averages, which are also about to exhibit a golden cross (bullish formation).
In the short term, the dollar may be overbought and due for a pullback, but the broader economic landscape is supportive of further strength. This is primarily due to the US’s monetary policy path in contrast with other nations.
If the dollar continues to rally, expect it to once again to dampen corporate profits and put downward pressure on commodities, including oil.
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Also keep in mind that one positive factor behind the expectation for rising profits in Q4 and beyond has to do with oil remaining above a barrel. Right now, the 2017 estimates shown in the first chart are based on oil prices rising to an average of .88 in Q3 2017. Should that not come to pass, expect those estimates to come down.
Altogether it’s another case of give and take. Just as earnings are coming around, the dollar appears ready to try to thwart that move.
Wrapping things up, let’s take a quick look at The Conference Board’s Leading Economic Index. September figures were released last Friday and showed a 0.2% uptick. This follows a 0.2% decline in August.
According to The Conference Board, the strength in September came from positive contributions in building permits, the yield spread, and average initial unemployment claims.
Interestingly, the last six months have seen a reacceleration in the growth of the LEI, rising 1.1% vs. 0.3% during the previous six months. While the advances in the index have been choppier and somewhat reflective of a topping process, it’s comforting to see the LEI rising at an accelerating pace.
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This suggests that the economy should continue to expand through at least early 2017. And that, in turn, should be supportive of both oil prices and corporate profits.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
