(Bloomberg) -- How important are profits? A cool 80 percent of S&P 500 gains have come during earnings seasons since 2013. Over that period, stocks had a perfect streak of rising whenever results were being reported.
That the streak ended in February with the most spectacular equity meltdown since 2011 was a reminder that the foundation isn’t invincible.
Indisputably, this will be another big quarter for profit growth. After President Donald Trump’s tax cuts, the expected gain in S&P 500 income stands at 17 percent for the January-March period, the fastest in seven years. It’s less clear whether it’s enough to restore order in the market. An identical improvement was under way last quarter when rising bond yields and signs of a trade war sent stocks into a correction.
“If we were to see another negative reaction to very healthy year-over-year growth, that’d definitely be a red flag,” said Charlie Smith, who helps oversee $2.5 billion as chief investment officer at Fort Pitt Capital Group in Pittsburgh. “It’s the old saying, ‘It’s not the news, it’s how the market reacts to the news that matters.”’
Bulls can find comfort in nearly unprecedented optimism among U.S. chief executive officers. Over 20 days through Monday, companies saying profits will beat analyst estimates exceeded those saying they’ll trail by 1.2-to-1. That’s the third-highest reading prior to the start of any earnings season in Bloomberg data since 1999.
Strategists from JPMorgan and Deutsche Bank have expressed confidence, citing everything from a weaker dollar to stronger global growth and buybacks as reasons S&P 500 earnings will surpass estimates by as much as 5 percent. That would be higher than the average margin of 3.1 percent over the past five years, according to data compiled by Bloomberg.
“Earnings have been a key catalyst,” said Binky Chadha, chief global strategist at Deutsche Bank. “The fact that much of the rise occurred during earnings season suggests ‘seeing is believing’ remains the norm.”
Others are less sanguine. Down 6.2 percent in the month before this week, the S&P 500 just posted the worst pre-earnings performance since the financial crisis. At 17 times forecast profits, stocks traded at the lowest valuations since early 2016, a sign that investors are reluctant to pay more for future income.
“There is a horrible aspect to the Street that we’re greedy and we want more and more, better and better,” Tobias Levkovich, Citigroup’s chief U.S. equity strategist, said in an interview on Bloomberg Television. “As soon as we don’t get it, we’re like spoiled brats and throw a tantrum.”
Another troubling development from last quarter: when companies beat estimates, their stocks saw muted rewards. They outpaced the market by less than 1 percentage point in first-day reactions, according to data compiled by Bank of America Corp. The punishment for falling short was more than twice as big.
The pattern is likely to play out again in coming weeks, Goldman Sachs strategists led by David Kostin said, warning that the downside risk for misses will be “substantial.”
“Positive 1Q surprises would confirm investors’ existing confidence in corporate fundamentals,” the strategists wrote in a recent note. “However, if 1Q results disappoint, fears about decelerating economic activity will compound mounting concerns around trade, regulation, and stretched positioning.”
Wall Street analysts are rushing to cut their forecasts for share prices just days before the start of first-quarter earnings season. Total downgrades on price targets for S&P 500 companies exceeded upgrades by almost 200 over the past week, the most since early 2016, data compiled by Sundial Capital Research and Bloomberg show.
It’s a drastic turnaround from January, when analyst optimism over their stocks’ 12-month outlook hit a record high. Back then, price targets were boosted along with an unprecedented stretch of earnings upgrades that were driven by tax cuts. Now, profit estimates have showed no signs of worsening, but analysts are turning sour on stock prices.
Is it a bad omen? Sundial looked at past instances when analyst sentiment deteriorated and found that such outbursts of bearishness actually boded well for equities. Since Bloomberg began tracking the data in 2010, the spread between price-target upgrades and downgrades dipped below -150 five times. On all but one occasion, the S&P 500 rose two months later, posting a median return of 6 percent.
“The message from Wall Street is a positive one for stocks, mostly because analysts have become so apathetic about prospects for earnings season,” said Jason Goepfert, president of Minneapolis-based Sundial.
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