The Bull in the Wall Street Area. (Photographer: Michael Nagle/Bloomberg)

No Number Is Good Enough as Earnings Begin Badly for Bulls

(Bloomberg) -- While nobody doubts earnings are soaring, the question is whether they’re soaring enough to restore order in the stock market. And while there are signs investors expect them to, right now the verdict is worrying.

As of Monday morning, the impact of early income reports had been muted. Stocks were mostly falling after companies released results, almost regardless of how good they were. Among 29 members of the S&P 500 that announced earnings through Friday, even those that beat analyst estimates saw shares trail in first-day reactions, data compiled by Wells Fargo & Co. showed.

Bulls got a major affirmation Monday night, when Netflix shares jumped about 6 percent after the company signed up more subscribers than analysts forecast in the first quarter.

Still, should the trend hold, it would be bad news for anyone hoping earnings would calm markets where turbulence has by some measures doubled from the last two years. Jim Paulsen, Leuthold Group’s chief investment strategist, says the reactions are a sign stocks got ahead of themselves and remain overpriced.

“There is so much impression on Wall Street that earnings is what it will save us, and it’ll return mojo to the market. I’m less convinced,” Paulsen said in an interview on Bloomberg Television last week. “I very much agree that earnings are going to be spectacular. It’s just that we may have already been paid” through previous equity gains, he said.

Early returns show lackluster or flat-out bad reactions in what’s forecast to be the fastest earnings growth in seven years. The KBW Bank Index fell Friday, even after lenders such as JPMorgan and Citigroup exceeded analysts’ profit estimates. It trailed the market again Monday as results from Bank of America failed to impress.

Among S&P 500 companies that have reported this season, their stocks fell an average 0.7 percent on the first day after earnings, data compiled by Bloomberg show. Tech stocks fared the worst, with shares falling 3.6 percent despite better-than-expected results.

The market is set up for lousy returns with valuations as stretched as they are now, according to Paulsen. While the S&P 500’s price-earnings ratio has fallen after the February-March selloff, at 21, the multiple still sits in the upper range that corresponds to the lowest returns in data going back to 1950, a Leuthold study showed.

Another lingering concern involves the potential increase in labor costs. Paulsen developed a model that compares the nominal growth rate of the economy to the unemployment rate as a gauge of the tightness of the labor market. He found that equity returns have shown an inverse relationship with the measure. That is, the higher the reading, the tighter the labor market and therefore the worse stocks perform.

The pace of GDP growth just topped the unemployment rate for the first time during this bull market and Paulsen forecast that the spread may reach as high as 2 percent “before long”. Such readings have seen S&P 500 advancing at an annualized rate of 2.6 percent since 1950, down from 15 percent when the indicator showed negative readings, his study showed.

Stagnant wage growth has helped S&P 500 companies more than double their profits since the global financial crisis, propelling stocks to record highs. Now that the labor market is approaching saturation, the scope for earnings expansions is narrowing.

There is no question that this earnings season will at least meet expectations, thanks to tax cuts and economic growth, but investors should look deeper at the trend of profit margins for clues whether double-digit growth can sustain beyond the first half of 2018, said Mike Wilson, Morgan Stanley’s chief U.S. equity strategist.

“We will be watching for early signs of margin pressure this reporting season as we suspect that headwinds will not come all at once,” Wilson wrote in a note. “Robust earnings should help move the market higher, but watch for early signs of margin pressure as a harbinger of earnings growth deceleration later this year.”

©2018 Bloomberg L.P.

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