Peak Earnings Rattling Equity Investors; History Says Stay Calm

(Bloomberg) -- It’s probably time to declare peak earnings. Does that mean the stock market’s doomed?

RBC Capital Markets studied the previous five profit cycles and found that the strongest rate of growth was always followed by a period of lackluster equity returns. What happens longer-term comes down to whether growth actually contracts -- something not forecast for at least another two years.

Among the profit peaks in the past 25 years, two occurred right before economic recessions, in 1999 and 2006. Stocks eventually fell into a bear market as economic woes took a toll on corporations. The other three happened in 1993, 2004 and 2009, with stocks all falling in the following six months. Yet as earnings kept growing, even at a slower pace, the market recovered each time to post gains exceeding 12 percent two years later.

Peak Earnings Rattling Equity Investors; History Says Stay Calm

And while no one expects profits to collapse any time soon, companies that have beaten profit estimates have seen their shares rise by a paltry 0.2 percent on average, highlighting the importance of earnings at a time when the threat of 3 percent bond yield and rising commodity prices are keeping a lid on equity gains.

“Recently, commentary during earnings calls have caused investors to start worrying about a peak in margins due to wage and commodity cost pressures,” Lori Calvasina, RBC’s head of equity strategy, wrote in a note to clients Monday. “History suggests this would be a problem for stocks, but a short-lived one.”

That profit peaks don’t spell the death knell for stocks was echoed by a similar study from Morgan Stanley that went back 50 years and found that the S&P 500 posted positive returns 70 percent of the time after such an event, with median gains standing at 7.7 percent one year later.

Peak Earnings Rattling Equity Investors; History Says Stay Calm

While investors don’t necessarily have to exit stocks, strategists led by Mike Wilson urged them to cut risk. According to their study, the market was able to stay afloat when earnings decelerated, but leading the charge tended to be energy and defensive companies such as health-care and real estate, whose growth is less sensitive to economic swings.

“Peaking earnings growth does not mean it’s time to panic, but it does mean that defensive leadership plus energy should emerge toward the second half of 2018,” the strategists wrote in a note.

Caterpillar put a fine point on the idea that earnings growth peaked last quarter, saying its report would be as good as it gets this year. S&P 500 profits were forecast to rise at a pace of 22 percent during the first three moths of the year, the kind of momentum not expected to be repeated. At about 80 percent, the proportion of S&P 500 firms exceeding analyst estimates is higher than at any time in the past 25 years. First-day reactions have been weak.

“The market is treading water right now while looking for its next cue.” said Matthew Litfin, portfolio manager of the Columbia Acorn Fund at Columbia Threadneedle Investments. “That cue likely comes either from inflation readings as U.S. rates are raised, or from unanticipated geopolitical events unfolding in an uncertain and recently contentious global backdrop.”

The S&P 500 is little changed for the year after falling about 7 percent from its all-time high reached in January. While concerns over inflation and global growth linger, investors shouldn’t give up on equities yet because valuations are reasonable and profits will continue to increase, according to Lisa Shalett, head of investment and portfolio strategies at Morgan Stanley’s wealth management unit.

“We are not in the camp that these factors together signify stagflation, peak earnings or a market top,” Shalett wrote in a note to clients. “We continue to see markets powering to higher highs during the next six months on solid earnings.”

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