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Investors are not rewarding American corporations for the best profits they’ve reported in years.
The second-quarter earnings season is underway, and the first reports look strong. So far, 87 percent of companies that have reported earnings have exceeded Wall Street’s estimates, well above the 70 percent average over the past five years, and FactSet is now forecasting that second-quarter profits for companies in the Standard & Poor’s 500-stock index will be up 20.8 percent from a year earlier.
This follows a first quarter in which profits ballooned by 24.6 percent and 78 percent of companies announced profits that exceeded analysts’ expectations.
Heading into 2018, many market watchers pointed to corporate earnings to explain their rosy outlook for stocks. Yet despite this performance, the stock market has been lackluster. The S. & P. 500 has gained 4.9 percent this year and is off 2.4 percent from its high, on Jan. 26.
So why aren’t stocks higher?
Rising trade tensions are perhaps the most obvious answer. While stocks haven’t tumbled as the bellicose talk has turned to action, the trade fights have created an unease that has weighed on the market. Laurence D. Fink, the chief executive of BlackRock, told The New York Times this month that concerns about a trade war were causing investors to withdraw money from the markets or choose not to increase their positions substantially.
The lack of excitement about the earnings surge shows up in stock movements. So far this earnings season, shares of S. & P. 500 companies that reported profits above expectations rose just 0.9 percent in the days surrounding the release of their results. During the first-quarter earnings season, shares of companies whose results topped estimates rose 0.2 percent, and those stocks even declined during the fourth-quarter reporting period.
So why aren’t investors rewarding companies? Expectations and valuation. Investors have already priced in big earnings from corporate America. The forward price-to-earnings ratio of the S. & P. 500 stands at 16.5, slightly above the 10-year average of 14.4. That valuation takes into account profits rising nearly 20.6 percent this year, the best annual growth rate since 2010.
With expectations already so high, there is little room for error. If the growth rate comes in lower than currently expected, the stock market will suddenly look overvalued in a bull market that is entering its 10th year.
The first-quarter earnings growth rate may have marked a high, in part because of the benefits of tax cuts. Although the tax legislation passed in December is certainly bolstering profits — profit margins are at a record high this year, according to FactSet — the positive impact on the earnings growth rate is expected to fade next year.
But the relationship between earnings and stock market performance is sometimes not cut and dried. Bank of America Merrill Lynch looked at 90 years of stock market data and found that the S. & P. 500 was slightly more likely to finish a year lower when earnings growth topped 10 percent than when it failed to reach double digits.
