Are company profits really primed to keep climbing?
The earnings recession is a memory, and corporate profits are poised to keep advancing. Right? That's the Wall Street consensus. But a case can be made that the earnings turnaround won't be as robust or as lasting as this widely held viewpoint suggests.
"Profits will plateau this year, and some disappointments are coming" in particular companies' performances, said David Levy, chairman of the Jerome Levy Forecasting Center, a leading voice for the pessimistic side.
His assessment clashes with what most analysts project after first-quarter 2017 earnings for the S&P 500 rose 13.6 percent, according to FactSet research -- the best showing since the fourth quarter of 2011.
For the second quarter, which winds up in 10 days, FactSet estimates earnings will rise 6.5 percent, not as exuberantly as in the first period, though a solid showing. Many analysts expect the balance of the year will bring similar good tidings. FactSet calculates its consensus as 7.5 percent growth for the third quarter and 12.4 percent for the fourth, for a full-year profit increase of 9.9 percent.
For ordinary investors, the reason this matters is that the stock market often follows earnings trends. If earnings are declining, the market tends to slide as well. During the earnings recession, which ran for most of 2015 through mid-2016, the S&P 500 was flat. The worst of it, from a profits perspective, was in 2016's first period, when earnings dipped around 7 percent.
That slump, which interrupted an erratic, but generally positive, upward post-recession trend, mainly stemmed from a dizzying fall in oil prices. Thanks to a surge in U.S. fracking and Saudi Arabia's campaign to preserve its market share no matter what, an oil glut occurred.
This sent oil sliding from $110 per barrel in 2014 to $26 a year later. The damage spread far beyond the oil fields, into industries that service and finance energy. Overall, it produced five consecutive negative quarters for profits.
Then the major oil producers, particularly Saudi Arabia, reversed their policy of flooding the market with crude, and oil began to climb again. So last year's final two quarters were in the black, and in 2017's first quarter, earnings for the S&P 500 had that best showing since 2011's final quarter.
The rosy profit estimates of most analysts rest on low unemployment and wages that finally are going up. On the other end of the expectations spectrum, economist Levy doesn't believe the economy is heading into a recession, but simply that the improving earnings picture is about to be tarnished somewhat. His reasoning for that conclusion:
- While corporate profit margins are at 9.4 percent, they don't look so good when compared to stock prices. This metric, called return on equity, is down to 4.3 percent recently, from 8.3 percent in 2011, a signal that profits are not keeping pace with record-setting stock prices.
- Inventory expansion, designed to meet rising consumer demand, has given indications it's starting to slow, a signal that businesses expect consumer spending might ebb.
- Nonresidential construction -- meaning for business uses ranging from oil wells to warehouses -- is skidding again. Part of this is likely due to oil prices sliding below $50 per barrel, which has prompted a slowdown in new rig installations.
Certainly, the economy has a few other red flags that might give an earnings optimist pause. A big one is the continued anemic level of economic growth. First quarter 2017 GDP increased by just 1.2 percent, significantly below the 2.1 percent average since the end of the Great Recession in 2009. Once-strong automobile sales are slowing, and many retail outlets are suffering, largely at the hands of online sellers and from overexpansion.
Another note of caution is that oil is headed back down again. Since mid-April, the price per barrel has tumbled from $54 to just below $43. Even though this isn't as bad as the depths of $26 two years ago, it weighs on the stock market. In addition, the Federal Reserve's intention to keep raising interest rates might at some point tamp down the animal spirits that are needed to propel economic growth.
And whether a jolt of fiscal stimulus from Washington will arrive to boost profits anytime soon is unclear. In the first months after the presidential election, markets ascended amid hopes that Donald Trump would bring lower taxes and fewer regulations. The president has started to deliver on the regulations, although continued turmoil in Washington raises questions about taxes.
When House Speaker Paul Ryan, D-Wisconsin, vowed in a speech Tuesday to the National Association of Manufacturers and on Twitter that a tax overhaul was going to happen this year, the stock market shrugged. The S&P 500 fell 0.67 percent for the day.
Continued improved earnings "will be harder to show with slow economic growth," noted Michael Cuggino, president and portfolio manager of the Permanent Portfolio Family of Funds. Plus, the results for this year's last two quarters likely will not be as handsome as the first quarter's because they'll be compared to the two final periods of 2016, which were positive. "The comps will be tougher," he said.
Still, earnings may keep delivering happy news throughout this year. Philip Orlando, chief equity strategist at Federated Investors, points to even better economic news from Europe, which saw 22 percent earnings growth in the first quarter. A sizable chunk of S&P 500 companies get at least a third of their sales in Europe, which flows to these American corporations' bottom lines.
He also thinks the other problem, oil, is temporary. "Energy has taken its hit, and its correction is over," he said.
With the S&P 500 up just under 9 percent for the year, investors have reason to be happy and hopeful. The coming earnings reports will tell them if their good mood is justified.
